Why New Fund Offers In Mutual Funds Have No Cost Advantage And May Be Risky

Strolling through a park and there's a bustling crowd around the newest food stall. Adorned with calling scrumptious-looking posters, the delicious smell draws one in for a closer look. The ripples of excitement in the crowd are caused not just by the urge to try something new, but also because of an introductory discount. Suddenly, one finds themselves in line to pay.

This is what New Fund Offerings have been for investors. NFOs have been bought faster than hot-cross buns by investors this year. These schemes, alone, have accounted for inflows worth Rs 99,661 crore into the mutual fund industry so far this year.

With promotion of potential, investors have poured their money into NFOs in hopes of a cost advantage and more. Despite the strong traction that NFOs have among investors, these offers may not have all the advantages advertised.

Today, fund houses have multiple channels as they have developed a mechanism for funds to easily be available for sale. All the advertising and buzz that the NFOs have during launches pushes their visibility and this tends to bring a lot more new and curious investors on board.

"There are direct platform sales and sales via wealth management firms that is available. There are banking channels as well today. All this increases the penetration and absorption" said Santosh Joseph, founder of Germinate Investment Services.

Now, there are a few other factors that have triggered massive inflow into NFOs. In a buoyant market where fresh capital is coming in, there is a general tendency to put money in a both new fund or idea than in existing schemes, he said.

They are not expensive, nor are they cheap. But if NFOs do not collect enough money, they may be more pricier than existing schemes, said Joseph. The expense ratio of NFOs may be in line with existing schemes and there is no cost advantage to these schemes, as this depends on the issue size.

Ironically, the strongest point of traction does not translate into much advantage when compared to existing mutual funds. This is better put with an illustration, so consider that Rs 10,000 is invested into both an NFO and an existing mutual fund scheme.

The NAV or net asset value of the NFO is at 10, while the existing scheme's NAV is at 20. Now, the investor gets allocated double the number of units in the NFO due to the lower NAV. This means the investor will get allocated 500 units in the existing scheme and 1,000 units in the NFO.

We'll assume that there was a 10% NAV growth in both the NFO and the existing schemes in one year. This brings the NAV of the NFO to 11 after one year, while the existing scheme's NAV would be 22. What we find from this calculation is that the NAV after a year for both schemes will stand at Rs 11,000.

With both investments bringing back the same value, the advertised cost advantage of NFOs do not exist.

"All NFOs are not good, all NFOs are not bad," said Radhika Gupta, chief executive officer of Edelweiss Mutual Fund. There is no Rs 10 NAV magic—its a myth. If a new fund is buying at Rs 10 NAV, and the existing fund is buying at Rs 50 NAV, both are buying new securities from the same market. There is no arbitrage and the Rs 10 NAV is false, she said.

The scheme being newly launched will mean that there is very little data to refer to understand its performance and consistency. Some NFOs may not come with new strategies, but this still means that investors would not be able to judge the strategy yet. Thus, investors are automatically at risk as the new strategy may or may not work well.

Many consider new fund offers a diversification to their portfolio. NFOs are still within the same asset class if the investor already has mutual fund investments. And finally, the notion that NFOs and IPOs being similar is far from the truth. While an initial public offering is the company raising money for its own use, an NFO raises money to run a mutual fund scheme.