Should you avoid mutual fund IPOs?

e've been bomarding you with information on why you should not enter the stock market now, directly or via a mutual fund.

• What to do with your money

But new mutual fund schemes seem to be screaming at you to act otherwise.

If you can't figure out what to do, maybe this example will help.

Let's say a new fund called ABC hits the market.

A fund has many units, just as a company has many shares.

ABC is offering its units at Rs 10 each. This, the current value of one unit of a fund, is known as its Net Asset Value.  So the NAV of mutual fund ABC is 10.

ABC has decided to offer 10,000 units.

Since each unit is worth Rs 10, the total amount the fund will collect is Rs 1,00,000. (10,000 units x Rs 10 each = Rs 1,00,000).

This is called the corpus of the fund.

The fund invests this corpus in the stock market.

These are the shares it buys.

The corpus of the fund is now linked to the value of the shares it has bought. Thus, the NAV will now rise and fall, depending on the price of the shares. Here are two likely scenarios.

SCENE 1

Unfortunately, the bull run has peaked. The market begins to fall and share prices drop. The result: the NAV decreases. 

If you want to exit from the fund (sell your units back to the fund), you will have to do it at the NAV on that day. In the above example, you would get Rs 9.62 per unit. But you paid Rs 10 per unit to enter the fund. As a result, you lose money.

SCENE 2

When the market fell, you bought the units of the mutual fund at Rs 9.62. Now, the market has begun to climb. The NAV increases. What you bought for Rs 9.62 is now worth Rs 10.27.

Now, if you want to sell your units, you can sell them at Rs 10.27 and make money.

Moral of the story

If the bull run continued and the NAV kept increasing, you would have been able to sell your units at a profit. If the market fell, you would have to wait for the next bull run to make profit.

You would have got the best deal if you had invested when the markets dropped.

Lessons from history

We only have to rewind a few years. Remember 2000? It was the start of the millennium and trading started in January with the Sensex recording 5,000+ onwards till about mid-April.

That was when everyone was buying technology and dotcom stocks.

To capitalise on it, mutual funds launched sector-specific technology funds which would only invest in such company stocks. At that time, each unit cost Rs 10.

Take a look at their worth today.

Alliance New Millenium launched in January 2000. Its NAV on December 5, 2004, was Rs 8.32.

Prudential ICICI Technology also launched in January 2000. Its NAV on December 5, 2004, was Rs 6.31.

Kotak Tech launched in March 2000. Its NAV on December 5, 2004, was Rs 5.56.

DSPML Technology.com-G launched in April 2000. Its NAV on December 5, 2004, was Rs 9.85.

That is the problem when you chase shares whose prices are already up. When the market reverses direction, the prices head south.

Take a look at some of the share prices of the darlings of 2000.

Got the picture?

Please note, the above example of how a mutual fund works is very simplistic and has not taken into account additional money coming into the fund, additional units being added to the fund or fund costs.

As for the stock examples, neither bonus issues nor stock splits are taken into account. It is presented solely to indicate that the price of shares can zoom to astronomical levels during a bull run.

DON'T MISS!

• Where's the money going
• Make money with shares
• Make your money work for you
• Select the right mutual fund

Illustration: Dominic Xavier