Challenges of Investing in New Fund Offer (NFO)

In the vast universe of investment vehicles available to retail investors in India, mutual funds have emerged as one of the most popular options. Within the mutual fund space, New Fund Offers (NFOs) hold an intriguing proposition for investors - a chance to get in early on a new mutual fund scheme before it develops a track record. However, NFOs come with their own unique set of advantages and disadvantages that require careful evaluation.

In this comprehensive guide, we analyse the pros and cons of NFOs through detailed real-life examples, analogies and case studies. The analysis covers key aspects like lack of past track record, the timing of the launch, costs involved and potential upsides in returns. By the end, you will have an in-depth perspective on NFOs that equips you to make informed decisions aligned with your risk appetite and investment objective.  

Challenges and Downsides of Investing in NFOs

While the low entry barriers and potential for higher returns associated with NFOs seem attractive, there are several downsides to consider before investing. Let's examine some of the key challenges involved:

• No Established Track Record

The biggest risk factor while investing in an NFO is the lack of a past track performance record. With no historical empirical data available, it becomes tough for investors to assess the fund's management quality or ability to perform well across different market cycles. 

For example: Investing in an NFO with a lot of hype without understanding the investment philosophy or macroeconomic conditions could result in losses. Therefore, ideally, one must study the NFO completely before deciding to invest.

Case Study: In 2022, a reputed AMC launched an NFO targeting the rural economy and agriculture sector. While the theme was unique and the AMC had a strong long-term track record, the lack of past data prevented investors from fully assessing the specific scheme's risk parameters or return potentials. Later on, the fund failed to outperform the benchmark index. 

The lack of historical data or a track record of performance makes it hard to set reasonable return expectations. Investors risk making over-optimistic projections about an NFO's profitability without accounting for associated risks.

• Timing of an NFO launch 

The timing of when an NFO is launched also significantly impacts its success. NFOs launched during bull market phases or when a particular sector is booming tend to get higher traction than those released when broader sentiment is weak.

For example: An NFO focused on banking and financial services companies launched just as the economy entered a growth slowdown phase and NPA levels in banks were elevated. Despite the pedigree of the AMC, the NFO had lacklustre growth due to market factors playing out in the sector. 

Additionally, existing market conditions also directly impact the type of stocks the NFO fund manager can access for the portfolio. Launching when market conditions are volatile or  valuations are stretched thin, limits the ability to find attractive investing ideas.

Case Study: An AMC launched a mid-cap-focused NFO when mid-caps traded at expensive valuations after a prolonged bull run. However, looking at the momentum of the market investors went on to heavily invest in this NFO. All the capital invested  forced the fund manager to compromise on quality and include over-valued stocks to deploy the capital raised. As expectations got excessive, the subsequent underperformance left investors with much lower returns that they were expecting. 

Therefore, the timing of the NFO launch and the prevailing market backdrop have an outsized influence on participation levels and eventual returns.

• Investors Tend to Have Unrealistic Return Expectations

Similar to IPOs,  NFOs tend to attract enthusiastic investors who think they may be to able to buy the NFO at low NAV and be able to generate higher returns when compared to any existing fund. The perceived notion of getting higher alphas, which means generating higher returns than the benchmark index by simply entering a new fund early accentuates this optimism.

However, these expectations often don't account for associated risks - especially in funds focused on higher volatility sectors. Investors are drawn by hype risk, underestimating potential downsides.

For example: An investor put 60% of their mutual fund portfolio into an NFO focused on small-cap startup investing, looking for massive returns. However, the portfolio tanked as underlying companies failed to scale up, causing significant losses versus benchmarks. The investor did not factor in that small cap funds have high risk and high volatility. 

Therefore, it is vital that NFO investors align expectations to the risk profile and volatility levels of the sectors/stocks the fund plans to target. 

• Costs and Fees 

Some NFOs tend to have  higher upfront fees and recurring expenses than established funds. The distributor commission and promotion expenses in marketing a new fund to investors account for part of these higher costs.

Fund houses also tend to charge a premium as the initial offer price, adding to the acquisition cost. For example, while the ongoing NAV may be ₹ 10 after launch, the NFO units could be allotted at ₹12 or ₹15 per unit.

Consider a hot new restaurant launching in a prime location. Given the heavy capital expenditure involved in setup/interiors and the high rentals, the owners price the food items significantly to recover costs quickly. Similarly, NFOs tend to have higher expense ratios and as the AUM of the fund increases, the expense ratios come down, much like the principle of economies of scale. The initial cost comes in the form of advertising, publishing pamphlets, printing of forms and marketing collaterals, road shows and broker meets across the country etc. 

The compounding impact of these higher costs can substantially eat into eventual returns delivered. So, investors should appropriately account for this cost factor in their overall expectations.

The Pros and Opportunities Associated With NFOs

While NFOs come with considerable risks, they also offer some unique advantages that merit exploration for investors with higher risk tolerance:

• Chance to Invest in Niche or Emerging Themes Early 

The dynamic nature of NFOs allows fund houses to launch targeted offerings focusing on specialised sectors or market segments too niche for mainstream funds. By investing in such an NFO, investors can gain exposure to potentially undervalued pockets primed for growth.

For example:  A fund house launched India's first NFO focused exclusively on environmental, social and governance (ESG) investing when this theme was still evolving globally. This allowed investors an early mover advantage to capitalise on the rapidly growing space.

The niche sector approach also facilitates higher conviction investing unconstrained by benchmark limitations. The fund manager can take concentrated bets in selected high-potential areas.

Case Study: An AMC launched an NFO focusing entirely on India's solar power sector just as policy thrust and environmental awareness were picking up. Its early investors reaped handsome rewards as solar adoption boomed over the next 5 years, delivering over 25% IRR.

• Chance to Participate at Lower Entry Barriers 

One major plus with NFOs is that they have substantially lower investment minimums than popular established funds in the same category. This allows retail investors with limited capital to participate in a relatively untapped thematic play without needing large ticket sizes.

For example: The minimum investment amount for several top-performing ELSS funds now ranges from ₹500 to ₹1,000 per instalment. However, an ELSS NFO launching now may set the figure between ₹100 to ₹500, opening the doors for more low-ticket investors.

The lower barrier benefits serious investors wanting to take measured exposure and first-timers looking to explore mutual funds.  

Some NFOs also offer discounted entry prices or bonus units for early investors, improving the investment proposition further. 

Case Study: An AMC launching an international funds-focused NFO offered a 10% discount on the entry price to investors participating in the first 3 days - incentivising quicker commitment.

• Potential for Higher Returns

Dedicated investing in specialised sectors by the NFOs can generate superior returns than well-diversified funds. The fund's managers have the flexibility and can indulge in higher levels of risk and churn the portfolios at a faster rate, thereby creating alpha generation opportunities.

Such upside is apparent for investors informed enough to stomach the volatility.

For example: A dedicated NFO for global cybersecurity companies got an IRR of 29% in 3 years, above the category average. Its highly concentrated portfolio of next-gen IT security names benefited massively from the pandemic-induced digitisation wave.

Early investors can earn huge profits if the underlying sector or stocks in that specialised NFO expand rapidly over subsequent years. Timing it well enables the capture of emerging upward opportunities.

• Scope for Investor-Friendly Product Attributes

Moreover, to appeal to desirability among early investors, NFO also carries a number of investor-friendly features that are not available in established schemes. These include:

• Low-cost ratios in first years to increase returns
• The option of flexible investment tenure or lock-in
• Tailored portfolio rebalancing/profit booking alternatives
• Rewards such as bonus units, cash rebates, loyalty points, etc.

Other Important Considerations Before Investing in NFOs

Apart from the advantages and risks discussed earlier, there are a few additional factors investors should evaluate before choosing to invest in an NFO:

• Portfolio Managers’ Track Record

Although the NFO itself may be new without any precedent, it is vital to analyse the manager profile and past performance record of the appointed fund manager. Compared to untested appointments, a manager whose abilities have been proven in the same industry or investing style is much safer. However, do note that the manager's past performance may  not directly translate to  success of the  NFO.

Case Study: In 2021, a well-known AMC introduced another banking sector equity fund, NFO, featuring an ace fund manager who has delivered excellent returns on the industry in more than 10 years across all market cycles. His expertise despite the lack of any past fund data.

• Capital Size After NFO

Although the entire amount of funds raised during the NFO period is not necessarily invested capital, yet it does determine the eventual value a fund manager can use to build up a portfolio. If the over-subscription is large enough to form a significant corpus, then such investments have greater flexibility in investing and lesser liability towards redemption pressures later, giving the fund more stability. 

In most cases, cash calls have to be taken by fund managers when under subscription takes place- affecting returns. The measurement of the final capital raised after an NFO closure is also a valuable assessment tool, but focusing on it now would be irrelevant.

• Strength of Investment Strategy and Process

Although an NFO may not have access to historical quantitative data with which it can assess itself, investors should judge the level of detail and accuracy in its articulated investment strategy and stock selection criteria.

Features such as portfolio concentration or diversification policy, buy/sell triggers, risk management guidelines, etc., offer insight into the quality perspective on design process robustness.

A higher level of transparency into the investment methodology increases trust and provides peace of mind to early adopters regarding the credibility of the proposition.

Conclusion

In conclusion, although NFOs are an exciting value proposition for investors interested in the emerging themes of higher return potential, they also have considerable risks to be mitigated.

Understanding attributes like fund manager profile, post-NFO capital position, and an elaborate investment process is critical before deciding to invest based on one’s risk appetite. With a critical eye well supported by knowledge of its subtleties, investors can make thoughtful decisions regarding new fund offers.

The analysis has also shown a need to temper the return expectations since it does not consider realities such as higher costs, no history and current market conditions of investing in NFOs. Systematic avoidance of over-optimism and diligent due diligence will continue to be hallmarks for long-term mutual fund investing success.

As we move on to the upcoming chapter, let us discuss how to diversify your portfolio by investing in International markets and understand the benefits and risks associated with it.