Though popular, MFs are the most misunderstood investment instrument ever. The most common perception is that a scheme with a lower net asset value (NAV) is cheaper than one with a relatively higher one. For example, currently HDFC Equity Fund (face value `10) is quoting at an NAV of `288, whereas the latest new fund offer (NFO) is available at `10. Now, isn't buying something at `10 far cheaper than at 288? The answer is a resounding no. Understand why.

Take the example of two schemes. Scheme A has an NAV of 200 and Scheme B has an NAV of 10. Assume you are the sole investor in both and you invest `1 lakh in each. So, you will get 500 units of scheme A and as many as 10,000 units in Scheme B. Owning 10,000 units as against just 500 makes Scheme B look the cheaper and the better option. Further assume that both the funds invest in Infosys. A year later, say the Infosys share appreciates by 50 per cent. The adjoining table shows the change in your investment in both the schemes and the subsequent change in the NAV.

Both investments will make you equally rich; neither has an edge over the other. So, other things being equal, you should be indifferent to investing in either.

HIGH NAV

So are other things really equal? An already performing scheme has the advantage of demonstrated competence. Though the offer documents of all MFs have the statutory warning that past performance is no guarantee of future returns, astute investors know that ignoring history in the financial markets is akin to committing financial suicide.

Sceptics point out that the portfolio of a high-NAV scheme could be fully valued. So are schemes with NAV below par undervalued and indicative of a buy signal? These same sceptics would vehemently claim these are proven bad performers. The concern is that stocks comprising the portfolio would have limited upside from here onwards. Again, one should know that MFs are dynamic in nature. The fund manager must identify stocks that have future potential and get rid of those that are fully valued or expected to underperform.

TRACK RECORD

Most MFs send monthly or quarterly reports to investors. These reports give you an insight into the performance of the fund. Comparison of inter-fund performances becomes possible and, the investor can judge the future of the scheme based on current portfolio. The data supplied by the fact sheets facilitates any shift decisions, if necessary. All this data-based decisionmaking is possible only for existing schemes and not NFOs. It is impossible to assess the capitalised value of expected earning power. Therefore, the associated risk!

DIVIDEND YIELD

Another concern voiced by investors is that high NAV pushes the dividend yield down. True on paper, not in actual practice. Here, again, investors should judge the return on their investments on a total outflow-inflow basis. Dividend is just one of the components of inflow, the other one being the (appreciated) capital itself. Dividend is paid out of the NAV: the undistributed surplus forms a part of the capital. The MF being a trust, the capital, reflected by the NAV, also belongs to the investors.

SUMMARY

There is no difference between an NFO and an existing one. Each scheme basically invests in the stock market, choosing between large-, mid- and small-cap stocks. To make an MF investment work, look for consistent returns over the past three - five years.

Bottom line: In MFs, old is gold and the flavour of choice should be plain vanilla.