The Old Problem of New Funds | Value Research Despite all logic pointing the other way, investors' fascination with new fund offers continues
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The Old Problem of New Funds

Despite all logic pointing the other way, investors' fascination with new fund offers continues

Even though it's not at the peak of 2006-07, mutual fund investors' eternal confusion about new fund offers (NFOs) continues. Among the emails that we get at Value Research asking for investment advice, there is a steady proportion that continuously questions the logic of the advice against investing in NFOs that I have always given. Somehow, the idea that they are being told to never, ever invest in new funds is hard to swallow for most investors.

The logic against NFOs is absolutely clear. New funds do not have a track record. No matter what the marketing hype of a new fund says, there is almost never anything genuinely new under the sun. There are always older funds of the same type that are available. It's much better to examine older funds of the same type and simply pick one which has the best track-record and invest in that instead of choosing a new fund.

One of the most misguided reasons for investing in a new fund that it is available 'at par', that is, at a low NAV. The idea that a fund with lower NAV is better than one with a higher NAV because it is cheaper is utterly wrong. Unfortunately, this is an idea that is still actively promoted by some fund salespeople. However, it does act as a litmus test of whether to deal with someone selling funds. If there is a fund salesman who suggests that lower NAV is good, you can, without further thought, conclude that either he is a fool or he considers you a fool.

Here's a simple way of understanding the underlying principle. The NAV simply reflects how much a fund has gained since it was launched and depends entirely on how well the fund manager has managed the fund's portfolio of investments. For example, if two funds of different age have an identical portfolio that has been gaining at 20 per cent a year then a one year old fund will have an NAV of ₹12 and a two-year old fund with the same portfolio will have an NAV ₹14.40. The NAV of a fund has no use except to compare to its own past.The NAVs of two different funds cannot be compared to arrive at any useful conclusion.

Even so, the NFO is not on its way to extinction. Even though SEBI is no longer as liberal as it was a decade ago in allowing new funds, other regulatory changes have meant that launching new funds--and selling them aggressively--makes good business sense. The biggest change that has happened is the abolition of entry loads that could be charged from investors and paid to distributors to incentivise them to go sell. This has resulted in the unintended consequence of closed-end funds becoming the favoured type of product for both fund houses and advisors.

Till about 2010, closed end equity funds had practically died out after their heyday in the 90s. However, they have now had a big revival. For example, last year, out of the 81 equity NFOs that took place, 57 were closed-end and 24 were open-end. In terms of the money invested during the NFO, ₹10,138 crore came into closed-end funds and 5,049 crore into closed-end funds.

The reason is clear--because fund companies are assured of a locked-in revenue stream, they can spend lavishly on commissions and other aspects of high pressure sales for closed-end NFOs. Investors, however, suffer doubly. Not only do they end up investing through NFOs into funds without a track record, the funds are also closed-end and so locked-in for all practical purposes.

So the logic is clear--fund investors should give NFOs a wide berth and invest only in funds with a good track record. Which brings us to the original investor's question--if everyone takes this advice then how will new funds ever be launched? My answer to that is that I don't actually care. The chances of the entire universe of fund investors starting to behave sensibly are non-existent. Investors should worry about their own investments, make decisions based on their self-interests and leave the macro problems to those whose actions created those problems in the first place.

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