Why investors need to be cautious about NFOs

There are a number of New Fund Offers (NFO) launched by fund houses that seem attractive but one needs to consider many points before investing. Here’s why

Kavya Balaji Oct 24, 2019

Mutual Fund NFOsInvestors who have been investing in mutual funds since the last decade would remember the flood of new fund offers (NFOs) from all the major Asset Management Companies (AMCs). They would have also noticed that the number of NFOs launched in these days have drastically come down. Is it a case of AMCs having consolidated their positions in the market thereby reducing the need for fresh launches? No, let us understand the real reasons.

In October 2017, SEBI had brought out a mandate for categorisation of mutual funds to bring in uniformity in the market. Subsequently this has been executed by the AMCs in 2018. The major impact of this SEBI directive has been on the new launches of NFOs.

How NFOs worked

Prior to this SEBI mandate, AMCs used to launch NFOs with fund objectives and portfolio composition very similar to their own existing funds. What could be the reasoning? A NFO could be pitched in the market with an attractive growth potential to excite investors. Typically the NFOs initially were also presented as a great opportunity to buy them at a Net Asset Value (NAV) of Rs 10. The fact that after the subscription the same NAV could drop to Rs 8 would not get discussed.

The existing equity funds of AMCs had to comply with the ceiling on the expense ratio once the fund crosses a certain level of Assets Under Management (AUM). The AMCs looked at NFOs as an opportunity to charge a higher expense ratio with fresh mobilisation based on the marketing buzz created through their distribution network.

The mandate

SEBI took this down by bringing down the major categories of equity mutual funds to 10 categories with exceptions like ELSS (Equity Linked Savings Schemes or tax saving funds), Sector Funds, closed ended funds etc. The major categories include Large Cap, Mid Cap, Small Cap, Multi Cap, Focused Fund etc. In fact SEBI took it one step further by defining the market capitalisation to bring in uniformity. Therefore a Large Cap fund needs to have a minimum of 80% large cap stocks; a mid cap needs to have a minimum of 65% mid cap stocks. This exposed funds which strayed away from the stated objective to cash in on market movements.

For example, even a large cap oriented fund as per the fund objective could have opted for 45% allocation in Mid Caps to show higher returns among the large cap peers. This would not be possible after the SEBI directive. The AMCs were allowed to merge the existing funds so that consolidation under the new definition is met across the industry. The AMCs which had multiple funds under various names of similar objective had to consolidate and merge these funds to comply with the SEBI rule. This also curtailed the flurry of NFO launches made by AMCs under varied names but with similar underlying fund objectives. The duplication had been removed.

While this has been an investor friendly move by SEBI, the investor needs to be still cautious in case of NFOs. Here’s why.

The questions you need to ask

Let us assume there is a NFO of a closed ended equity fund. The bank’s relationship manager discusses the fund manager’s rationale and the great potential behind investing in this fund. The first question that the investor needs to ask would be whether there are existing open ended funds of similar objective. If yes, it would make sense to invest in an open ended fund which is highly liquid when compared to a close ended fund. If the theme of the fund is unique enough, then investor needs to understand the sectors that would form majority of the fund’s portfolio.

Suppose the composition of the proposed NFO is very similar to an existing fund in the investor’s portfolio, there is no urgent need to invest in the NFO. That would almost be duplication within the portfolio and portfolio diversity is compromised.

In any case the investor has a better understanding of the performance of his existing fund and has the choice of realigning his portfolio if it does meet the expectations. In the case of a close ended fund, there is no choice but to wait for the maturity. The flexibility angle for the investor in terms of tactical realignment based on periodic reviews would be available only in case of open ended funds.

The other major point to understand regarding a NFO would be the expense ratio. If the expense is higher than an average equity fund, the investor is better placed to let it go. Without a track record of performance in place, the NFO cannot be judged only on the basis of fund manager’s reputation.

Another key point to note while investing in NFOs would be to look whether it is fitting into your existing asset allocation proportions.

For example let us assume that an investor does not want more than 20% of his portfolio to be invested in mid caps. He/She needs to have an idea based on stock level composition of his overall portfolio in terms of large cap, mid cap segregation. When there is a launch of an emerging opportunities based NFO investing in small and mid cap oriented stocks, the investor needs to check if he/she has any space for allocating such a fund in his portfolio considering the overall break up based on market cap. If the NFO upsets the balance of the overall portfolio, it needs to be avoided keeping in mind the overall asset allocation that the investor has committed to.

Choice of investing in a NFO is quite tricky. The question is ‘why’ rather than ‘why not?’. If the rationale applied would be to invest in a unique theme which has high potential, then the first question is on fitment to the investor’s overall portfolio objectives. If that matches, then the cost angle needs to be clarified. If there is a higher differential in terms of cost when compared to the existing funds, the decision needs to be reviewed. If the NFO is a close-ended fund, then the obvious question of liquidity needs to be raised. Is the investor comfortable with the lock-in period?

When all these factors are reviewed carefully, the investor can go ahead with the choice of investing in a NFO with the comfort of having done the research on the need, fitment to portfolio and cost aspect.

Kavya Balaji

Kavya Balaji is a senior contributing writer with RupeeIQ. With more than 14 years of experience in the finance space, Kavya loves everything to do with personal finance. She feels financial literacy is important for every household and likes to stick to simple language for explaining personal finance stories. She is a consultant with investment management companies. In spare time, she reads murder mysteries.

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