FundsIndia explains: What is an NFO?

October 10, 2016 . Mutual Fund Research Desk

Expanding into New Fund Offer, an NFO is the launch of a new mutual fund by an asset management company. Here’s what you should know about NFOs.

An NFO is not like an IPO. In an IPO, a company is raising funds from the public that it will use for a specific purpose. You have detailed information about the company financials, its business, its prospects, and so on in the prospectus. You therefore know the company’s business, its profits, its growth over the years and whether the current offer price is justified. The company’s price may even soar on listing if more investors (higher demand for the stock) see value in it.
An NFO is not a company. It pools in money from investors and invests that in a set of securities (stocks or bonds or government securities and so on), based on a stated strategy. At the time of NFO, the fund does not hold any stocks and you, therefore, do not know whether the underlying stocks are cheap or expensive. The Rs 10 is just a price it begins with to allot units and has no underlying instruments for you to value it.
The fund’s NAV will change as soon as it deploys the pooled-in money based on the movement of price of the stocks it buys. The NAV change is not a factor of demand for or supply of units. If more investors want to invest in the fund after it reopens for subscription, it will simply collect this money, issue fresh units, and put it to work immediately in the stock or bond markets.
An NFO is not cheap. The growth of a fund’s NAV is based on the performance of the instruments it invests in and not based on demand-supply forces. You will therefore be wrong if you think you’re getting units ‘cheap’ at ‘just Rs 10’ in an NFO. The NAV is a tool used to account for investments in a fund – and to do such accounting in an NFO where there is no portfolio value, the NAV is taken at Rs 10. The absolute NAV does not matter – it could be Rs 10 or Rs 20 or Rs 100 – your investment is still worth the same.
Assume that you invested Rs 1,000 in an NFO, thus receiving 100 units. After a month, thanks to the fund’s strategy, the portfolio rose 10% and the NAV became Rs 11. Your investment will now be worth Rs 1100, or a 10% absolute gain. But say the NAV at the time of the NFO was fixed instead at Rs 100, giving you 10 units. The portfolio gain of 10% will take the NAV to Rs 110. Your investment is still worth Rs 1100. At the end of the day, it is the amount you are investing and how that investment grows that is important, and not the NAV. What you are buying is a mutual fund’s performance.

An NFO has no track record. Because you need your fund to deliver, consistently, benchmark and peer-beating returns, you need some sort of proof of its ability to do so. That proof, that validation of a fund’s strategy, comes about only when it has been around for some time, when it has seen a market cycle or two, and you are able to see what it does and how it navigates the markets.
In an NFO, all you have to go by is the fund’s mandate and an outline of what style it will follow. You do not know whether that strategy will be successful, you do not know the fund manager’s ability to take the correct calls on stocks or bonds at all times. The risk you take in an NFO is much higher than when you go for a fund that has already been around for a few years and built up a history.

An NFO can be open or close ended. You can well afford to wait out an NFO and see whether it’s worth going for. In an open-ended NFO, once the offer period closes, the fund will reopen for subscription and you can invest in it at any time. In such NFOs, you will be able to give it time to judge its performance before making an investment. In a close-ended NFO, you can invest in it during the offer period only, and not after that. Here, the risk is the highest.
You could argue that if everyone waited for funds to perform before investing in them, you wouldn’t have funds at all. That may have been true in the very early days of mutual funds. Today, given the sheer variety of funds available, it is rare that you will find an NFO whose mandate or type isn’t already available through established funds. You are not missing anything by skipping that NFO. Even if the NFO promises something new or different, you still do not know whether it makes for a good strategy. In close-ended NFOs, yes, you will not be able to make the investment once the offer period closes. But given that lack of control you have in close-ended funds, it’s prudent to stay away from them altogether.

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