Mutual Fund NFOs have Hidden Costs

5 comments Written on November 17th, 2006 by
Categories: MutualFunds
New Fund Offers (NFOs) by Mutual Funds are common. In fact they are touted by most distributors saying "NAV is only Rs. 10!, buy!"

But should you just buy?

Firstly a new fund is very risky. You don't know how it will perform. If you have similar funds with a good track record, of greater than five years, you might want to invest in those instead.

NAV at Rs. 10 makes no difference really. Mutual fund units are a function of "percentage" gains only - that means if the stock market goes up 5%, a mutual fund with NAV of Rs. 10 will go up to Rs. 10.5 and one with NAV of Rs. 100 will go up to Rs. 105. Gains are the same for you - your investment grows 5%.

And there's the question of commission.

Fund houses will offer distributors upto 6% commissions for selling NFOs. If you buy a fund anytime after the NFO, the distributor gets only upto 2.5%. No wonder distributors want to sell the NFOs. So who pays for this commission?

If you buy a fund after the NFO, this is usually an "entry load", meaning you get charged upto 2.5% of your money upfront to pay the distributor.

In an NFO, it's a "hidden" cost. Though many NFOs come with zero entry load, SEBI allows fund houses to charge upto 6% "NFO marketing" fees, part of which goes to the distributor and a part to the ads etc. that they put. This is 6% of all the money collected; for instance, Reliance Equity fund collected more than 5000 crores, and the 6% marketing fees is about 300 crores. That is a lot of money for advertisements and commissions!

This amount is (usually) taken out from the net assets of the fund, so the NAV goes down, sometimes below the issue price.

In some NFOs, fund houses like Templeton have decided to bear the marketing charges themselves so that the NAV remains at Rs. 10 or above after listing.

Earlier (before July 2006) Fund houses were allowed to amortize expenses over five years, meaning they remove only 1/6th part of the expenses in the first year and so on. (They usually do it quarterly or monthly) Basically, if you buy those funds even four years after the NFO, you are still paying the NFO expenses. Also, a similar fund, more than five years old, will give you better returns!

Those rules have changed but such funds like Reliance Equity can continue to amortise over the next four years, since the rules came after their issue. Be aware that investing in such funds even now (till 2010) will involve your NAV suffering to the extent of the remaining NFO charge.

The other problem with the old rules (which still apply to funds that had an NFO before July 2006) is that usually big investors take out their money immediately after the NFO. Why does that affect you? Because you pay more of the marketing costs. Let me give you an example.

Let's say you invest in an NFO that collects Rs. 1000 crore. Of that, Rs. 60 crore is marketing cost (6%), amortized over five years, so 12 crores per year, which is about 1.2% per year. Now big investors take out Rs. 600 crore in the first year. So the 12 crores has to be taken from the remaining corpus of Rs. 400 crores, which is 3% per year. If you invest for five years, your NAV suffers 15%! That simply means, another fund that has been around for more than 5 years, will make 3% per year more than your fund. This applies even if you invest in the fund AFTER the NFO, since this is amortized.

(New NFOs though do not have this problem, since the cost must be charged initially itself and no further amortization is allowed)

This is true for closed ended funds also. In fact for recent closed ended fund NFOs, if you try to get out of a closed ended fund before the end date, you are charged part of the amortised portion of the marketing charges. Closed ended funds are allowed to amortize the initial charges for five years (open ended funds are not).

In simple language: unless the AMC is bearing the marketing charges, Don't invest in NFOs. Don't invest blindly in funds that have had an NFO before July 2006, within five years of the NFO; they have a hidden cost that is applicable to you.

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About the Author:
http://www.capitalmind.in
The man behind Capital Mind. Deepak is a co-founder at MarketVision, a financial knowledge company. Deepak also provides data research and consulting services, and now lives in Bangalore. Connect with him at deepakshenoy@gmail.com.

5 comments “Mutual Fund NFOs have Hidden Costs”

>Well, take a look at the Sebi circular dated April 4, 2006:
http://www.sebi.gov.in/circulars/2006/cirimd01.pdf

Point 1, states:
- The initial issue expenses will be permitted for closed-ended schemes only.
- b. Open ended scheme should meet the sales, marketing and other such
expenses connected with sales and distribution of schemes from the entry load and not through initial issue expenses.

Does that not limit this article to close ended funds only? (for which I say this is an excellent read for all investors being lured into NFOs by their evil advisors)

>You’re right, and the proposal has attracted almost exclusively closed ended schemes since then! In the few open ended schemes the AMC has taken on the initial expenses.

Soon most new funds will come with 6% initial expenses, or distributors will agree to lower commissions.

>Absolutely excellent !

I m a software professional and totally unaware of these fine lines.

Please continue to help novices like me with this sort of gyan

>This is regarding the example you gave for the devolution of the ad & mkt spend. Is it not true that at the time of exit, the amortized amount remaining for the ad & mkt spend has to be borne by the person exiting the fund?

>Anonymous: That is true only for closed ended funds who had an NFO after June 2006.