Simple rules to invest in NFOs

Many individuals we met during the last three years felt that their advisors wrongly sold them unit-linked insurance plans (ULIPs). These individuals have equally complained about their investments in certain active mutual funds that have underperformed their benchmarks.

Our intention here is not to accuse the advisors for selling such products or comment on the insurance companies and asset management firms offering such products. Rather, our attention is on you, the investor. We think it is your responsibility to protect your investments! And the only way you can do it is to invest time and effort to understand the products you buy. In this article, we discuss the issues that you should address before you invest in a new fund offering (NFO).

Asset management firms continually introduce new products and add to the already flooded market. Given this, how should you evaluate a fund? Below, we offer you a handle to evaluate investments in NFOs.

Choosing active funds

Is the new product based on a benchmark on which index products are available? This question is important because you should always weigh the pros and cons of active and passive investment.

An NFO benchmarked to, say, CNX 100 may not have a passive alternative in the market at present.

If index funds are not available, is the investable universe less crowded, if not new? This is, perhaps, the most crucial question you should consider before investing in an NFO. How will you know? Check if the fund describes its proposed strategy in the offer document. Often, the fund will simply state that it “seeks to generate long-term capital appreciation”. That does not say much about its strategy! So, check if the fund proposes to invest in a universe of stocks that is uncommon. A fund proposing to have a CNX 100 or BSE 200 is more common than, say, a fund that proposes to have the NSE Commodities Index as its benchmark index. The benchmark index tells you that the fund manager is likely to choose among the stocks that constitute the index. If more funds are benchmarked to the same index, lesser the chances of a fund beating its benchmark, as all funds are chasing the same investable universe.

Assuming the fund has a relatively new investable universe, are you comfortable with the asset management firm? If yes, invest. Choosing the asset management firm is, perhaps, the easiest step, as you may prefer to invest in NFOs offered by firms with which you have an existing relationship.

Conclusion

In short, you should invest in an NFO if the fund proposes to invest in a less-crowded investable universe. You can use the above as filter-rules to evaluate existing active funds.

Unless you have a compelling reason to invest in an active fund, you should consider an index fund, its passive alternative, if available. Why? Empirical evidence has shown that active funds do not consistently beat their benchmark index. The ability to beat the benchmark index is a function of two factors- assets under management (AUM) and number of peer funds. And the likelihood of beating the index reduces with the increase in AUM and peer funds.

This is further compounded by the fact that the cost of investing in an active fund is higher compared to an index fund (approximately 2.5 per cent vs. 1.5 per cent of the average AUM). This cost is important. Why? For one, you will incur this cost even if the fund earns negative return in any year! For another, higher cost means lost money, money unavailable for you to invest and earn higher return.

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