Mutual funds: Why are market prices depressed?

Currently, the market prices of 28 (out of 35 closed-end) mutual funds in our two stock exchanges are trading below their net asset values (NAV). In most cases, the differences are slight, but in other cases they are significant. NAV comes in two varieties: cost and market bases. NAV calculated on market value will fluctuate more than NAV calculated on the cost price.    

This anomaly is a disincentive for issuers as well as investors and may even impede the healthy growth of the industry. I offer six plausible explanations.

First, a large number of retail investors play the market in anticipation of a rise in prices. When this happens, they sell the shares and pocket a tidy profit. However, this is not possible in the case of mutual funds principally because "pump and dump" schemes are not applicable here. As funds are organized as trusts, there is no scope for insiders or sponsor directors to engage in such nefarious activities. Moreover, funds being quite transparent, there is hardly any insider information to take advantage of.

Second, at inception closed-end funds had a ten-year life. This gave investors the confidence that they could recoup their money (NAV) at some determinate date in the future. But the authorities have extended the life of these funds for a further period of ten years. This immediately dampened prices because the redemption dates were pushed back.

Illustration: TBS

Third, if a fund has dud assets, its net asset value (NAV) will reflect this fact. Certain funds carry shares of disreputable companies. This means that these entities are loss-making or are stung by financial irregularities. Even if the funds try to paper over these weaknesses, the investing public will surely see this through.

Fourth, a certain class of capital market investors may be chasing yields. They may even have target yields. In case the actual yields on the mutual fund units do match their expectations, the units will be sold off exerting downward pressure on prices.

Fifth, investors seek a positive net present value (NPV) on their investment outlay. This simply means that the annual cash flows on a discounted basis should exceed the initial investment. Following this logic, if a particular unit price is found to be overvalued, the unit price will fall – ultimately leading to the desired level of NPV. But remember that the NPV is inversely related to the discount rate used. In other words, a higher discount rate will yield a lower NPV and vice-versa.  

Sixth, reinvestment risk is tied to redemption. To put it differently, as an investor, you may be unsure that on the day your money is returned whether equally attractive investment avenues are open or not. This fact may act as a disincentive.        

To round off the discussion, the law of supply and demand must be mentioned. Maybe there is an oversupply of mutual funds, at least from the perspective of asset managers who do not have the confidence of investors. 

The Author is a retired bank officer.

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions and views of The Business Standard.