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5 mutual fund myths busted
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September 19, 2007 08:25 IST

Mutual funds have witnessed a marked growth in popularity over the past few years. Statistics reveal that retail investors have increasingly warmed up to the idea of investing in mutual funds.

However, this has given rise to its own set of not-so-pleasant trends. It can be safely stated that there is a large amount of disinformation about mutual funds doing the rounds. And when investors act on such flawed information, it leads to incorrect investment decisions.

In this article, we debunk 5 popular mutual fund myths.

1. Equity funds do invest up to 35% in debt

Equity funds are commonly known to take on the mandate to invest up to 35% of their assets in debt and money market instruments. This in turn leads investors to believe that the fund manager intends to use asset allocation as a strategy for delivering growth i.e. investors expect the fund to capitalise on opportunities from both the equity and debt markets.

However, in reality, most equity funds rarely use the mandate to invest in debt. In other words, the intention is to be a 'true blue' equity fund that is almost entirely invested in equity instruments at all times.

Equity funds (if at all) invest a smaller portion of their corpus in debt and that to only with the intention of cutting losses in a falling equity market.

Clearly, benefiting from investment opportunities in the debt markets, by being invested therein at all times is not the intent. Investors who intended to invest in an 'asset allocation' kind of fund are likely to be disappointed by their equity fund.

The learning: Investors looking to invest in 'asset allocation' funds should consider investing in hybrid funds like balanced funds (usually 65% in equities and balance in debt) or Monthly Income Plans -- MIPs (usually about 20% in equities and balance in debt).

2. Funds with more stars/higher rankings make better buys

Often investors make their investment decisions based on the fund's ranking or the number of stars allotted to it. Fund rankings and ratings have gained popularity over the years; a higher ranking/rating is construed as a sign of the fund being a good investment avenue.

Sadly, what investors fail to realise is that often rankings/ratings are based only on the past performance on the net asset value (NAV) appreciation front; only some rankings/ratings consider factors like volatility and risk-adjusted performance.

Secondly, rankings/ratings are known to change over a period of time in line with a change in the fund's performance. Does that mean investors should start buying and selling a fund in line with a change in its ranking/rating?

More importantly, fund rankings/ratings operate on the rationale that one-size-fits-all. They fail to reveal who should invest in the fund.

For example, if an aggressively managed sector fund notches the highest ranking based on performance, will it make an apt fit in a risk-averse investor's portfolio? Clearly not! However, fund rankings and ratings do not convey this to the investor.

The learning: At best, rankings and ratings can serve as starting points for identifying a broader set of "investment-worthy" funds. But investing in a fund, based solely on its ranking/rating would be inappropriate. Instead, investors should engage the services of a qualified and experienced financial planner, who can help in selecting funds that are right for them.

3. Once a fund house makes the grade, so do all its funds

'One swallow does not make a summer' goes the proverb. Similarly, just because a fund house makes the grade, it doesn't necessarily mean that all its funds are worth investing in.

Typically, for a fund house to make the grade, it should be governed by a process-driven investment approach; also it must have a track record of delivering and safeguarding investors' interests at all times.

Investors often make the mistake of confusing the fund for its fund house i.e. they assume that simply because a fund belongs to a given fund house, it's worth investing in. Such an investment approach is far from correct.

It is not uncommon to find funds (from quality fund houses) that have either lost focus on account of persistent change in positioning or have fallen out of favour with the fund house itself, on account of their lacklustre investment themes. The result of the neglect (on the fund house's part) is visible in the fund's performance. Despite being exposed to the best of investment processes, such funds fail to deliver.

The learning: While the importance of the fund house is indisputable, the same shouldn't be seen as certification for every fund it offers. After passing muster at the fund house level, each fund must also prove its own worth, in terms of its investment proposition and track record across parameters.

4. A fund invests in the same stocks as its benchmark index

A number of investors believe that a mutual fund always invests in the same stocks that constitute its benchmark index. For example, if the BSE Sensex is the benchmark index for a fund, then it is expected to invest in the same 30 stocks that form the BSE Sensex.

This is true only in the case of index funds i.e. passively-managed funds that attempt to mirror the performance of a chosen index. In all other cases i.e. in actively managed funds, the fund manager is free to invest in stocks from within the index and without.

The benchmark index only serves the stated purpose i.e. benchmarking. It offers investors the opportunity to evaluate the fund's performance.

Generally, a fund's success is measured in its ability to outperform its benchmark index. Secondly, the benchmark index also aids in 'broadly' understanding the kind of investments the fund will make.

For example, a fund benchmarked with BSE Sensex or BSE 100 would typically be a large cap-oriented fund, while one benchmarked with S&P CNX Midcap is likely to be a mid cap-oriented fund.

The learning: Don't expect a fund to invest in the same stocks as its benchmark index. While the benchmark index can prove handy in evaluating the fund's performance, it certainly need not form the fund's investment universe.

5. The growth option is better as it delivers higher returns

While investing in a mutual fund, investors can choose between the growth and the dividend options; furthermore, within the dividend option, they can select either the dividend payout (wherein the dividend is paid to the investor) or the dividend reinvestment (wherein the dividend is used to buy further units in the fund, thereby enhancing the investor's holdings) options.

A common misconception is that, opting for the growth option is better, since it delivers higher returns. This fallacy is rooted in the difference between the NAVs of the growth and dividend options.

Investors expect the dividends declared till date to account for the difference between the two NAVs. On finding that the difference between the two NAVs is greater than the dividends declared, the conclusion drawn is that the growth option is better.

However, since the growth rate is being applied to different bases (higher NAV for growth vs. lower NAV for dividend), the eventual results (read NAVs) are different.

For example, assume a 25% growth being applied to a Rs 15.00 growth option NAV and a Rs 14.00 dividend (after a 10% i.e. Re 1.00 dividend has been paid) NAV. The resulting NAVs would be Rs 18.75 (for growth) and Rs 17.50 (for dividend); the difference between the NAVs being Rs 1.25 which is greater than the Re 1.00 dividend declared.

The learning: Don't select the growth option assuming that it will offer better returns. Instead, the investor's need for liquidity and his investment objective should play a role in deciding which option is chosen.

Attention NRIs! Here's how you can better the performance of your India portfolio. Read on...

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