During a stock market bull run, you will come across many companies launching their initial public offering (IPO) and fund houses launching their new fund offering (NFO). Both of them have their pros and cons. This blog focuses on all you need to know about new fund offerings (NFOs): NFO meaning, Benefits, and risks. Before we look at the NFO benefits and risks of investing in an NFO, let us first understand NFO meaning.
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NFO meaning and its benefits
When a mutual fund house launches a new mutual fund scheme, they invite the general public to invest in it through the new fund offering (NFO) process. The fund house announces the NFO dates during which the investors can submit their investment applications. The fund house releases documents specifying details about the mutual fund scheme like scheme objectives, investment philosophy, the risks involved, the fund manager/s, their experience and schemes handled by them earlier, etc. This is the basic NFO meaning.
Risks of investing in an NFO
An individual can invest in a new mutual fund scheme at the time of the NFO or any time later (in the case of open-ended mutual fund schemes). Before you take a call on whether you should invest at the time of the NFO, consider the following risks.
1. Most NFOs are usually launched during bull markets
During a bull market, there is a lot of euphoria among investors. Most companies and analysts tracking them come out with rosy projections about the future. Due to this, most investors are willing to invest in these companies, wherein the rosy projections may or may not materialize in the future. To cash in on the positive investor sentiment, many companies come out with their initial public offering (IPO), and fund houses come out with their new fund offering (NFO).
During the downturn that follows the bull market, the share prices of companies that had gone up based on the rosy projections see a big fall. During this time, the net asset values (NAVs) of mutual fund schemes that came out with NFOs during the bull run and invested in these companies saw a big fall. Investors are left with capital losses on their investments. Hence, you should be cautious about investing in NFOs, specifically those that come out during bull markets, to cash in on the euphoria.
2. The NFO doesn’t have any proven track record
When a fund house comes out with an NFO, there is no past proven track record of the mutual fund scheme. An investor has no way of assessing whether the investment philosophy that will be followed by the fund manager of the new scheme will work or not. You can only judge the fund manager based on the other existing schemes they are managing. But, the investment objectives and philosophy of the existing schemes may be totally different from the new scheme being launched.
You should be cautious about the NFO meaning & schemes related to new or emerging themes like blockchain, digitization, ESG, renewable energy, electric vehicles, climate change, etc. There is not enough past data available to see the financial performance of the companies operating in these themes. Besides, technology related to these themes is changing fast. So, we don’t know whether these technologies will survive or something else will replace them.
Hence, you should be cautious about NFOs that will be investing in these themes. You should wait till the theme plays out to some extent and there is enough evidence that it will sustain and grow in the future. You can assess this by skipping the NFO and investing later.
3. The expense ratio is usually high during the NFO
SEBI has a tiered structure for mutual fund schemes to charge the expense ratio. As per SEBI guidelines, a mutual fund scheme has to reduce its expense ratio as per the specified band as its assets under management grow. So, the higher the AUM, the lower the expense ratio band.
During the NFO period, the scheme doesn’t have any AUM; hence the expense ratio will be on the higher side. A higher expense ratio will directly eat into your returns. Hence, you may skip the NFO when the expense ratio is high. After the NFO, once the scheme acquires a decent AUM, it will have to reduce the expense ratio as per SEBI guidelines. You can then invest with a low expense ratio. By then, you will also have enough past performance data to analyze the NFO meaning & performance and evaluate whether it is worthy of investment.
4. An NFO can’t give capital appreciation like an IPO
We see many IPOs listing at a significant premium to the issue price during a bull market. During the period 2020-22, we saw many IPOs listing at a 50-100% premium to the issue price. Many people compare a mutual fund NFO to a company IPO. They invest in a mutual fund NFO, hoping that they will get capital appreciation similar to a company IPO.
Investors need to understand that mutual fund scheme units are usually issued at a NAV of Rs. 10 per unit. There are no listing gains once the NFO ends and the purchase and redemption of units starts. The NAV of the unit depends on the value of the underlying securities of the scheme divided by the number of units. The movement of the NAV of the scheme units is slow and steady on either side, whether up or down. The gains of the unitholders will depend on the number of units held and the NAV of each unit. Hence, investors shouldn’t invest in mutual fund NFOs hoping to make listing gains on the lines of IPOs.
Now that we understand the NFO meaning and the risks involved in investing in it, you can take a call on whether you want to invest at the time of NFO or wait for some time, observe the performance and then take an investment call. Understanding the NFO meaning is of utmost importance, as NFO can turn out to be a risky investment if not invested properly.
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