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  4. How and when you should invest in NFOs

How and when you should invest in NFOs

2021 wasn’t the year of only IPOs. In the mutual fund space, AMCs launched funds at a blistering pace, taking advantage of the market upswing and investor sentiment. So far this calendar year, including the ongoing ones, the total number of just open-ended NFOs were 128. That’s more than 10 new funds hitting the market on an average in a month! This year’s NFO count is significantly higher than 2020’s 74 and 2019’s 110 NFOs. 

when you should invest in NFOs

For many reasons, an NFO appears to hold charm for you and we get queries from you on whether a particular NFO is worth investing in. We did write an essay on when you should consider an NFO and when it can be avoided. In that article, we had listed 3 questions to ask before evaluating an NFO for investing. What’s also different in this year’s NFO is the nature of the funds/ETFs up for grabs, many of which appear to make great diversifiers. We’ve covered a good many of these over the course of this year.

So, if an NFO appears to be worth investing in, should you go for it? What should your approach be, in NFOs? The trends in this year’s NFOs are useful ways to understand when to go for NFOs and what to look for.

Trend #1: AMCs plugging gaps

The first trend – though this is not exactly new – is that of AMCs launching schemes to fill up a particular fund category. After SEBI’s categorization mandate allowing an AMC to have only one fund per category, AMCs that didn’t have funds in some of these ‘new’ categories launched schemes to fit the gap.

For instance, 2021 saw the introduction of a brand-new ‘multi-cap category’ in equity after the earlier multi-cap morphed into flexi-cap. AMCs that classified their earlier multi-cap funds into the flexi-cap category launched funds in the new multi-cap category. Therefore, you saw the likes of HDFC, Axis, Kotak, Aditya Birla SL and so on launch multi-cap schemes. The reverse was also true – AMCs that kept their old funds under the multi-cap category launched new schemes in the flexi-cap category. These include ICICI Pru, Nippon India, and Mahindra Manulife. AMCs such as ITI and Trust saw several fund launches as they worked on developing their range of fund offerings. 

The second aspect is AMCs latching on to prevailing investor interest and launching schemes along those lines. SBI AMC did this in its balanced advantage NFO; it merged its existing (and underperforming) balanced advantage/dynamic asset allocation fund into its conservative hybrid fund, and then launched a new balanced advantage fund, garnering a record AUM collection. The category saw other AMCs too ride on investor preference for the apparently safer way to play equity volatility and risk these funds offered. Similarly, value funds in equity, and floater funds in debt saw about 3-4 NFOs each.

The approach

When an AMC launches a fund in order to bridge a gap in its fund range, to fill up categories in which it can have funds, or riding on popular themes, here’s what you should do:

  • Skip such NFOs as they do not offer anything new to your portfolio and you could be taking higher risk from the lack of history of the NFO. 
  • Such NFOs are typically a way for the AMC round out its offering, and in consequence also increase its AUM. 
  • Usually, these funds require understanding strategy and how it performs across markets; the important aspect in balanced advantage funds, for example, is the extent to which they use derivatives to hedge equity risk. For multi-cap funds, how they allocate to different market caps based on opportunities, the ability contain downsides and so on are important. You do not know all these aspects at the time of the NFO. 
  • Finally, it’s very rare that such funds are truly differentiated from others in the category. You will have established alternatives in the same category that are better options until there’s more history built up.

Trend #2: Going passive

If there’s one theme that’s firmly taken root this year, it is passive investing. Of the 128 NFOs this year, 65 are passive plays in equity or debt (or FoFs investing in ETFs). To put this in perspective, passive NFOs in 2020 and 2019 together were fewer than the 2021 figure. A second trend within the passive space was that AMCs simultaneously launched an ETF and a fund investing in that ETF in order to make the opportunity available to a wider swathe of investors. Of course, in terms of AUM, these funds account for less than a fifth of the total AUM of the 2021 NFOs.

But even so, the sheer number of passive options that exploded this year, which was across different AMCs and not only a small number as it was in the past, add heft to the passive movement. These NFOs were also diverse in the range they covered. For example, you had NFOs in large-cap bellwethers Nifty 50 or the Sensex as well as in mid-caps, small-caps, and multi-cap indices. There were sector ETF and index fund NFOs. There were NFOs on overseas market indices (see trend #3). 

Then there were NFOs on strategy or factor-based indices such as the Nifty Alpha 50, Nifty Alpha Low Vol 30, equal-weight indices, Nifty 50 Value 20. Finally, an emerging space was NFOs for target-maturity debt funds and ETFs, which started out with the Edelweiss Bharat Bond series in 2019 and gathered significant pace this year.

The approach

Because these funds/ETFs are passive, you already have a history by which to judge investment worthiness. They are going to be low on costs and low on maintenance. So, what should your approach be?

  • Do not assume that all ETFs/ index funds are good investments. There are indices that do not deliver and do not make good portfolio additions. Always check and compare index performance, using the same metrics that you would with active funds – consistency, upsides, downsides, volatility. For example, the Nifty Large Mid 250 does not offer a significant edge over another high-return-high volatile index such as the Nifty Next 50 in the longer term.
  • If the index is derived from a parent index –Low Vol, Alpha, Value, Quality and so on – understand whether that index beats the parent. Index data is usually available, at least for equity indices, for both BSE and NSE. If the index is a market-based one, look for ability to beat a comparable index or beat active funds of comparable categories. For passive debt funds, our earlier article explains how to choose them.
  • Where a similar index fund or ETF (based on same benchmark) is available, look at these existing funds to get an idea of trading volumes (for ETFs) and tracking error. For example, index funds or ETFs from the mdi or small-cap space often have a high tracking error, going by the existing index funds. But volume can be a tricky one to decipher. While volumes in sector ETFs and BSE-based ETFs are generally very low, there can be a popular index with high volume from an established AMC while a smaller AMC with similar choice of index may see low volumes in its ETF. Hence, in the case of ETFs, waiting for few months of traded turnover data may be an better option.
  • If the NFO ticks the above points, then check whether the index fits into your portfolio in terms of strategy and whether it offers any diversification. For example, if you’re a very conservative investor, an index such as the Nifty Smallcap 250 may not be a good fit. If you already hold the Nifty Next 50, a Nifty Momentum 30 doesn’t help. If you hold the Nifty 50, indexes like the Nifty 100 or the Sensex doesn’t help diversify. An equal-weight index and sector indices are more timed bets than long-term.
  • Therefore, choose wisely and avoid chasing after every passive option because it is there. Doing so will increase the number of funds you hold to minimal benefit. Low allocations to a large number of funds also reduces the impact a fund will have on your portfolio. Using a few funds/ETFs and making reasonable allocations to these will serve better than adding multiple funds.
  • If your investment or portfolio size is on the smaller side, aim for blended indices rather than individual indices. For example, a more concentrated allocation to the Nifty 500 may work well instead of small allocations to separate mid-cap and small-cap indices. For larger portfolios, combining individual indices in different proportions could offer a good balance.
  • Know that investing at the time of the NFO offers no benefit. Therefore, you can always invest in that fund or ETF at a later date. For example, when reviewing your portfolio, you prune underperformers, you can reinvest in these funds. Similarly, you can wait until you accumulate some surplus and then invest a good amount. Making a shortlist of potential ETFs/funds will help you keep track of options that are available.
  • The shortlist strategy will also come in handy because the passive space is an evolving one. There could newer options opening up gradually. So, if you do find an interesting index, try not to invest all your surplus into it. Either add it to your shortlist, or invest a part of your surplus and set aside a part for other opportunities.

Trend #3: International options

Moving overseas appears to be a fancied theme, with both active and passive NFOs sprouting this year. Of the NFOs, a good 10% were investing internationally – and this is not including other domestic funds that have invested in overseas stocks as part of their mandate. 

The international fund NFOs this year were, like the passive options, diverse in variety. They ranged from being thematic – such as the BNP Paribas Aqua FoF or the HSBC Global Equity Climate Change FoF, to the more mainstream Nasdaq 100. MSCI indices, too, found some ETF/FoF takers. There was even global REIT funds after the one from Kotak last year - from Mahindra Manulife. Passive international index options were another new trend this year, dominated by Mirae Asset and Motilal Oswal AMCs. There are several ETF/index fund NFOs still lined up, built along global themes.

The approach

Investing internationally is a great way to introduce diversification into your portfolio and access a completely different set of stocks, trends, and markets. 

  • An international fund, whether active or passive, does not equate to a good investment. As with any other fund, as explained above, always evaluate performance.
  • Where the fund is passive, look for historical index data from the index provider. Measure this performance against the Nasdaq 100 or the S&P 500 - the US markets offer among the lowest correlations with our own markets and serve as good benchmarks.
  • Where it is an active feeder fund (i.e., it invests in another global fund), you will have the underlying fund’s performance to go by. If the NFO is directly investing in stocks, it's best to wait and watch performance before opting for these funds. you have no dearth of funds to play the international space, and you will not be missing out on opportunities. The other risk in active international funds, is that it is hard to judge fund performance. Many of these funds invest across markets – i.e., many are built along the lines of being disruptors, innovators, global opportunities and the like. This makes finding a comparable benchmark and measuring performance difficult. Tracking and reviewing performance is a similar challenge.
  • As far as possible, therefore, stick to passive options in the international space. Keep overall international allocations to 10-20% of your portfolio; if you're already at this limit with indexes such as the Nasdaq 100/S&P 500, or US-based funds, you don't really need to add more funds unless it's one that offers a better correlation or return profile. We have explained in depth about how to choose international funds in this article
  • Remember that these funds are equity by nature. They will be volatile, and they will need long-term holding.
  • Similar to passive funds above, note that you will always be able to invest in these funds once the NFO period is done. You can add investments gradually, when both your surplus and portfolio allow for it. There’s no necessity to focus on these funds only in the NFO period.

Trend #4: Thematic differentiator funds

While thematic funds have always been launched, SEBI’s directive one one-fund-per-category has led to AMCs choosing the thematic category, where there are no such restrictions, to launch funds. But 2021’s thematic NFOs were along the lines of those in the year before – building along ESG, special opportunities, or business cycles. That is, these were broad-based themes, without focus on specific sectors or industries. Sector-focused NFOs were very few, and were more by AMCs bridging the gap in their categories.

The approach

Thematic funds serve as a return booster, as a theme can play out really well when markets take preference to those themes or sectors. For example, this past year has seen both infrastructure and IT doing very well as sector/themes. However, where themes appear more broad-based, note the following points before going for an NFO:

  • Where the theme is far too broadly defined, it’s best to wait and watch performance before going for such funds. For example, ‘business cycles’ has no clear definition; nearly every fund, whichever the category, will look to pick stocks based on where opportunities lie based on economic or business cycles. Similarly, ESG funds have a lot in common with normal diversified funds.
  • Where themes are more specific or interesting, such as disruptors or quant-based, and you are convinced that it is worth investing in, you can either choose to wait and watch performance, or start small through SIPs. Based on performance, you can increase the investment gradually. Of course, this strategy will hold only if the theme is broad-based and amenable to long-term holding.
  • Where themes require timing, consider adding it at the time of the NFO. In such cases, if there are existing funds in the same theme, look at these funds to know how returns may pan out. In sector funds, while there may be several funds present, past performance and strategy does not always hold out. However, note that the risk in these funds is higher, not just from the timing, but also from the lack of history.

Trend #5: Few closed-end funds

Closed-end funds are typically debt Fixed Maturity Plans or hybrid schemes. This year saw very few such schemes at just 21, slightly higher than 2020’s 13 but far below 2019’s 145 closed-end NFOs. FMPs, generally, are best avoided when the rate cycle is low as you will be locking into low yields. If you must, invest in FMPs when the rate cycle is near or at its peak, and time your investment horizon to the maturity of these funds. Also note that concentration risks – that is, exposure to individual issuers - in FMPs can be high, even if the credit quality is strong. The lack of liquidity is also a key risk. Therefore, avoid investing heavily in FMPs.

While there have been closed-end equity NFOs in the past, this year saw a few of them mature but then get merged into open-ended funds due to lack of performance. Given that equity is best held for at least 5-7 years, avoid closed-end funds in this space.

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