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When “at-par” is not so good: New Fund Offer (NFO) versus existing MF schemes

Many people get attracted to a New Fund Offer (NFO) because it is available at par, or at face value of Rs. 10. But does it actually mean that the units are cheap or inexpensive? Is there any advantage of buying MF units during an NFO compared to buying units of an existing scheme?

This article talks about New Fund Offers (NFOs), and why they should be avoided – in favour of old, established schemes having a good track record.

Various mutual fund houses keep announcing new MF schemes. And the biggest advantage that is showcased to investors for these New Fund Offers (NFO) is that the units are available “at-par” or at “face value”, that is, for Rs. 10 per unit.

We know that getting a share at-par is a very good deal. And many investors think that getting a MF unit at-par, therefore, is also great. They think the units are inexpensive, or are available “cheap”.

This is not the case – getting a stock face value is very different from a MF unit at face value. Let’s understand why.

 

What does a Share Represent? Shares = Ownership

Each share that you own represents your part ownership of that company. (Read more about it in “Want to own a company? Buy stock!”)

Now, the fact is that there are a finite (or limited) number of shares that each company has issued. Therefore, your ownership of the company depends on the number of shares that you own versus the total number of outstanding shares.

Thus, if you own 10 shares, and the total number of shares is 1000, you own 1% of the company.

Now, if you bought each share for Rs. 50, it effectively means that you got 1% of the company for Rs. 500 (Rs. 50 per share * 10 shares).

But if you bought each share at-par, that is, at Rs. 10, then you got 1% of the company for Rs. 100 (Rs. 10 per share * 10 shares). And it is definitely a better deal!

 

Deriving Value of a Share

How does a share get its value?

Since each share represents an ownership interest in the company, its value is derived from the strength of the business behind it, and the extra amount people are willing to pay for the ownership.

The strength of the business is represented by the earnings of the company (Earning Per Share, or EPS), and the extra amount people are willing to pay is defined by the Price to Earnings multiple (PE) of the stock.

(Want to know more about PE multiple? Please read “What is Price to Earnings (PE) ratio?” and “Interpreting Price to Earnings (PE) Ratio”)

Price of a Share = EPS * PE Ratio

Thus, each share has a value of it own, which is derived from its underlying business. And therefore, getting shares of a good company at a low price is good. And if you get it at-par, it is even better!

 

How Do Mutual Fund (MF) Units Compare with Shares?

MF units are totally different from stocks.

What does a unit represent?

A MF collects money from different people, and invests it collectively. People are issued units in proportion to their investment. The money is invested in various assets (stocks, debt, etc).

If the scheme is popular and people want to invest more through that scheme, the MF scheme simply issues more units, and invests this extra money as well! Remember, any number of extra units can be issued.

If the scheme is not popular and people want to withdraw money from the scheme, the MF scheme simply redeems the units, and returns the money to investors.

In either case, there is absolutely no change to the units held by you: The units you hold remain proportional to your investment.

Then, what does a unit represent? It just represents your investment in that scheme. Nothing more, nothing less.

Deriving Value of a Unit

A mutual fund unit does not have any value of its own. Its value is derived from the value of the investments made using the money raised while issuing that unit.

Value of a Unit = Value of investments / Number of units

This is similar to the book value of a share, which is value of underlying assets of the company per share. And in case of stocks, the book value and the market value can differ by a huge margin.

Issue Price of a Unit

Since a unit’s value is derived from the underlying investments, the price of a unit is totally inconsequential.

Let’s take an example to understand this.

You have Rs. 1,500 to invest. You have two options: Invest in an NFO at Rs. 10, or invest in an existing scheme with a Net Asset Value (NAV) of Rs. 150. Let’s see what would happen in either case.

Case 1: New Fund Offer – NFO

If you invest in the NFO at par, you would receive 150 units. Let’s say the MF scheme invests all its money in Company A: It buys 15 shares at Rs. 100 per share, and after a year, the price of each share is Rs. 150.

The NAV of your units would be:

Rs. 150 per share * 15 shares / 150 Units = Rs. 15.

Thus, the value of your units would be Rs. 15 * 150 units = Rs. 2,250.

Case 2: Existing Scheme

If you invest in an existing scheme at the NAV of Rs. 150, you would receive 10 units. For comparing apples with apples, let’s say that this MF scheme also invests all its money in Company A: It buys 15 shares at Rs. 100 per share, and after a year, the price of each share is Rs. 150.

The NAV of your units would be:

Rs. 150 per share * 15 shares / 10 Units = Rs. 225.

Thus, the value of your units would be Rs. 225 * 10 units = Rs. 2,250.

Surprised??

 

Bottomline

The bottomline is that shares and units are vastly different, and “at-par” means totally different things in each case.

There is no price advantage for units in an NFO. A mutual fund scheme available at face value is not inexpensive or cheap.

Remember: While at-par means a good deal for shares, it means absolutely nothing as far as MF units are concerned.

(A side note: In the past, the MF companies were explicitly trying to take advantage of people’s belief that at-par MF issues are similar to at-par Initial Public Offerings – or IPOs – of stocks by calling these new issues “IPOs” of the MF scheme.

SEBI directed the MF companies to call these new issues New Fund Offers (NFOs) instead of IPOs, so that at least the name would not mislead the investors!)

 

Should you buy units in a New Fund Offer (NFO), which is offered “at-par”?

As we saw, the much-hyped advantage of NFOs being at-par is not an advantage at all.

So, are there any other advantages? In most cases, the answer is no.

Mutual Fund investment should be done after doing a lot of research. Since you trust your money to be managed by someone else, you need to make sure that it would be managed well.

The best indicator of a well managed fund is its track record. More specifically (as those of you who read articles on www.RaagVamdatt.com more often would know it well), this is its long-term track record.

You might be tempted to invest in a MF that has done very well in the last year. But it is not a good fund if its long term returns are not good.

Good return over the past 3 years (at least – preferably the last 5 years) indicates that the returns are not one-off, and that the fund is capable of sustaining the good performance.

Therefore, it is extremely important to judge a fund through its long term track record.

I’m sure by now, you would have guessed where I am going – New Fund Offers are “new”, and therefore, NFOs have no track record at all! In that case, how can you know if it would perform well or not?

Well, you can’t! And therefore, you should stay away from them most of the times.

Also, when it comes to existing schemes, you can know its portfolio. Thus, you would know what you are getting into.

In case of a new fund scheme, you have to go just by its investment objectives.

This adds one more “unknown”, and gives us one more reason to stay away from NFOs.

 

When you should buy units in a New Fund Offer (NFO)

Although it is advisable to invest only in MF schemes having a good long term track record of good performance, there are certain situations when investing in an NFO makes sense.

This is when the new scheme offers something that is totally new – something that is not offered by any other existing fund in the market.

A good example would be the first fund that invested in shares of companies operating overseas (foreign companies). This was a totally new kind of fund that offered a totally different investment avenue to investors.

Another example would be the first fund that took advantage of arbitrage opportunities available in the market. Again, no other fund offered this opportunity, and it was something totally new.

 

Conclusion

Apart from situations where a new fund offers fresh avenues of investment, stick to an old fund that has a proven track record of good returns over a long period.

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