Lately, several mutual fund houses have been introducing NFOs, or New Fund Offers, into the market. An NFO is when a fund house launches a new scheme for us investors to put our money in. Subscriptions to an NFO run for a limited period, during which we can invest in the fund at a unit price of just ₹10. This low cost, though the attractive bit, isn’t the only factor to consider when investing in an NFO. An NFO is akin to an IPO, but not quite. Today we’ll explore why investing in NFOs isn’t such a good idea, and how they are different from IPOs.
Open-ended versus Closed-ended Schemes
Every mutual fund scheme that you have invested in has been an NFO when it was first launched. NFOs could either be open-ended or closed-ended. An open-ended scheme re-opens for investment after the initial subscription period. A closed-ended scheme however, closes when the stipulated number of units has been subscribed to or at the end of the subscription period. While open-ended schemes do not have any restrictions on redemptions, closed-ended schemes require a certain lock-in period, of say 3-5 years, before redemptions are allowed or on maturity of the fund.
A little background
In the late 1990’s and the early 2000’s, thematic NFOs were quite the rage. A thematic fund invests in companies of a specific theme, say only companies of the IT industry. Since this industry was booming during this period, investors flocked to IT sector NFOs. When the IT bubble burst a few years later, these funds were drastically affected, with unit values falling from ₹10 to as low as ₹2!
Clearly, going by a theme can be risky. Like today, with the pharmaceuticals and healthcare sector getting all the attention, one would think it wise to invest in this sector. However, since the valuations could already be quite high, there is still some risk of sharp falls.
To mitigate these risks, and protect investor interests, SEBI, in 2018, brought in a rule of one scheme per category. This rule mandates fund houses to launch only one scheme under each of the 36 categories of schemes. For instance, a mutual fund house can only have one large cap equity fund, one liquid fund, one balanced hybrid fund and so on. This certainly reduces the confusion for us investors. But what does it mean for an NFO? Simply that for that particular fund house, it will be the first and only scheme in its category.
3 reasons investing in NFOs isn’t a good idea
1. Lack of parameters to judge performance
While picking a mutual fund, we usually consider its past performance, the fund manager’s strategies, the expense ratio, etc. We compare these parameters with other funds in the same category. For an NFO, such information will not be available since it is an entirely new scheme. There is absolutely no part data to refer to. It is as good as pre-ordering a new novel in a totally new genre, without knowing who the author is, and without getting a sense of how the novel is going to be.
2. High expense ratio
A mutual fund incurs various expenses like administrative, advertising, distribution, etc, and charges it to investors in the form of an expense ratio. This usually ranges between 0.5% to 1% on average. However, a small fund that manages lesser assets, may incur more expenses than a large fund managing more assets.
AMFI (The Association of Mutual Funds in India) has prescribed a maximum expense ratio that a fund can charge its investors. According to these rules, a fund can charge a maximum of 2.25% on its first ₹500 crore worth of assets, 2% on its next ₹250 crores and so on. NFOs are usually small and may therefore have a higher expense ratio, which ultimately results in lower returns.
3. The myth that NFOs are cheap
Sure, the Net Asset Value (NAV) or the price of a new fund is ₹10. And when compared with a scheme having NAV of ₹30 or ₹200, this may look like a good bargain. But when it comes to mutual funds, what matters is the returns earned. A fund with ₹10 NAV can grow 10% in a year and become ₹11, while the fund with ₹200 NAV can grow 15% and become ₹230. Unless the NFO is offering a discount, it is not cheap.
How are NFOs different from IPOs
The birth of a new scheme and the launch of new shares, might appear to be similar, but they are not. A company issues an IPO when it wants to raise additional funds. Here, the said company already has a history, some past performance to go by, a business in place, etc. But an NFO is the launch of a totally new scheme. Here, in the initial period, the returns can even be negative as there are heavy marketing, advertising and admin costs to be incurred. One cannot treat it like the opening pop of an IPO where reputable companies often list much higher than their initial price.
NFOs will almost always seem attractive because of their novelty. And as we now know, the decision to invest in them must not be based solely on the low unit value, but on the other factors as well. Ultimately, the choice must fit into the kind of portfolio we want to build, with the right mix of asset classes.
