Why we should NOT focus too much on this very irrelevant metric - NAV


Posted By : Kushal Kothari
Tags :  direct funds funds NAV

Net Asset Value, or more commonly called as NAV. One of the most tracked, yet utterly useless, some might even argue dangerous, information about a mutual fund

 

Let's first talk about stocks. We know that a stock, say Reliance or HDFC, trades on the stock market and has its price quoted daily. Some day it goes from 1000 to 1100, and hence becomes more expensive. On other days, it goes from 1000 to 900, and hence becomes relatively cheap. A value investor is always looking for cheaper stock price to be able to get better returns. This is a very simplistic explanation about the price of a stock. But it's basically our understanding of what the stock price tells us.

 

Mutual Fund-amentals

A Mutual Fund, on the other hand, is a collection of various securities, i.e., stocks, bonds and other financial instruments. Instead of stocks, investors buy units, and instead of stock price, each unit has a NAV (Net Asset Value). However, what needs to be kept in mind is that unlike a stock, whose price is determined by the market, the collection of securities in a mutual fund is actively managed by a fund manager. The stocks/ bonds within the fund are changed as per their performance to ensure that returns are maximised.

To give an example, let's say a new mutual fund X is launched with Rs. 1000 from investors and invests half of it in HDFC and half in Reliance. The fund house then, arbitrarily, decides to set the NAV at the outset as Rs. 10 per unit. Correspondingly, a total of 100 units are distributed to the investors. Hence, we see that the NAV itself is set arbitrarily, and making any decisions based on this NAV are pointless.

In order to actually make a decision whether to buy or sell mutual funds, our old friend Returns (excuse the bad pun). In our example, we would determine whether to buy or sell more of X’s units based on the history of returns it begins to show. Also, unlike stocks, where the stock price could be a direct indicator of overpricing, the NAV cannot be used the same way for a mutual fund.

Suppose one year after the launch, the NAV has risen to Rs. 15 per unit. That’s a total of 50% return in one year. Does it mean that -
a)       The mutual fund has done well?

Answer - On absolutely basis, it looks good. Though one needs to analyse the historical trend of the fund’s returns w.r.t. other funds in the same category to ascertain it's relative performance


b)      Things are too expensive and it's time to dump and run? 

Answer - NO. As mentioned, there is a fund manager who actively takes care the portfolio of the mutual fund; for all you know, it is now holding SBI and Infosys, which may be reasonably cheaper and may give a further return. None of this is reflected in the NAV change from 10 to 15.
 

Sadly, for a number of years, we've had this mentality to buy what is cheaper. Hence year after year, Fund houses have traditionally launched hundreds of schemes, at a magical NAV of 10, which gives the false comfort to the investor of buying it cheap. Read an article by Economic Times which helps explain this in better detail.

 

DIRECT Hits

Let us now talk about REGULAR and DIRECT Mutual Funds. The main difference between the two is that there is a commission levied on the REGULAR Funds, while there are no such costs while purchasing a DIRECT Fund. Otherwise, there is no difference - both have the exact same portfolio and holdings.

When DIRECT schemes were launched (in 2013), both the variants had the same NAV. Since then, DIRECT schemes have given better returns due to savings in commissions, and hence have a higher NAV today. So if you switch today, you might well be trading a REGULAR scheme at 10, for a DIRECT scheme at 11. Does this mean you are buying an expensive scheme? Again, NO! Both have the exact same portfolio and exact same holdings. The only difference is you get up to 1.5% higher returns in the case of DIRECT ones. Read more from Value Research online here

 

In Summary,

1. Ignore the absolute NAV value. It means nothing!

2. Focus on returns. They tell you how good or bad the scheme is performing and if any action is required.

3. Don't worry about higher NAV while switching to DIRECT schemes. That's how it is supposed to be.

 

Hope this helps.

 

Happy Investing!