Investing in NFOs – 3 questions you should ask

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Many of you ask us about investing in NFOs. With this article, we hope to give you a playbook on whether and when you should consider NFOs.

Earlier this week, we analysed Kotak International REIT FOF’s NFO. A few weeks before that, we’d looked at the Nippon India ETF Nifty CPSE Bond Plus SDL NFO. And in the months before, NFOs that we’ve explained to you include the NFOs of ICICI Pru Alpha Low Volatility ETF, the Bharat Bond debt index funds/ ETFs, and the Motilal Oswal S&P 500 index fund. Notice any trend?

It is this – each of the NFOs offered an investment opportunity that was not already present in the mutual fund space. And that’s the key to answering the yes or no question in NFOs.

There is always a need to carefully consider NFOs. And when they come in soaring markets, more reason to deliberate before you decide. Right now, there are about 10 funds that are tapping markets, with several others already closed in the past few weeks.

In this article, we’ll give you 3 questions to help you decide when an NFO is worth evaluating for investment. But a quick word before that – beginners in mutual funds need to understand that there is nothing advantageous in going for an NFO. Rs 10 is not ‘cheap’. It is just a starting NAV for a fund that is yet to build its portfolio.

Caution when investing in NFOs

Questions to ask before investing in NFOs

Now for the questions you need to ask to judge if investing in NFOs is worth it.

Q Does the strategy require you to wait and watch how the fund executes it?

In any fund, whether debt or equity, past performance is important. It offers the only way to gauge the effectiveness of the fund strategy. In an NFO, you have no information to rely on to gauge either how the fund will manage across markets or the nature of its return or its suitability in your portfolio.

Why is it important to know these aspects? One, as you can’t predict returns, you can only draw comfort from the fact that a fund has weathered different market cycles and still maintained returns. You need to know that the fund you’re investing has a strategy that can straddle across market phases (whether debt or equity). In an NFO, you won’t know this.

Two, you need to know the nature of returns. Is its USP containing declines well? Is it a high-return, high-volatile fund? The way the fund performs, the way its returns pan out, and its strategy will help you use the fund in your portfolio the right way, besides knowing if it even fits your risk-return profile. For example, a fund that’s high on volatility but still good on returns may not fit conservative investors. Or it may be used only if your portfolio has other less-volatile funds. Again, you do not know how this works in an NFO.

Consider the HDFC Dividend Yield NFO, for example. Dividend yield involves picking stocks where dividend yields are higher than a set benchmark. Stocks with higher dividend yields are typically undervalued, and when such companies pay out high and steady dividends, they are qualitatively strong as well. It therefore translates to a form of value investing.

In other words, the strategy is not unique but it definitely needs watching over to know how the fund picks stocks, what sort of mix (large, mid or small) it builds, to know its risk and return profile. In fact, the existing dividend yield funds have a chequered history and have fallen precipitously where they took aggressive calls.

Or take the Axis Special Situations NFO. The fund, according to its literature, will invest in disruptive stocks. Now, what traits go into defining ‘disruptive’ is open-ended; which stocks qualify as disruptive is equally vague. The fund could really pick up global or domestic change-makers or simply be another normal diversified equity fund. Besides, there are always market disruptors, so again timing is not the need here. You can well wait, even if it’s just a few quarters, to see how the fund really deploys your money and if there is merit to the ‘disruptive’ tag.

In a nutshell…

Skip investing in NFOs where:

  • The fund’s strategy, or where it invests, is such that you need time to understand how it will maintain its portfolio across interest/ stock market cycles, key to knowing if that fund will fit your portfolio and is a good performer.
  • The fund does not require a timed entry

Evaluate investing in NFOs where:

  • The fund is a passive fund/ETF as you have the underlying index to check how returns have been. We recommended the Motilal Oswal S&P 500, for example, because it was an index fund and US exposure provides good portfolio diversification.
  • The fund is unique and is in a fund-of-fund structure with information on the performance and strategy of the underlying fund(s). An example here is the Kotak International REIT FOF since we had the main REIT fund to gauge merits of the opportunity.
  • Timing can make a difference. The first Bharat Bond ETF/FOF tranche, for example, allowed you to lock into higher long-term yields at the time of its launch which may not have lasted later on.

If a fund is neither unique, nor requires timing and needs time to understand how its strategy is executed, best to watch and skip the NFO.

Q Is the fund going to be different from other funds?

There are over 900 open-ended funds across equity, debt and hybrids. Over the years, as the mutual fund space grew and developed, funds have come up with a wide variety of strategies and themes. Given the enormous range, ask this of the NFO – what’s new about this fund that isn’t already present?

But you may wonder why being different is important. For that, go back to Question 1 and the answer. You need to know how a fund performs if you are to be confident that it can deliver well for you. You can’t do that with an NFO.

As a result, when there is an established fund that’s following the same style as the NFO, and this established fund is beating the market and peers it would be far safer to go with the known entity. The presence of a consistent, quality fund gives you the same opportunity, reducing the need to go for the NFO. It gives you the freedom to watch the new fund for some time in order to make a more informed decision.

For example, the DSP Value fund NFO garnered interest for its value-style blend of domestic and international equity along with cash calls. But there already is an equity fund that does the exact same strategy and very well at that, which is Parag Parikh Long Term Equity. So, if it’s the strategy that’s attractive, there’s already a well-performing alternative. This reduces the need to opt for the NFO; watching how the DSP fund builds and changes its portfolio would give a better grasp of whether the fund is worth going for.

The current hot trend of ESG ticks the same box. In an ESG theme, funds pick stocks that score on environmental, social, and governance metrics. We’re not getting into the nuts and bolts of ESG investing. But going by both the basics of ESG investing and what funds so far have done in their portfolios, it boils down into picking quality stocks with strong governance.

Funds already look at governance when selecting stocks, as well some of the factors that go into the ‘E’ and ‘S’ components. A company with a strong ESG score does not automatically make it a good buy, it also needs to deliver on revenue and earnings growth. So funds still have to look at these fundamental strengths, just as they do with any of their other funds.

That means ESG fund portfolios share similarities with other equity funds that invest across market caps. For instance, about 60% of SBI Magnum Equity ESG’s November portfolio overlaps with Canara Robeco Equity Diversified, which goes for quality growth stocks.

Therefore, the ESG theme alone is not unique enough warrant an immediate entry into a fund without knowing where exactly it is going to invest. Existing funds may still provide a similar opportunity even without being called ESG.

When there is an established fund that’s following the same style as the NFO, and this established fund is beating the market and peers, go with the known entity.

On the other hand, the recent debt ETF NFO from Nippon India which invested in PSU bonds and SDLs was completely different from other debt funds or even the Bharat Bond series. The Kotak International REIT FOF is another example where the fund offered a way to play real estate that was both absent in India and had good potential. Funds like these are worth considering because they add a different characteristic to your portfolio.

But where funds offer unique investment styles, you still need to run a check to know if it’s better that you wait for some performance and portfolio details, or whether it even is the right time to invest. An example here is the ICICI Pru Quant Fund that uses a model that combines macro factors, fundamental stock filters and technical indicators to construct its portfolio. Quant models may work well in theory but may not pan out as well in reality. This apart, the fund manager retains the freedom to evaluate and change factors used in the model on an annual basis.

In a nutshell…

Skip investing in NFOs where:

  • The fund does not offer a different investment opportunity
  • There are alternative funds available which make similar investments and which have established a strong performance record

Evaluate investing in NFOs where:

  • The fund offers a new investment avenue or style/strategy that will help diversify your portfolio
  • There is no established peer fund that has done well, provided the strategy does not require watching as explained above.

Where funds offer unique investment styles, you still need to run a check to know if it’s better that you wait for some performance and portfolio details

Q Do I really need it in my portfolio?

So an NFO satisfies Questions 1 and 2 above. It is interesting enough to invest in. But then, the final question to ask is if you really do need to invest in it. For one thing, remember that this will add to the list of funds you already have. An excessive number of funds does not help your portfolio and makes it more difficult for you to review and manage.

Two, your portfolio could already be sufficiently diversified and adding another fund may not make a material difference. For instance, the ICICI Pru Alpha Low Vol may share little with other equity funds. But if you already have a combination of low-volatile funds (passive or otherwise) and those that score on upsides, the Alpha Low Vol ETF may not help much. If you already hold debt funds that span gilt funds, quality corporate bond or banking & PSU funds, going for the fund like the Bharat Bond series may simply be yet another one in your portfolio.

Bottomline

Remember this. An NFO is nothing special that needs your immediate attention. It is just another fund that’s now available in the market. Investing in NFOs is not like IPOs where there may be a pricing advantage (or potential listing gains, if you’re a trader). Even when NFOs offer different opportunities, you can invest in them at any time even after the offer period. Unless there’s timing benefit involved, an NFO offers no advantage compared to existing funds.

Also read: HDFC Housing opportunities fund – Exit?

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4 thoughts on “Investing in NFOs – 3 questions you should ask”

  1. Thank you team for writing this. Helps analyse NFO’s. Would you be doing some coverage of the Axis special situations funds NFO?

    1. Hello sir,

      No, we don’t plan to cover Axis Special Situations. Its stated strategy is too vague to form any opinion on what the potential could be. We’d need to wait to see what the fund does, and as mentioned in the article above, it’s not really a theme that needs timing.

      Thanks,
      Bhavana

  2. A very common topic but nicely articulated. Read this topic in other blogs/ platforms, but don’t have hesitation in saying that this point by point explanation with example is so far best.

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