Are New Fund Offers Made For You?

The last one year has been quite hectic in terms of launch of new fund offers (NFOs). According to a report by Morningstar, in FY21 the industry launched 110 funds which have collectively raised Rs 48,988 crore. Such data would be quite tempting for investors to check out the NFO route of investing. But have you considered all the pros and cons? The article underlines the salient factors of NFOs

A lot has changed in the last couple of years for new fund offers (NFOs). Recently, one of India’s largest fund houses, ICICI Prudential, collected around Rs 10,000 crore in its NFO, ICICI Prudential Flexi-Cap Fund. To give you a perspective on this number, out of 400 odd equity dedicated mutual fund schemes, only 29 funds have asset under management (AUM) of greater than Rs 10,000 crore. Even within 30 flexi-cap funds that we have now, only seven of them have AUM greater than Rs 10,000 crore. This is probably the biggest collection by any single mutual fund scheme in India. Compare this with the start of the year 2019 when the fund houses had to extend the issue dates to collect a respectable amount in NFOs.

This highlights the euphoria around the NFOs. The last one year has been quite hectic in terms of launch of NFOs. According to a report by Morningstar, in FY21 the industry launched 110 funds which have collectively raised Rs 48,988 crore. Out of this, 45 funds were from the equity category that garnered around Rs 30,000 crore. Historically, we have seen that a lot of NFOs come when the equity market is doing well. The equity market from the lows of March 2020 has seen an impressive rise. This is also reflected in most of the equity-dedicated funds that have delivered spectacular returns. Many categories of funds have generated returns in triple digits over the last 15 months. The last time we saw such a performance from equity-dedicated mutual funds was in 2017. Again in that year we saw 32 open-ended, equity-oriented NFOs getting launched.

The pattern that we have observed is that a good number of NFOs are launched after a good year of equity market performance. For example, 2010 was a good year for equity returns and BSE 500 index generated return of 15.32 per cent following which in the year 2011 we saw six NFOs getting launched. When in 2011 BSE 500 generated negative return of 27.78 per cent, there was only one NFO in 2012 while the BSE 500 gave return of 31.04 per cent. The year 2019 has been an exceptional year as we saw that despite 2018 not being a good year for the broader equity market, 36 NFOs were launched in 2019. One of the reasons for such a high number was due to the rejig done by market regulator SEBI in 2017 in terms of standardisation of the mutual fund schemes.

In October 2017, SEBI came up with its initiative of rationalisation and categorisation of mutual funds to bring forth uniformity in the way asset management companies (AMCs) function and standardise the character of fund schemes across categories. Some new categories were also introduced such as large-cap and mid-cap. This gave many AMCs an opportunity to launch schemes in the new categories. Besides, there were couple of fund houses that launched index funds tracking different stock indices.

One of the characteristics of recent NFOs is that many of them will be passively managed. An increasing number of index funds and ETFs are being launched now. In the last one year out of 104 NFOs launched, including debt and hybrid, almost one-third of them have been either index funds or exchange-traded funds that are mostly passively managed. What we have also observed is that after a good number of NFOs being launched, the equity market after has given a subdued return many a times as in the years 2015 and 2018. So, with a slew of NFOs coming forward, should you invest in them? Let’s find out in the following paragraphs.

Performance of NFOs
In last one year ending June 30, 2021 there were 34 equity-dedicated funds launched in India. The sub-category that got the most launches was ESG funds, where six funds were launched. This was followed by the ‘other’ category that included a couple of quant funds. 

We will compare the performance of these funds against their benchmark and category average in the same period to arrive at the relative performance of these NFOs. To start with ESG funds, there were six funds launched since the start of 2020. Out of this, four funds are underperforming the benchmark in the same period whereas two funds are outperforming the benchmark. Quant ESG Equity Fund has generated exceptional return due to its unconventional portfolio where its top holding is a mid-cap stock and forms almost 9 per cent of its net assets.

When we compare with the category, for all practical reasons, SBI Magnum Equity ESG Fund is the only fund in this category that has a history of more than three years. SBI Magnum Equity Fund was reclassified and repositioned as SBI Magnum Equity ESG Fund in May 2018. This fund roughly imitates the return of its benchmark and therefore most of the recently launched funds have underperformed the existing fund in the category as they have underperformed the benchmark.

Timing it Right

As our study shows, NFOs should be avoided as they have higher expense ratios and no past record at all to gauge their performance. Nonetheless, an NFO is not something that is untouchable. There are cases when you can invest in NFOs.

• Different Theme: If the NFO is offering a new investment idea or theme that goes along with your investment objective or overall financial plan, you can invest in it. If it is offering a niche that is not currently covered by the market, you can take exposure to it.

• Complementing Portfolio: If a NFO is launched that can give you access to new asset classes or investments that will help you to either diversify your risk or add to your returns in ways that are not currently possible, you can look into such NFOs. Going through the scheme information document (SID) will help you to know all these and make the right decisions.

Now we will extend our study to other categories where limited numbers of NFOs were launched. Three mid-cap-dedicated funds have been launched year till date. All the three funds have outperformed both the benchmark and category average since their launch. In the case of small-cap dedicated NFO, there was only one actively managed fund that was launched while the other two are passively managed. What is surprising is that passively managed funds were able to beat the index while the actively managed fund underperformed both the benchmark and peers in the same period. There were three NFOs launched in the ‘value’ sub-category of equity.

Out of this, once again one was an index fund. Another was launched in the month of June 2021 and hence does not merit any comparison. Another fund from this category has been barely able to match its benchmark performance. There were three focused funds also launched in the last one year. Most of them are benchmarked to S & P 500 – TRI. All of them were able to beat the index returns; however, when it comes to the category average in the same period we see that one was able to beat the category return whereas the other lagged the category returns. Our study of equity-dedicated funds launched in the last one year shows that most of the NFOs were able to beat the benchmark returns but there was a mixed bag when it comes to beating the category average.

Only 40 per cent of the NFOs were able to beat the category average in the same period. Most of the outperformance from the category average has come from the NFOs dedicated to the broader market. We saw that large-cap dedicated funds have not been able to beat category returns and benchmark returns in the shorter duration. 

We also did a study where we assumed that you had invested an equal amount in each of the 34 NFOs. The extended internal rate of return (XIRR) of such investment would have been 60.77 per cent at the end of June 30, 2021. Compare this to 49.75 per cent return you would have got if you had invested the same amount in Nifty 500 TRI index. It shows that the NFOs have outperformed the broader market.

Nevertheless, this comparison is not on a like-to-like basis as only 10 per cent of the NFOs we studied are large-cap-dedicated while in Nifty 500 TRI, large-cap stocks have weightage of 50 per cent. In the last one year we have seen that the broader market has outperformed the frontline market by a huge margin. Small-cap and mid-cap indices have generated returns greater than 70 per cent in the last one year compared to just 42 per cent return by Nifty. Since the NFOs that we studied have larger weight to the broader market, the returns were skewed towards the broader market and hence showed larger returns. 

Industry body AMFI has run a high decibel awareness programme for investors; despite that many investors still continue to focus on Rs 10 net asset value (NAV) or cheap NAV. They believe that an NFO is cheaply priced as they are getting it at just Rs 10. They get confused about the initial public offer (IPO) of a company with that of the NFO of a mutual fund. Unlike in shares or bonds there is nothing like cheap NAV or expensive NAV in mutual funds. The NAV of a mutual fund reflects the investments made by the company after deducting its liabilities. Since a new fund is yet to start its investments and construct its portfolio, there is nothing to show. Offering units at Rs 10 attracts potential investors to subscribe to the NFO.

The low net asset value makes investors assume that it is available at a cheap price. But this is far from the truth. The returns delivered by both existing funds and an NFO depend on the underlying returns of the securities during a similar timeframe. To illustrate with an example, if you had invested Rs 10,000 in BOI AXA Flexi-Cap Fund (Regular) NFO last year in the month of June at NAV of Rs 10, you would have got 1,000 units of the fund. Currently its NAV is Rs 18 and so your investment value would have grown to Rs 18,000. In the same period, if you had invested in another fund called Nippon India Growth Fund whose NAV was around Rs 1,025, you would have got 10 units of the fund. Currently the NAV of the fund is Rs 1,871. Again your investment would have grown to around Rs 18,710. Hence, NFOs are cheaper is a maxim that is not true.

Investing in NFOs

Analysis of the last one year’s data shows that investing in NFOs may not create alpha in shorter duration especially when we compare with the existing funds. We believe that avoiding NFOs is advisable in most of the cases. The reason being that it takes almost a couple of months to build a portfolio and till then in most of the cases if the market is rising the NFOs give negative return. Only in case where the market is falling do you get the chance to earn more, but not necessarily. Our analysis of all the sub-categories of equity-dedicated NFOs clearly highlights the point. Besides, investing in NFO is like taking a shot in the dark. You do not know anything about the fund other than its benchmark, fund manager and his track record in some cases.

However, none of these play as important a role as the portfolio of the fund and fund’s performance in different phases of the market cycle to gauge its future performance. These factors give an investor the confidence to invest in a fund. Sometimes investors get influenced by the performance of certain fund houses and want to bet on their new schemes. If many schemes from a fund house are doing well, investors are confident of the NFO also doing well in the long term.

They may be right in their perception; however, it does not present a strong case to invest in NFOs as history has shown that outperformance of the funds by a fund house is transient in nature. HDFC MF had been a leading fund house a few years back with most of its funds remaining in the top quartile in their category. The situation, however, has changed now and very few funds from the fund house are beating their category average. It truly exemplifies that past performance may not be a guarantee of future returns. Therefore, even if you want to invest in a NFO, you can always wait for a few months, analyse the structure of its portfolio and then invest.