Big Story | Are New Fund Offers worth the hype?

Anything that’s new always catches our eye. This bias for novelty is one reason why mutual fund companies find New Fund Offers (NFOs) an easy route to gain assets.

With NFOs, it is easy to plug the flavour of the season, be it US investing, smart-beta investing, small/mid-cap plays, ESG/responsible investing, quant strategies or just sector bets to cash in on a recent upmove.

A snazzy presentation, colourful brochure/product notes and an army promoting the NFO on social media add to the appeal.

Between 2017 and 2020, coinciding with the ongoing bull run, equity NFOs collected between ₹27,000 crore and ₹33,000 crore annually from investors. That’s about ₹1.23-lakh crore across open-ended equity NFOs, including exchange-traded funds (ETFs) such as Bharat 22 and CPSE, and fund of funds (FoFs). In the first two months of 2021about ₹4,500 crore has been in through half a dozen new schemes.

When markets go up 50-60 percent, like they have over the past year, those investors suffering from FOMO (fear of missing out) feel a new fund offer is a ticket to board a flight they had missed. For others, an NFO offers fresh hope when 80 per cent of existing equity MFs have found it tough to beat their respective benchmark indices in the one-year time-frame.

Given that they’re so popular, we analysed the NFO trends and performances of the past five years (from March 2016 to March 12, 2021) to present some findings:

1 NFOs are timed to bull markets

A basic principle of equity investing is: higher your entry price and entry valuation, the lower your future returns. This makes bull markets a poor time to invest lumpsums in mutual funds, and bear markets the best time to do it.

But AMCs like to bunch up their NFOs in bull markets because such times are more friendly for mopping up large assets.

In a bull market, investment stories sell easily. The Sensex has never clocked an annual drop since 2015.

Such has been the pace of rise that markets have doubled in five years. This has accelerated the NFO frenzy.

This year has seen at least one new equity NFO each week. In 2020, 48 new equity funds were launched in 52 weeks despite the Covid-19 pandemic. The year 2019, too, had seen a similar number of funds launched.

The high number of NFOs coming at you in the last 4-5 years is merely history repeating itself and is unlikely to end well. Between 2003 and 2007, when stock markets went up six-fold, new fund launches garnered over ₹97,000 crore, including from numerous close-ended products.

During phases of exuberance and euphoria, it is important for you as an investor not to commit mistakes.

Don’t put money in equity NFOs because their NAV is ₹10. A low NAV of ₹ 10 does not mean that a new fund is undervalued compared with other equity mutual fund schemes.

Hypothetically, if an NFO at ₹10 maintains the same portfolio as that of an existing equity scheme with an NAV of ₹150, the future returns would be the same for both the schemes irrespective of the NAV.

You just get more units when you buy a fund with ₹10 NAV.

Seasoned funds that have withstood past bear markets may be safer to own in euphoric phases like the present, going by the performance track record of NFOs in the past five years. This takes us to the second finding.

2 The wait for Mr Alpha continues

One of the major reasons one invests in actively managed equity funds is alpha generation. So, how do new funds actually fare on alpha generation?

To find out, we analysed the actively managed equity funds (with at least a one-year track record) launched over the last five years.

We found that the share of new funds launched in the past five years underperforming their respective benchmark in the last one year is as high as 79 percent. For instance, many newly launched small-cap funds generated a one-year return of 56-78 percent, but came short of matching the 80 per cent gain notched up by the benchmark Nifty Smallcap 250 TRI.

This means the sharp rise in markets was too fast for the actively managed new funds. But this trend may not be limited just to new funds. When markets do a swift turnaround, as they have since April 2020, even seasoned funds cannot be right on the money, in terms of adjusting their portfolios to be in sync with the reversal.

Even stretching the performance to a three- year period suggests that NFOs underperform. More than 70 per cent of actively managed NFOs with a three- year history have underperformed their benchmarks. Considering that the market has not seen a particularly prolonged bearish period in the past three years, if a fund finds it tough to outperform its benchmark, such products may not fare better when markets enter a two-way street.

Moreover, benchmark return data available for 63 equity NFOs launched in the past five years show that nearly half of them have failed to beat their respective benchmarks since inception. So, investing in new funds is far from a sure-shot recipe for alpha generation if you are thinking of investing in a new fund because existing ones are lagging in alpha.

3 Betting on flavour of the season not a good idea

Every market phase has its own favourites. Money keeps going out of the least-preferred pockets and into the new-found darlings. Of late, most NFOs hitting the market are not of the diversified variety but thematic funds playing on various new ideas.

The major reason behind many thematic/sectoral fund launches now is the 2017 transformative exercise by the SEBI to re-categorise and rationalise mutual funds. Only one scheme per category has been permitted, except for index funds/ETFs, FoFs and sectoral/thematic funds. This window has given AMCs a greater preference for thematic launches.

Now, going by history, thematic and sector fund launches are seldom made when a sector is down-and-out and truly offers bargain buys. Instead they’re rolled out when a sector or theme is highly fancied.

For instance, US market-based funds are being launched now, when the markets there are as heated up as the Indian markets. Between 2004 and 2008, infrastructure was a much fancied theme — about 17 infrastructure funds were launched by Indian AMCs. Half of such funds have, since inception, generated 2-8 per cent .

About one-third (eight) of the 22 new-fangled thematic/sectoral funds launched in the past five years have struggled to beat the Nifty 50 since inception. This means that money was better invested in a Nifty 50 index fund.

Of course, some could argue that two-thirds of the thematic/sectoral funds beat Nifty. One should note that five of the 14 such funds belong to the healthcare and pharma sector, a space that has seen massive stock price appreciation against the backdrop of Covid-19. These funds happened to be in the right place at the right time.

As promising and attractive as a thematic NFO may seem, it is important for investors to see whether their portfolio really needs that new fund. Thematic/sectoral funds should form 10-15 per cent of your portfolio, if you go for it. The core of a fund portfolio should comprise plain-vanilla large-cap, index or multi-cap funds.

4 Passive funds in vogue

While most active fund NFOs are driven by asset-gathering objectives, one category in the NFO market that may add value to investors is the passive space where Indian AMCs are just expanding their menu.

SEBI’s one-fund-per-category rule leaves the entire room open for passives. Fund houses are attempting to cater to the demand for index and ETFs. Over the past year, more than three-fourths of actively managed equity funds have lagged their benchmarks, while 63 per cent of funds have under-performed their respective benchmark indices in the three-year period. Below-par performance of actively managed funds has meant that passives are in vogue globally as well.

In August 2019, assets of US indices-based equity MFs and ETFs topped those in active stock funds for the first time.

In 2021, the filings for proposed equity funds is split down the middle for active and passive products. Passive equity NFOs have a high share (75 per cent) among overall equity fund launches this calendar year. This picture was completely different 10 years ago. In 2011, it was actively managed funds that accounted for over a 70 per cent share in NFO launches.

With equity indices proving hard to beat for actively managed schemes, some exposure to passively managed equity funds is perhaps necessary.

When you select an index fund or ETF, choosing options with the lowest impact costs (for ETFs), the lowest tracking error, the highest trading volumes (for ETFs), and in sync with your overall strategic asset allocation is ideal. But many new ETFs and index funds will not make the cut, going by this checklist.

That said, passive funds based on the Nifty 100, mid-cap indices, or smart-beta indices such as the Nifty Low Volatility or the Nifty Equal Weight may be better than diversified index funds that track indices with 250 or 500 constituents.