Investing in mutual funds? Avoid these two common mistakes

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What actually matters is what a mutual fund invests in and how the fund manager runs it.

An elderly gentleman, a retired military officer who was once my neighbour, has been asking me pretty much the same question for decades, “What are some good dividend-generating equity funds?” All these years, I’ve been explaining to him, as patiently as possible, that fund dividends are not really dividends, etc., but it hasn’t made much of a difference.

It took me a long time to understand that while I was trying to fill this vessel, a liberal supply of fund dividends were drilling holes in it. Eventually, I gave up on trying to explain this to him. He would receive dividends and reinvest them, doing no real harm to his investments. This worked fine until this year’s budget, when the new tax rules made dividends actively lethal for your equity mutual fund investments.

This dividend delusion is a very common one. The flaw lies in the fact that the basic terminology of mutual funds is needlessly confusing, even misleading. Terms like net asset value (NAV) and dividend don’t actually mean what a newcomer would assume they mean. This is an unfortunate reality which is not going to change soon. Therefore it’s better that we make an effort to understand what’s going on, rather than make bad decisions.

The problem with mutual fund dividends is that they are not dividends at all. To the investor, the word dividend brings to mind corporate dividends, which are indicative of how profitable a company is and how much of the profits are being distributed to shareholders. In funds, dividends are nothing like that. Instead, they are a withdrawal from your account.

If the value of your investment in a mutual fund is Rs 1 lakh, and the fund gives you Rs 5,000 as dividend, the value of your investment will be reduced to Rs 95,000. In the case of debt funds, what you will actually receive is Rs 3,558, because the fund would withhold 28.84% of the dividend and pay it as tax. No such tax was applicable to equity funds till this year. Now, even in an equity fund, there’s a 10% tax. Accounting for the surcharges, you will get Rs 4,353 as dividend while your investment goes down by Rs 5,000. Thus, it makes no sense to opt for a dividend plan.

If someone tries to sell you a fund with the lure that it pays lots of dividends, it’s a foolproof indicator that the salesperson is trying to misguide you.

NAVs are another problem. The first thing that a new investor learns about funds is that you buy a fund in ‘units’ and the price of each unit is called ‘NAV’. While buying anything else from shoes to cars, one always prefers a lower price. You are thus primed to accept the idea that a fund with a lower NAV is better because it’s cheaper. It’s possible, even likely, that you are being sold the fund by a salesman who is actively pitching a lower NAV as a reason to buy the fund.

This idea is completely incorrect. Low or high NAV is irrelevant in choosing a fund. In fact, this idea is so thoroughly wrong that it can serve as a good indicator for detecting a fund salesperson or ‘advisor’ who is deliberately misleading you. So remember this: anyone who is asking you to choose a fund because it has a low NAV is misguiding you, and you should not engage with such a person or organisation. Just as in the case of dividends, there are no exceptions to this rule.

What actually matters is what a mutual fund invests in and how the fund manager runs it. A fund with Rs 10 NAV and another one with Rs 100 NAV will generate the same returns if their portfolios are the same. The actual NAV and number of units you own are irrelevant. If a fund gains 20%, your Rs 1 lakh invested in it is going to grow to Rs 1.2 lakh. This could be 10,000 units at an NAV of Rs 12, or 100 units at an NAV of Rs 1,200, there’s no difference. So why is the NAV relevant? The only use of the NAV of a mutual fund is to compare it to its own earlier NAV, which is how one calculates the returns generated by a fund. Comparing the NAV of one fund to another is not just useless, it can actually lead you to make random investing decisions.

Both these misconceptions are extremely widespread, and yet the fund industry never appears to try and clear them up. I wonder what the reason could be.