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Low-NAV Fallacy

Investors' passion for new funds is a result of poor understanding and misinformation. A large number of investors still believe that a fund with a lower NAV is cheaper and therefore better

How do you think funds are born? I don't mean the legal process of filing with SEBI and the regulatory work, but the design of a fund-what kind of investments it will make, how much risk will it take and other things like that. How are funds designed?

In a perfect world, there would possibly be only two kinds of reasons that fund companies would have for creating new mutual funds. One would be new or changing customer needs and the other new or changing investment scenarios. For example, till a decade ago there were no cash or liquid funds in India. The underlying market in which such funds invest simply didn't exist. Come to think of it the typical customer of such funds-cash rich companies-also didn't exist in large enough numbers. Similarly, till four years ago, it wasn't possible to have a fund that invested abroad-the law of the land didn't allow it. One example of a fund type that I think is based on a real world customer concern is the so-called capital protection funds.

But we don't live in a perfect world and therefore, the reality of how funds come into being is very different. Fund companies are in the business of making money and the more money they manage the more they'll make. The simple fact is that new funds are created because they are easy to sell. However, the basic principles of marketing dictate that one has to differentiate between one's products. Therefore, funds are invented that are supposedly based on some theme or the other and can therefore be marketed aggressively as something special, something that is a different from other funds.

Investors' passion for new funds is a result of a combination of poor understanding and misinformation. A very large number of investors still believe that a fund with a lower NAV is cheaper and therefore somehow better than one with a higher NAV. By this logic, new funds at Rs 10 always appear more attractive. Take a look at our cover story Stylish Funds on page 30 to get answers to some questions about these 'thematic' funds.

The high-decibel advertising of new funds, coupled with the roaring markets creates a situation in which investors find it difficult to ignore new funds. The low-NAV-is-good fallacy has another bizarre effect-some investors seem to believe that selling an older fund which is at a higher NAV and buying a new one at Rs 10 is a form of selling high and buying low. Apparently, this belief is encouraged by many unscrupulous salesmen because it feeds on an idea that is perfectly valid while trading in equity. That investors are doing this is clear from the way the assets of older funds are shrinking even as money is pouring into newer funds. And since salesmen earn far higher commissions on selling new funds, no one has any incentive to give the correct advice to the investor.

What is sustaining this situation is that the long bull run has ensured that everybody is making money, whether more or less. Sure, those invested in badly managed funds are making less money than they could have, but they feel fine as long as they don't actually lose anything. The good part is that a lot of people are getting used to investing in stocks through mutual funds and since they are making money at least some of them will make saving and investing a habit. And the bad part that I pointed out above…well, the bad parts' effects will stay hidden as long as the markets keep moving along.