Five Mutual Fund Myths You May Be Harbouring

With close to 38 Lakh Crores of assets under management, Mutual Funds are the perfect investing tool for those who do not wish to spend hours every week studying financial markets and managing their own portfolios. Having said that, there are a multitude of wrongly held beliefs that investors still harbour. Here are six of them to watch out for.

All debt funds are OK for short term investing: 

Contrary to the commonly harboured belief that all debt funds are suitable for short term investing, most of them are really not. If you have a time horizon of less than a year, you should ideally not look beyond liquid funds or ultra-short term debt funds. Watch out for a parameter called “modified duration” – if it’s anything more than a year, it’s not suitable for parking your short-term money, as the fund’s NAV could get materially impacted by fluctuations in bond yields. Any fund that falls under the category of “credit risk” or “corporate bond” should be invested with a minimum time horizon of 3 years. For dynamic bond funds and GILT funds, one should aim for a minimum of 4 years. 

Fixed Income Funds are meant to generate income: 

The nomenclature “fixed income fund” leads many an investor (and advisor!) to falsely believe that this category of fund is geared to generate income, monthly or otherwise. Resultantly, many investors are disappointed when they fail to generate income for themselves. In reality, income funds are a category of debt fund that generates returns mainly by accruing the “incomes” from their underlying bonds. In other words, they rely less on the capital gains arising from the potential changes in bond prices, and more on the regular coupon payouts being made by the issuers of the securities within their portfolios. Don’t invest into income funds with the expectation that they’ll be providing you with an income on a regular basis. In fact, by choosing the dividend option in these funds, you’ll be paying a hefty dividend distribution tax to boot; so, choose wisely. 

GILT Funds are Risk Free because they hold “government issued” bonds: 

GILT Funds or G-Sec funds invest their money into government securities. The nomenclature often misleads investors and clients into the fallacious belief that they are “risk free” in nature. This couldn’t be further from the truth. Although it’s a fact that GILT securities have very low default risk, their prices are heavily sensitive to changes in yields. Bond yields can move up or down depending upon sovereign risk or interest rate changes, among others. For instance, if the RBI were to raise interest rates, yields would go up in tandem and the prices of G-Secs would take a hit, thereby impacting the NAV’s of GILT oriented funds negatively. When S&P downgraded India’s sovereign ratings in 2009, GILT fund NAV’s sank like a stone, much to the consternation of debt investors who harboured the misguided notion that they were investing into a risk-free product. The worst year return for most top-performing GILT funds are worse than –15 per cent, so keep that in mind before you invest! 

FMP's provide a guaranteed return: 

FMP’s or “Fixed Maturity Plans” are a type of close-ended debt fund that invests money into bonds, with the intent of holding them to maturity. In this manner, they eliminate interest rate risk, and purely retain the default risk associated with bond investing. Perhaps due to the word “fixed” being present in their name, FMP’s have led many investors to believe that they provide a “fixed” or guaranteed rate of return. However, this isn’t true. Until 2010, fund houses could release data on “indicative yields”, which were, as the name suggests, indicative return that the FMP could provide, if none of the bonds in its portfolio defaulted. However, this practice was banned by SEBI in 2010, as many Advisors were misusing this information to tout FMP’s are a “Fixed Return” product. Bear in mind that FMP’s carry the risk of bonds in their portfolio defaulting, impacting their final rate of return.  

Dividends are amounts earned over and above your fund value: 

Each year, thousands of misguided MF investors select the “dividend” option of a fund over the “growth” option, due to the misguided notion that the former will provide them incremental returns over the latter, through dividend payouts. However, this really isn’t the case. Dividends are essentially nothing more than a chunk of your own investment, paid out to you by the Asset Management Company. After a dividend is paid out, the NAV (price of your units) falls by an extent that reduces your fund value by the amount of dividend paid out. For instance, if your fund value prior to the dividend payout is Rs. 1.2 lakhs, and the fund pays out a dividend of Rs. 20,000, the fund’s “cum-dividend” NAV will fall to the extent that your fund value will fall to Rs. 100,000!