Myth or fact? The best time to invest is during an NFO of a fund

Some investors may rush into investing in an NFO of a Mutual Fund that is to be launched because they think that it gives them a bargain opportunity to invest at an NAV of just ₹ 10 per unit. Let's pause for a moment and examine whether it really is a bargain opportunity or not.

Assume there is an NFO offering in fund X available at an NAV of ₹ 10 and there is another existing fund Y available at an NAV of ₹ 1,000. You invest ₹ 100,000 in each of the funds at the same time. So, from the below formula we can arrive at the number of units that you will hold in each of the funds:

Number of Units = Investment Amount / NAV per Unit

This gives us 10,000 units held in fund X and 100 units held in fund Y. Now, we know that Mutual Funds are pooled investment vehicles. Both fund X and fund Y would deploy your investment amount to buy stocks at the current market prices. Let's assume that both funds A and B invest in the same underlying stocks in the same proportion. So, if the weighted average of the prices of these stocks move up 10% in a year, then the NAVs of both fund X and fund Y will move up by 10% each. Then the gains calculation table for both these funds will look like this:

As we can see, the investment gains are exactly the same in both cases at ₹10,000 each even though their starting NAVs were different! It means that if the underlying holdings grow at a certain rate, your investment amount would grow by the same rate irrespective of what the starting NAV of the fund was when you invested. A higher starting NAV could probably just indicate how long the fund has been in existence. But both the ₹ 10 NAV fund and the ₹ 1,000 NAV fund have the same growth potential if they have the same underlying holdings as shown above.

The performance of the funds could of course differ based on other factors that determine what stocks are selected and what allocation is given to each stock by the fund management team. And here is where the differentiating factor lies between existing funds with a performance track record and NFOs. How do you know for an NFO without any performance history, how is it likely to perform?

Even if the NFO is launched by a reputed AMC or even if the fund management team is already running another fund well, there is no guarantee that a new fund launched with a different strategy will do well. In fact, we know from past data that no single fund house has ALL their funds performing within the top 2 quartiles across all timelines. So, what is the guarantee that the NFO they are launching will be at least a 1st or 2nd quartile performer in the future? Therefore, it may not make sense to decide on investing in an NFO based on just the brand of the AMC.

On the other hand, if there is already an existing fund with a proven track record of great performance in the same fund category, it may make more sense to invest in it rather than the NFO. After the new fund builds it's own track record over time and when sufficient historical data for it is available, then it can be considered for evaluation against the existing funds across the same timeline. How many years of historical data is sufficient for a reasonable comparison would depend on the volatility of the fund category that the fund belongs to. For less volatile fund categories, historical data over a shorter period would be sufficient. While for more volatile fund categories which take a longer time to smooth out the volatility and reflect their return potential, historical data over a longer period would be needed for a comparison.

What if a new fund category itself is introduced and there are no existing funds to compare the new launches of NFO against, in this category? In such a scenario, since the category will have only new funds, it would be wise to wait until some time has passed and we have sufficient historical data available to compare them with each other before investing our hard-earned money.

In summary, it is clear that the current NAV of a mutual fund is not an indicator of it's return potential. Just like how a high stock price does not mean a low return potential and a low stock price does not mean a high return potential. The performance of the stock price generally depends on the performance of the company that issues it, and does not depend on it's current price. Similarly, the performance of a mutual fund will depend only on the performance of the underlying stocks that it holds, and it's current NAV has no bearing on it's return potential. With this clarity, the investor can focus on funds selection based on analyzing their track record in detail along with other factors in consultation with a knowledgeable financial planner, rather than getting carried away by the hype surrounding NFO launches!