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Upcoming NFOs

Every fund house has to issue units for the first time to raise corpus for its schemes and this is referred to as an NFO. Quite often the argument for investing in an NFO of mutual funds is the same as an IPO; it is available at a low price of Rs10. As far as NFOs are concerned, that is far from the truth. SEBI has now become a lot stricter with respect to the criteria for issuing NFOs, especially considering that most retail investors were being misled by the mere concept of NFOs. SEBI does not permit AMCs to issue NFO on an existing theme and an NFO is allowed only if there is a fresh theme in the market, or which the particular fund does not have.

When a fund issues NFOs, the fund actually creates new units. For example, when a fund collects Rs3000 crore in an NFO, then a total of 300 crore units will be created considering that the face value of the unit is Rs10. This face value is in no way an indication of whether the NFO is undervalued or overvalued. It depends on the market conditions.

NFOs can be either for an open ended fund or a closed ended fund. In case of an open ended fund, the fund is created either out of an initial NFO or by acquiring the schemes of another fund. In case of closed ended schemes, the NFO is kept open for a period of 15-20 days and then the fund is closed and the entire corpus invested in stocks. However, such closed ended NFOs are listed on the stock exchange and normally quote at a discount to the NAV. This gives buyers and sellers an exit route from the closed ended fund as it does not accept fresh inflows. In case of debt, the most popular NFOs come from Fixed Maturity Plans (FMPs). These are fixed maturity plans and therefore work almost like assured return plans since the tenure of the assets of the FMP matches with the tenure of the fund, which largely eliminates interest rate risk.

There is no real USP in putting money in an NFO. However, here are some key factors that you need to consider when you invest in mutual fund NFOs.

  • Does the NFO really have a unique story to tell? Just launching another NFO for a plain vanilla diversified fund is not really justified, nor is it permitted by SEBI. There is one thing to be cautious about. Normally, mutual fund NAVs get bunched at the peak of trends like we saw in IT funds, pharma funds, infrastructure funds etc. Hence if you get into the NFO at the wrong time then it can take a fairly long time for your NFO to break even.
  • The pedigree of the fund manager of the NFO also matters a lot. Check the fund manager’s track record. Don’t judge the fund manager’s track record purely based on returns over the short term. Ensure that the fund manager has been able to consistently outperform the market index in most of the years over the last 10 years. Also ensure that the fund manager has a track record of managing risk well.
  • The most important point is that these NFOs, whatever be the theme, must fit into your financial goals. We are referring to goals in terms of asset mix, your life stage and also your sectoral exposure limits. If that is violated then just ignore the NFO.
  • As investors we all need alpha and NFOs give that sectoral special exposure or thematic exposure to gain alpha in the markets. As an investor, you need to exercise due diligence before getting into an NFO. You need to be clear that the NFO offers something unique that existing funds do not offer.

Buying an NFO is just like buying a normal mutual fund from the purchase and redemption window. There is no difference. Here are some basic things you should know when you are investing in an NFO; be it equity NFO or a debt NFO.

  1. Learn to distinguish between NFOs and IPOs as the difference is very critical. Quite often, investors confuse an NFO with equity IPOs. IPO is used by companies to raise fresh funds. Hence you focus on track record and visibility in terms of performance, profitability and management bandwidth. The evaluation of an NFO is slightly different. An NFO will typically start off with negative returns as the marketing and distribution costs will get loaded to the fund upfront. The NAV of the NFO will only reflect the market realities and hence focus more on what valuations you get into the NFO.
  2. Quite often, an NFO from a new fund can be like a blind data as it has just no track record. The problem here is that you have no idea how the fund will perform in the absence of any performance track record to fall back upon. Just buying these NFOs due to the pedigree may not be a good idea.
  3. Look at the total loading on the NFO corpus because NFOs will debit all costs to your NAV. Hypothetically, if your NFO of Rs10 NAV starts issuing fresh NAVS at Rs9.70 (after adjusting for marketing, distribution and statutory costs) then you need to first recover the shortfall before you can start earning positive returns on the NFO. From that standpoint, you are better off buying an existing fund. So don’t be perturbed if you find your NAV lower than face value; that happens to all NFOs.
  4. There is nothing alluring or seductive about buying an NFO at Rs10. In short, it just creates a value illusion among investors. This is the same logic that many investors use to buy penny stocks. In fact, the NAV only reflects the unit value of the portfolio. This feature of NFOs is also prone to mis-selling by aggressive salespeople and retail investors are more vulnerable to such an illusion.

There are five key advantages that an NFO can offer to investors. Of course, investors must use their discretion before committing money to an NFO. Here are some of the key benefits of an NFO.

  1. It is a good opportunity for the fund to gauge the market appetite and a good opportunity for the investors to get exposure to a new idea. When we look at NFOs we cannot take a short term view. Generally, investors who have invested in good NFOs at reasonable valuations have made profits in the long run.
  2. NFOs give a choice between equity, hybrid and debt instruments. Based on market valuations and the potential interest rate movements, the investors have a wide array of products to choose from. Also, NFOs are vetted by SEBI and hence there is a greater degree of seriousness and diligence that you will find in these NFOs. This works in your favour as a long term investor in mutual funds.
  3. An NFO comes without any legacy and there is no risk of legacy risks and the risk of existing investors subsidizing exiting investors. An NFO starts off on a clean slate and the portfolio is just being created. The investors has the chance to take a fresh view of the fund strategy and then take a call on continuance accordingly.
  4. An NFO comes with a clearly stated objective and hence there is no ambiguity about the core purpose of the NFO. This enables a clearer fit into the overall financial plan of the investors. In case of existing funds, there is a lag in transparency. However, in case of NFOs, the objective itself is quite clear and so the investor is in a position to pin point the risk and return points of the fund quite clearly.

FMP is a closed-ended plan with a fixed tenure which can be a 3-month FMP, 12-month FMP, 13-month FMP, 36-month FMP etc. FMPs are closed ended schemes where the maturity of the underlying assets held by the FMP is equal to or less than the maturity of the FMP. FMPs invest in commercial paper (CP), certificates of deposit (CD) and also in corporate debt. Since FMPs match the tenure of the instruments with the tenure of the FMP, they are almost like assured return instruments, although not exactly that. Here are some of the highlights of an FMP.

  • FMPs address the challenge of interest rate risk. Interest rate risk arises because bond prices are vulnerable to changes in the yields. FMP overcomes the interest rate risk by matching the maturity of its underlying assets with the maturity of the FMP. Effectively, the FMP locks in the yield on the date of investment and realizes the yield on the date of maturity. That is the reason these FMPs are not impacted by changes in interest rates.
  • You can reduce your overall portfolio risk with FMPs. FMPs add CP, CD and corporate debt of high quality, which enhances returns of G-Sec funds. The diversification also ensures that the portfolio is not dependent on just one debt class or one particular maturity. This reduces the overall risk.