Should You Invest In NFOs

A New Fund Offer or commonly called NFO is a launch of a new scheme by a mutual fund Asset Management Company (AMC). An AMC has multiple investment scheme options which investors can choose from depending upon their investment objective. Like any other product manufacturer, an AMC also enhances its product offerings by introducing newer schemes over a period of time. But should I invest in a New Fund Offer ? Read on.

Analogy from a Restaurant Menu

There are two hypothetical multi cuisine restaurants in a city – Restaurant A and Restaurant B. They offer similar dishes with subtle different tastes. One day the owner of Restaurant A dines out in a restaurant outside India and learns about a very successful dish which is not available in India. He quickly adds the dish to his menu. This adds a lot of value for the customers of the city as they get access to a unique taste. Restaurant B quickly learns about it and copies the dish in its menu.

Later, Restaurant B’s chef innovates upon a combination of spices which adds value to his recipe. This becomes a big success only to be copied by Restaurant A in a few months. However, the taste of Restaurant A’s dish is not as appealing considering the chef wasn’t as experienced as B’s chef.

Adding new dishes to a restaurant menu can be equated to a New Dish Offer or NDO in their business. You could notice the driver behind the NDO and how quickly one NDO drives another NDO.

New Fund Offer (NFO) versus Initial Public Offer (IPO)

I have often seen investors mixing up NFOs with IPOs. An IPO is a first time listing of a Company on a stock exchange. This could provide an opportunity to invest in a Company which may be unique in nature and is not available for investors in the listed equity space. It may not always mean that the investment into an IPO could result in a great outcome for investors, but this topic is for another blog post. A few examples of the recent IPOs which did not have a listed peer included:

  • SBI Cards – a pure play credit card company;
  • Nazara Technology – an online gaming company
  • CDSL – a depository
  • Bombay Stock Exchange – a stock exchange
  • IEX – An energy trading exchange.

When it comes to NFO of a mutual fund, it is important to understand that a mutual fund scheme holds underlying Companies as investments. A NFO may not mean that an investment option is unique as it may end up holding similar Companies in the portfolio, albeit in different proportions or weights. It may have a differentiating strategy which may combine Companies of a specific category, geography, theme or a different asset category. A few examples of relatively unique New Fund Offers included :

  • Kotak International REIT Fund of Fund > The first one to bring in Real Estate Investment Trusts investment option for retail investors in a mutual fund format
  • ICICI Prudential Balanced Advantage Fund > One of the initial offerings of a Dynamic Equity allocation product
  • Edelweiss Maiden Opportunities Fund > Invests in recently listed Equities. This scheme is now called as Edelweiss Recently Listed IPO Fund.
  • Motilal Oswal S&P 500 Index Fund > The first scheme to give retailer investors in India access to  the big daddy of US passive index – the US S&P 500 Index.
  • Motilal Oswal NASDAQ 100 > First offering giving investment opportunity into US NASDAQ 100 listed Companies.

Why are NFOs launched ?

NFO is a way for an AMC to launch new schemes or in other words new products. Why would a product manufacturer launch new products ? It could be a combination of one or all of the points mentioned below :

  • Introduce an innovative investment strategy which may be not exist in the investment universe;
  • A similar scheme may exist via one or more AMCs, but may not be in the product basket of the AMC. Here NFO serves a key objective of the AMC to have a full range of products under its umbrella and get the maximum investment wallet share on an investor;
  • An investment theme which could become hot in the future. However most of such themes are fully hot by the time NFOs are launched;

When to Consider a NFO for Investment

In last one decade, I have only invested in only one NFO. The specific compelling reasons were :

  1. The NFO was targeting to invest in an investment strategy which wasn’t available via existing investment options;
  2. It was challenging to replicate similar investment strategy for retail investors owing to limited funds at their disposal;  AND
  3. It was a close ended NFO. A close ended fund is open for investment only at the time of NFO and has a specific maturity date when one could exit, generally 3 years. This meant that I would not get an opportunity to invest in the scheme post NFO.

A point to emphasize is – I did not invest in the NFO just because it was a close ended NFO. My decision to invest in the NFO was all of the above.

When not to Invest in NFO

During last decade, I have lost count of how many NFOs have been launched. As a corollary to the above paragraph, I have given 99%+ NFOs a miss. This was despite some of them being unique and fulfilling a compelling investment need. My specific reasons were :

  • I generally do not find a unique proposition which is compelling enough for me to take a plunge at the time of NFO. Most of the NFOs are a copy of an investment option which is already existing.
  • NFOs do not have a track record. The only thing to bet upon is the scheme objective and the reputation of the AMC.
  • I do not have a visibility of the underlying stock portfolio of the scheme at the time of NFOs. NFOs, gather money from the investors and take a few weeks / months to deploy the money. I prefer to see the full investment portfolio of a scheme and not just the tag line. You may want to read my blog post which fully applies on NFOs  > How to Shortlist a Mutual Fund. At the time of NFO, I am unable to assess the new offering on most of my assessment parameters.
  • Unless a scheme is launched as a close ended fund, they can be bought like any other mutual fund post NFO period finishes. If this is the case, I do not find the rush to invest during the NFO. I find it better to let the scheme investment settle down and go through their full disclosure. This approach ends up being a more informed investment rather than being driven by a NFO marketing pitch.

Misselling Tactics

NFOs are at times prone to a unique mis-selling tactic which is worth being devoted a specific paragraph.  A NFO is launched at a Net Asset Value or NAV of Rs. 10.

As time progresses, the underlying investment Companies in a scheme’s portfolio grow in value. This is directly reflected in the growing NAV of a fund. There is nothing special about it. NAV will grow over a period of time for the best and even the worse fund of the industry.

Let us assume that an AMC launches a NFO which is an exact copy of an existing scheme in the market. Both the NFO and the existing scheme hold the same stocks in the same proportion. The only differences are :

  1. The existing scheme is managing a lot more money as it has been in existence for a longer duration of time; and
  2. The existing scheme would be holding the same stocks for a lot many years and owing to the growth in their value, its NAV may have grown from initial INR 10 to say INR 100.

From here on, with any growth / de-growth in the value of the underlying portfolio Companies, the stock prices will impact both the existing scheme & NFO’s NAV in the exact same percentage. With a 10% growth in value of investment holdings, the NAV of existing scheme would grow from 100 to Rs. 110. The NFO NAV will grow from INR 10 to INR 11, i.e. 10%. If an investor invests say INR 100,000 in either schemes, the growth in his portfolio will be same, i.e. 10%.

Some crafty minds try fooling investors by convicing them with the following logic > your existing scheme’s NAV has grown from INR 10 to INR 100. How far will it go from here as it has already grown 10 times and is more expensive now.  It may be sensible to exit from your current scheme and apply it in the NFO which is available for a cheap price of Rs. 10. 

Would you agree with this misselling or an ill informed pitch?

High Expense Ratios

Mutual Funds charge fees for managing the funds. The ratio of the total expenses charged by them to the scheme versus the total investment amount managed by the scheme is called the Expense Ratio. For example, if the scheme manages Rs. 1000 crore and charges Rs. 20 crores annually as expenses, its expense ratio is 2%. Other things being equal, a fund with lower expense ratio will result in better investment outcomes. You may want to read our post Mutual Fund Expense Ratios for more understanding.

As the size of the money managed by an investment scheme grows, it enjoys higher economies of scale associated with the cost of managing the schemes. The fund management expenses would not grow disproportionately with the increase in the size of its assets. To ensure that these cost benefits are passed on the investors, the regulator mandates AMCs to have a tiered expense ratio. This results in a lower expense ratio as the size of the scheme grows (see image below)

Source : AMFI India

A NFO starts from scratch. It would hence have a higher cost structure versus an existing fund managing larger sum of money. Hence, a new fund offer comes with a higher expense tag.

To conclude, NFO is the way to bring new investment schemes and strategies to the investors. However, it would not always mean that the investors must get lured into them. A new product offering will be made more attractive with a disproportionate marketing spend. It is here that an investor must exercise caution and do a full due diligence before making an investment decision. The basics of investing remain the same. Having said that, some one would need to invest in a NFO so that it gets subscribed and is live for other investors post NFO. However, I am an informed selfish investor. I would rather not be a part of the initial investor base.

Note – the author has referred to specific stocks and scheme names in the blog post. These are purely for educational purposes and must not be considered as an investment advice.

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