The Myth about NFOs

Published in The Hindu - Sunday Magazine on Jul 12, 2009

Investors have a misconception that New Fund Offers are cheaper than existing fund schemes.

Over the last couple of months, there has been a surge in investor interest for mutual funds. And as expected, UFOs, er..NFOs are back. As on Jun 2009, the money managed by mutual funds in the country was around Rs 6,70,000 crores across thousands of schemes managed by forty-odd fund houses. This is expected to triple by 2015! (Source: KPMG). With so much money going into mutual funds – one would expect the average retail investor in a mutual fund to possess atleast the basic knowledge about mutual funds. Ah! Me with my stubborn optimism…I couldn’t be more wrong. The truth (however hard to grapple it may be) is that the popularity of an asset class (mutual fund) does not imply that people understand it! So, for most people, the reason for investing in a mutual fund is as simple as - “The stock market is rising and I want to make money, yaar”

In the eagerness to not be left out in the bull-run (wonder why even as adults we harbor nightmares about being left out of the game?) many investors get caught in the wrong fund or invest for the wrong reason. The direct consequence of this ignorance is the hype about NFOs. It’s hard to believe that the next NFO is going to achieve something better than what thousands of existing schemes cannot.

The common myth about Equity mutual fund NFO is the perception that an NFO at Rs10 is cheaper than an existing scheme with a higher NAV(net asset value). This school of thought believes that lower the NAV better the bargain.

At the time of launch, all mutual fund schemes, issue units at face value of Rs 10. This is just an arbitrary number, but it is the standard practice. Here’s a hypothetical example. Let’s say a popular NFO named Tiger, is offering units at Rs 10 per unit. A competitor’s NFO named Pussy Cat is offering units at Rs 5 per unit. Does this mean Pussy Cat is cheaper? Of course not. Remember, an NFO is a mutual fund scheme that is being launched for the first time and is collecting money from investors so that it can make its first investment. The bottom-line - the money collected by the NFO is going to be used to buy stocks worth the amount you paid…not a penny more. You pay Rs 10 for a unit of Tiger and you will hold assets worth Rs 10 per unit; you pay Rs 5 for Pussy Cat and you will hold assets worth Rs 5 per unit (Note: for the sake of brevity, I am ignoring upfront fees that will be deducted). So there’s no bargain really and the face value of a unit is equal to the NAV i.e. net asset value per unit (Rs 10 for Tiger and Rs 5 for Pussy Cat respectively). The returns that I will get are going to depend on what stocks the two funds buy with the money and how these stocks perform – not on whether I paid Rs 5 or Rs 10 per unit.

Let’s fast-forward three years from now. The stock market witnessed a significant increase during the period and now one unit of Tiger is worth Rs 15 (NAV) and one unit of Pussy Cat is worth Rs 7.5 (NAV). Am I right to say that Tiger has performed better, since its NAV increased by Rs 5 while Pussy Cat’s NAV has increased only by Rs 2.5. No! I need to compute their respective returns in percentage terms, which works out to the same approx. 15% per annum appreciation - for both Tiger and Pussy Cat. Had I invested Rs 1000 in each of the schemes, my investments after three years, would each be worth Rs 1500.

At this point in future, let’s say you have a chance to invest additional Rs 1000. Call it great timing, there is a NFO in the market called Jaguar, which is offering units for a bargain price of Rs 5. Now I have three options. Buy units in already existing schemes 1) Tiger at Rs 15 per unit 2) Pussy Cat at Rs 7.5 per unit. Or as a third option, invest in the Jaguar NFO at Rs 5 per unit. Which scheme should I invest in?

The right answer – the decision should be based on appreciation (returns) potential post investment and not on cheapness (price or NAV) of a mutual fund scheme. Irrespective of varying NAV levels of the three schemes, a similar performance level of 15% per annum across the schemes would increase your wealth by the same amount. The NFO Jaguar that claimed to be a bargain is no bargain actually and that’s the truth that is rarely understood!!

Sadly due to the media blitz of NFOs (claiming their cheap availability at “just” Rs 10 NAV!), the fact that what matters is the percentage return on invested funds and not the NAV level at time of investing, is overlooked. NFOs are in no way cheaper than existing schemes. The only truth is - they are more risky than existing schemes. The longer a fund scheme has been alive and the longer its track-record of returns, the safer it is to invest in. Even then, the past performance of a scheme is not an indicator of future performance. But, at least having long-term track record on your side is better than having no track record whatsoever (which is the case of an NFO)!