Pros and cons of investing in NFOs

Mutual fund investors are attracted to new fund offers (NFOs) primarily because the units of these new schemes are available at par, that is, Rs 10 per unit. The investors probably reckon that since the units are available at par value, these are cheap and, therefore, the dividend yield will be higher. Let us examine these underlying assumptions to find out whether investing in NFOs is a better idea than investing in old mutual fund schemes that are available in the market at a premium, that is, at NAVs that are higher than the face value.

Since the scheme is new, an NFO does not have any track record of performance to show for to the prospective investor, hence the investor might be taking a shot in the dark by investing in an NFO launched by a small mutual fund house. However, if the NFO is from a large and reputed fund house (AMC) having a team of highly experienced and professional fund managers with proven track record of performance, the NFO may offer good prospect for growth and may be worth investing.

However, this does not guarantee that the scheme might do well as the past performance of the fund managers does not necessarily mean that the performance may be maintained in future too. This is because investing in equities and debt instruments is a risky proposition as equity investments are exposed to the risks of market volatility and macroeconomic factors and fundamentals of the company, while investments in debt instruments are subject to interest rate risk and the risk of default. Hence, the performance of a mutual fund scheme depends on the market conditions prevailing at the time of launch and thereafter.

Since the NFOs are usually launched during a bull phase when the investor sentiments and market valuations are high, the risk of capital loss in the case of such schemes is real as the market may go into a correction mode, thereby depreciating the value of investments. However, if the mutual fund scheme performs well and starts paying high dividend every year, the investor who invested in the NFO stands to benefit immensely. Since the cost of buying the units is low for the NFO investor, the dividend yield would be much higher than those who buy the units few months or years down the line.

Another factor that needs to be considered is the asset base of the fund. If the NFO fails to collect enough funds due and has to make do with a small asset base, the marketing and distribution costs and the fund management expenses get apportioned over a small asset base. This leads to a higher expense ratio and, as a result, the returns on the investment made by the investor may be compromised.