Why Looking at the NAV of Mutual Funds to Create a Winning Portfolio is Futile

August 2, 2022 Mutual Fund

Mutual Funds are a popular investment vehicle. But with a plethora of mutual fund schemes to choose from, it becomes a daunting task for investors to select the best schemes and create a winning portfolio. Very often investors look at the NAV of mutual funds to choose the best equity schemes. However, in my view, it is an imprudent strategy that can lead to sub-optimal choices.

Read on to know why the NAV of mutual funds does not make a difference to its returns potential.

But first, let’s understand what is the NAV of mutual funds…

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

Here is how the NAV of mutual funds is calculated:

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

Mutual fund houses disclose the closing NAV of each scheme after deducting expenses towards management, administration, and other costs, on a daily basis. All purchase and sale transactions of mutual funds take place at the closing NAV of the scheme.

Why you should not look at the NAV to select mutual funds

It is a common misconception among investors that a mutual fund scheme that has a low NAV will have higher growth potential. So, when a New Fund Offer (NFO) hits the market, many investors rush to buy it lured by the ‘Rs 10 NAV’ proposition. While doing so, they often disregard whether the traits of the mutual fund schemes and their envisioned financial goals and risk profile sync well.

But in reality, the NAV of a mutual fund is not similar to the stock price of a company. Unlike stock prices, where the forces of demand and supply influence the price, the NAV of a mutual fund is not affected by the number of people entering or exiting the scheme. Likewise, NAV does not tell if the fund is available cheap or expensive. It simply denotes the current value of all securities the scheme’s portfolio holds.

Generally, funds that have been in existence for a long time have higher NAVs, which suggests that they have performed well in the past. By avoiding a scheme that has a high NAV you may be penalizing it for its stellar performance record. That said, there is no assurance that it will generate good returns in the future either.

The NAV of mutual funds is a useful tool to determine how much your investment has grown in value, but it does not indicate the future prospects of a mutual fund scheme.

So, if two schemes have invested in the same companies with similar weightage, they are likely to generate similar returns. Their NAV will not have an impact on their potential in any way.

Table: NAV does not have an impact on the performance of mutual funds

Data as of July 29, 2022
Direct plan – Growth option considered. Past performance is not an indicator of future returns.
(Source: ACE MF) 

As we can see in the table above, there is a stark difference in the returns of some of the prominent schemes in the Large Cap Fund category, irrespective of whether the scheme has a high NAV or low NAV. This highlights that a scheme that has a high NAV does not mean it has reached a saturation point. Similarly, a low NAV does not mean it will generate higher returns. In short, the NAV should not be a criterion to compare the potential of schemes.

Furthermore, if two funds have a similar NAV, it does not mean that they will generate similar returns. At the most, funds in the same category may move in one direction; but the overall performance depends on how prudently the fund manager has played his/her role.

Consider another instance:

Say you have invested Rs 5,000 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. When you invest Rs 5,000, you will be allotted 500 units of Fund A and 100 units of Fund B.

Let’s assume in 1 year both funds have grown by 10%.

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:  500 units x Rs 11 = Rs 5,500

Fund B:  100 units x 55 = Rs 5,500

Thus, both the funds have generated similar returns irrespective of the NAV.

Therefore, it is wrong to assume that a mutual fund available at an NAV of, say, Rs 10 is cheaper than a mutual fund with an NAV of Rs 100 per unit. A mutual fund with a higher NAV does not mean it is expensive, just as a low NAV is not indicative that it is available at a bargain price.

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

1) Risk-reward matrix

Evaluate the mutual fund’s past performance as well as performance across past market phases and cycles when compared to its peers and benchmark index. This data will give you a comprehensive idea about how consistent is the mutual fund’s performance. However, avoid giving too much weightage to past performance because it is not an indicative of future returns.

Then determine how well the fund has rewarded its investors for the risk they have taken using risk-reward ratios like Sharpe Ratio, Sortino Ratio, and Standard Deviation over a 3-year period.

When short listing funds for your portfolio, give preference to those funds that stand strong on risk-reward parameters.

2) Portfolio characteristics

The performance of a mutual fund is extensively dependent on the quality of its underlying portfolio, i.e. stocks and other securities. A mutual fund scheme should be well-diversified across stocks/sectors/market caps/asset classes, depending on its investment mandate. Remember that a concentrated portfolio can expose you, the investor, to higher risk.

Moreover, ensure that the fund has a reasonable turnover ratio. High turnover can make a fund more volatile and also lead to higher expense ratio, which can impact the overall returns.

3) Qualitative indicators

Qualitative parameters are often overlooked though they are a vital aspect in the selection process. It involves determining the quality of the portfolio and the efficiency of the fund manager/house.

The mutual fund house should have a significant performance record and must follow robust investment processes with adequate risk management systems in place.

And because the fund’s performance is directly dependent on the ability of its fund manager, check the qualification and experience of the fund manager and the track record of the other schemes they manage.

4) Asset under Management (AUM)

The Mutual fund AUM, also known as corpus, indicates how big or small a scheme is. Do note that while a high AUM shows a fund’s growing popularity, it does not necessarily mean that it will translate into better returns. On the contrary, it may hamper the fund’s ability to perform.

A large corpus can make it difficult for a mutual fund scheme to actively manage the portfolio and time the entry and exit more efficiently, in line with changing market conditions. A Large-cap oriented mutual fund can still deliver decent performance despite its large AUM because large-cap stocks are highly liquid. But if the mutual fund is mandated to invest across market capitalisation, a large asset size may cause constraints as mid and small caps are less liquid.

Given the burgeoning size of some equity funds in India, it is best to assess the proportion of AUM actually performing.

Most importantly, the scheme that you choose should be in alignment with your risk appetite, financial goals, and investment horizon. Following these principles while selecting a mutual fund and it will surely help you to build a winning mutual fund portfolio.

This article first appeared on PersonalFN here