You could be overwhelmed if you see the number of New Fund Offer (NFO) documents filed now with markets regulator SEBI for its approval. In this article, we discuss how to decide on whether to invest in an NFO.
Experience vs process
It is typical for us to explore new products and services. For instance, in eating out, it is highly likely you would want to visit a new restaurant rather than the one you went to the last time.
Investing is different. You accumulate your savings in mutual funds and fixed deposits so that you can consume new products and experience new services in the future; such as going on a world tour (experience) or buying a cottage by the seaside (material good).
Investing itself is not an experience, but a process to help achieve life goals. You must analyse NFOs in this context. It is typical of an industry to continually introduce new products, as demand for existing products may dip after a while. So, the motivation behind a company unveiling a new product may be to create additional demand, not to necessarily fulfil your existing needs.
The pricing of the product is another factor. New mutual funds are offered at a net asset value (NAV) of ₹10 per unit. Suppose an individual must choose between an existing fund with NAV of ₹50 and an NFO priced at ₹10, small wonder that he or she will choose the NFO, as it offers five times more units for the same amount. But that is not how you should make investment choices.
Gauge performance
The first step in the investment decision should be to choose a benchmark. In the portfolio management process, this is called as a policy benchmark. Eg, do you want a fund benchmarked to the Nifty 50 Index? Your choice of the benchmark should be geared towards achieving your goal without taking high risk. If you are saving to fund your child’s college education, choosing a mid-cap fund may be risky, given that mid-caps are vulnerable to momentum crashes.
The second step is to select a fund based on the chosen benchmark. This is when you must decide whether to invest in an NFO.
The principle to adopt is as follows: are funds already available on your chosen benchmark? If yes, then you should prefer existing funds.
Here’s why: Investing in an active fund is about generating alpha, ie the positive excess return a fund generates over an appropriate benchmark. So, choosing an active fund requires an enquiry into whether a fund can sustain alpha in the future, given that it has generated alpha in the past. That means analysing its performance. NFOs do not have a track record. Existing funds do. True, the absolute NAV of existing funds will be greater than the NAV of an NFO.
But you should be sensitive to the expected returns on investments, not the NAV. Only when existing funds are not available on your chosen benchmark should you consider an NFO.
Policy benchmarks don’t matter when you invest surplus cash (not intended for any goal) in a mutual fund.
Your choice of a fund should depend on whether it offers attractive return for the associated risk. In such cases, choosing NFOs on new benchmarks could be meaningful, that too when you are uncomfortable trading stocks in the markets.
For goal-based portfolios, however, existing funds on policy benchmarks could be a better choice. This argument is not different from an active trader preferring stocks in the secondary market to initial public offers (IPOs); it is relatively easy to analyse stock trends from price charts than to read financial statements of companies making the IPO.
(The writer offers training programmes for individuals to manage their personal investments)
