NFOs - Winning Formula Or Losing Proposition?

Mutual Fund NFOs or "New Fund Offers" were all the rage before the global meltdown of 2008 saw equity investors scampering for cover. Fueled by euphoric sentiments and buoyed by distributor support, the industry seemed to be churning out an endless series of new funds, each with a specific unique proposition or theme. The NFO mania really peaked in the first quarter of 2008, which saw as many as 28 new funds being launched. There was actually a 2 year period between 2006 and 2008 when NFOs accounted for 100% of the net industry inflows! Tapering off dramatically in the years that followed the crash, NFOs witnessed resurgence in the year 2014, with Asset Management Companies mopping up in excess of 12,000 Crores across 75 NFOs.

Putting it bluntly - in many ways, NFOs are more often that not an effective selling tool that allow AMC's to boost their assets by providing the lure of a 'new investment idea' to the unsuspecting retail investing junta. Erstwhile SEBI Chairman C.B Bhave was right in questioning the intent behind the glut of NFOs back in 2010 when he said, "There are 3,000 schemes. Is so much of financial innovation happening or is it driven by short-term nature of incentive structures that are driving people away from what the customer really needs?"

Not entirely conflict-free
Back in the days leading up to the crash, Mutual Fund distributors received extremely high upfront commissions (even going as high as 5-7%) for mobilizing funds in NFO's. This created an inherent conflict of interest. There were countless instances of distributors 'flipping' investor funds from NFO to NFO, earning upfront commissions each time - to the great detriment of the investor. Fortunately, the regulators have quashed this phenomenon now. Aashish P. Sommaiyaa, Managing Director, Motilal Oswal AMC, assures us in this regard. "The Association of Mutual Funds in India has now created best practice guidelines which prevent fund houses from paying distributors above certain limits - NFO or no NFO. Hence there is no longer any differentiation between NFO and ongoing scheme as far as distributor is concerned", he says.

The honest truth
A BCG study conducted six years ago actually found that 50% of NFO investors exited with losses between April 2008 and March 2010. Over 40% of these NFO redemptions made at this point were at an NAV lower than 9.50, indicating that investors exited the fund at a loss of at least 5% after waiting for two years, and after the markets had recovered significantly.

Investors would be much better off investing their money into an established fund rather than choosing an NFO with no proven track record. Even if the fund in question is being launched by an established AMC, common sense and wisdom would dictate that one should opt for a fund which has proven itself across market cycles. Even NFOs with seemingly lucrative investment philosophies can prove disastrous - the well marketed and widely 'advised' JM Core 11 Fund serving as unfortunate reminder of this fact (the fund's NAV fell over 70% after its NFO). Sommaiyaa of Motilal Oswal AMC supports this view. "It's very rare that an NFO comes along that provides an investment opportunity that just didn't exist. So I wouldn't recommend NFOs", he advises.

The myth of Rs 10
In spite of the industry's concerted efforts to promote investor awareness over the past few years, it's surprising that a large number of retail investors still rush into NFO's because the 'units are available at Rs 10'. The truth remains that irrespective of a fund's NAV quoting at Rs 10 or Rs 300, future growth in your portfolio will depend on one factor only - that is, how the underlying securities will perform. A 10% growth in the underlying portfolio will take the NAV of Rs 300 NAV scheme to Rs 330, and an NFO's NAV to Rs 11.

Sommaiyaa explains this phenomenon in a lighter vein: "On a lighter note, you know it's an NFO I know it's an NFO, but the stock market doesn't know and doesn't care. Share prices quote at the same level for everyone irrespective of caste, creed, color, religion, nationality, open ended, closed ended, NFO or ongoing. There is no quota, no reservation, no beneficial status and definitely no favoritism in the markets. Performance will depend on what happens to earnings of companies after you have bought them, nothing else matters."

Marginally higher expense ratios
There are costs involved in bringing a new fund to the market, and these upfront costs do in fact get factored into the NAV and can spike up expense ratios. This effect is more pronounced for NFOs that fail to collect higher AUMs (in excess of 700- 1000 Cr) in their NFOs.

However, in a product like equity funds which have a potential range of returns spanning 15-20% or more in a year, this marginally higher expense ratio should really not be the key determinant of your decision making process -that would be akin to missing the woods for the trees. You need to consider the investment opportunity as a whole. "If you are going to change your choice of fund based on 25-50 bps returns, and then that fund goes onto have differentiated performance, you will feel foolish. TER can never be the only criteria for choice", Sommaiyaa says in this regard.

Summing up
As a thumb rule, avoid NFOs and opt for funds with established track records. Rare exceptions could be made in situations where an NFO involves genuine financial innovation and provides the opportunity for tapping a previously untapped market segment, or providing a hedge to your current portfolio of investments. For the best part, retail investors are advised to stay away from them for their own benefit.