You May Not Benefit Much By Investing In NFOs Of Mutual Funds, Here’s Why

Some investors feel that investing in new fund offer (NFO) is a good idea as they are buying a newly launched mutual fund unit at its face value of Rs. 10. In reality though, such investors have confused mutual fund units with stocks.

So let us first understand what an NFO is.

New Fund Offer

When a mutual fund scheme is made available for investment for the first time, it is called a ‘new fund offer’ (NFO). The NFO aims to accumulate an initial corpus so that the fund manager can build a portfolio based on the investment objectives of the scheme. If it is an open-ended scheme, then the fund will again reopen for investment after the NFO period gets over, which is usually a week to 15 days.

An investor should not invest in a fund during NFO just because its net asset value (NAV) is low. What is more important is the price at which the funds raised during an NFO will be invested.

For instance, suppose there are two schemes–Scheme A and Scheme B. In Scheme A, units are new and have a face value of Rs. 10, whereas, in Scheme B, units have been in existence for over a decade and have a value of Rs. 50.

Let’s say you decide to invest Rs. 50,000 each in both Scheme A and Scheme B. You would get 5,000 units (50,000/10) in scheme A and 1,000 units (50,000/50) in scheme B. Assuming that both the schemes deliver 20 per cent returns, let us now check how much you would gain from both schemes.

The NAV after one year for Scheme A will be Rs. 12 (Rs. 10 + 20 per cent of 10). The NAV after one year for Scheme B will be Rs. 60 (Rs. 50 + 20 per cent of 50). In scheme A, the end value of investments will be Rs. 60,000 (Rs. 12 x 5,000 units). In scheme B, it will be also Rs. 60,000 (Rs. 60 x 1,000 units). So, you actually invested the same amount in both schemes and the end value is also the same. So, you do not get any advantage if you invest in NFOs.

Says Sriram Jayaraman, a Sebi-registered investment adviser and income tax planner, “NFO collects new funds in a new category of funds, and mutual funds cannot have more than one fund in a category. Most fund houses already have a large-cap, mid-cap and small-cap fund. They typically come up with another NFO category where they don’t have an existing fund. So, they are more likely to come up with a sector or thematic NFO. These sector and/or thematic investments are not recommended as they are riskier compared to diversified funds.”

The only exception is when an investor considers investing in NFOs for a closed-end fund that fills a gap in their portfolio. In closed-end funds, the option to invest is only available during an NFO. But here, as Jayaraman says, “closed-end funds don’t make sense as you may find it difficult to exit it at a later date.”

Other Disadvantages

NFOs have no track record, and investors do not know if the fund house has the expertise to overcome new challenges associated with a new investment strategy for the particular fund.

Second, unlike initial public offerings (IPOs), the NAV of a mutual fund does not get affected by demand and supply. So, one cannot expect to make a profit when prices rise due to demand. Third, NFOs have higher costs because of the smaller AUM, which allows for a higher expense ratio. When a mutual fund comes out with an NFO, it has to spend heavily on marketing, publicity and distribution, so these costs may get added to the NAV.

Lastly, investors should be cautious of the timing of the launch. AMCs launch new funds because they want to increase their product basket, or because of market demand for a particular kind of fund.