Should you invest in mutual funds with a low NAV?

How do you invest in mutual funds? And do you select mutual funds with a low NAV, assuming that they will have a higher upside potential?

Well, you are not alone. It is a common belief among investors that investing in a low NAV mutual fund will translate into high returns.

But investing in a mutual fund solely based on its NAV is not the right approach. To understand why you need to first know what exactly is mutual fund NAV and how it works...

The Net Asset Value (NAV) of a mutual fund scheme is the value of its assets minus liabilities, i.e., the net worth (also known as book value) of the scheme. In other words, the NAV of a mutual fund reflects the current market value of all the securities that it holds. This value is divided by the number of outstanding units (the number of units the scheme has issued to investors) to calculate the NAV per unit.

The NAV per unit of a mutual fund is calculated as below:

NAV per unit = [Total Assets – (Total Liabilities + Expenses)] / Total Number of Outstanding Units

Due to the dynamic nature of the stock market, the NAV of mutual funds fluctuates every day. All purchase/sale/switch transactions of mutual funds take place at the closing NAV of the scheme.

Why you should not go after a low NAV mutual fund?

It is vital to understand that mutual fund NAV is not similar to the stock price of a company. Unlike stock prices, where the demand and supply influence the price, a mutual fund NAV is not affected by the number of people entering or exiting the scheme.

As the forces of demand and supply do not affect the NAV of the mutual fund, a low mutual fund NAV does not mean that it is available at a bargain price, nor does a high NAV mean it is expensive. As mentioned earlier, it simply denotes the current value of all the securities the scheme holds in its portfolio.

A scheme could have low NAV if it has been in existence for a relatively short period of time. Notably, most schemes are launched at a NAV of Rs 10. Over a period, as the value of the securities in the underlying portfolio grows, the NAV of the scheme soars as well. This is why schemes that have been in existence for a long time, for instance, 10-15 years or more, and have performed well in the past have a higher NAV.

Let’s assume that you want to invest Rs 50,000 each in two Large-cap Funds that have similar portfolios. Fund A has a NAV of Rs 10 and Fund B has a NAV of Rs 50. At the time of investment, you will be allotted 5,000 units of Fund A and 1,000 units of Fund B.

If, after one year, both funds grow 10%, the NAV will be as below:

The NAV of Fund A will be 11, and the NAV of Fund B will be 55.

The value of your investment will be:

Fund A: 5,000 units x Rs 11 = Rs 55,000

Fund B: 1,000 units x 55 = Rs 55,000.

Thus, If two schemes (whether old or new) have invested in the same set of stocks with similar weightage, they are likely to generate similar returns. The NAV will not have an impact on its growth potential in any way.

Usually, schemes within the same category move in the same direction. But the actual growth of the scheme will depend on the weightage of stocks/sectors/market cap in the underlying portfolio and the fund manager’s investment strategy/style, and the overall market conditions, among other factors, irrespective of the NAV.

So while mutual fund NAV is a useful tool to determine how much your investment has appreciated in value, it does not indicate its future prospects.

Instead of assessing the mutual fund NAV, you should focus on the following parameters to select the high potential and best equity mutual funds:

1) Track record of performance

One of the most important parameters for selecting a winning mutual fund is determining how consistently the scheme has performed. For this, you need to evaluate the mutual fund's past performance over various time frames such as 1-year, 3-year, 5-year, since inception, etc., along with performance comparison across past market phases vis-à-vis its peers and the benchmark index.

Also, determine how well the fund has rewarded its investors for the risk they have taken by evaluating the risk-reward ratios, viz. Sharpe Ratio, Sortino Ratio, Standard Deviation, etc. That said, keep in mind past performance because it is not indicative of future returns. So, avoid giving too much weight or relying on past performance.

2) Portfolio Characteristics

As you may know, the growth potential of a mutual fund depends to a great extent on the quality of its underlying portfolio, i.e., stocks and other securities held. Therefore, determine whether the scheme is well-diversified across stocks/sectors and other securities depending on its investment mandate to avoid concentration risk.

3) Efficiency of the fund management team

It is always advisable to select schemes from mutual fund houses that have a superior performance record and follow robust investment processes with adequate risk management systems in place as opposed to giving much importance to star fund managers.

Moreover, because a mutual fund's performance is directly dependent on the ability of its fund manager/s, it makes sense to check the qualification and experience of the fund manager and the track record of the other schemes they manage.

To get the best out of your investment, avoid falling for the ‘low NAV = cheaper fund’ narrative. Instead, create a diversified portfolio of best equity schemes selected using the aforementioned parameters. More importantly, the scheme that you choose should be in congruence with your risk profile, broad investment objectives, financial goals, and time in hand to achieve those goals.

Happy Investing!

Above article is authored by Quantum.

View All