Due Diligence. Why you must give most NFOs a pass

The past few months have seen many equity new fund offers (NFOs) from leading fund houses, thanks to the buoyant equity market. With a stable government at the Centre and expectation of improvement in the macro-economic situation, equities may remain in favour, and one can possibly anticipate more NFOs in the coming months.

While some of us may tend to mistake an NFO as being similar to an IPO, and hence, be tempted to rush and invest, it is not so. One needs to tread with caution while investing in an NFO.

First, the investment risk in a mutual fund is tad lesser than that in direct equities, given that the money is invested in a pool of securities and the fund is managed by a professional.

However, even fund managers can make mistakes, and that can eat into your returns. Hence, when you commit your hard-earned money to a fund, it is important to be convinced that your money is in the hands of a seasoned professional who understands the market well and can foresee adverse situations and, thereby, do all it takes to safeguard your money during bad times.

Therefore, past performance, which is a measure of the fund’s ability to stay afloat during bad market cycles, is critical to making the investment decision. For instance, while evaluating an equity scheme for investment, it is important to understand how the fund has fared across market cycles — bull and bear phases.

No track record

Unlike in the case of an existing fund, where the data on past performance is available, there is no such track record for these new funds. Historical performance is important in fund selection as it helps assess aspects such as the fund manager’s ability to make the right sector shifts, move out of under-performing stocks, identify long-term winners and take cash calls at the right time, which are critical to performance. It is, hence, better to invest in schemes that are managed by experienced fund managers with a good performance track record. Without any past performance data, NFOs are certainly riskier than existing funds.

Know the mandate

Two, there need to be compelling reasons to invest in an NFO. Most of the time, newly launched schemes are not very different from the existing ones. It is important to understand the mandate of the new fund to see if there are other existing schemes with a similar mandate. In case there are, you may be better off investing in a scheme that is already in existence and has a good performance track record.

In case the fund has a unique mandate or investment objective to no other comparable scheme, it is important to understand the risks associated with it. For instance, if it is a sectoral fund which invests in stocks of select sectors, the concentration risk in such funds is high.

These funds may not be not suitable for novice investors who have a low appetite for risk. It is risky to bet on these funds, unless one understands the sector well and is convinced about the prospects of the stocks. This is because many sectors are cyclical in nature, and entry and exit into them will have to be timed well to make the investment work.

Three, even if the fund has a unique mandate, if you have invested in other equity schemes and/or direct equities, there could still be some overlap. And it may be difficult to understand and assess the stock overlap before the corpus has been invested into, which typically happens over a few weeks from the closure of the NFO and allotment of units. Therefore, to avoid concentration risk, it may be better to wait for the fund to deploy its resources and understand the scheme portfolio, before taking a call on the investment.

Four, NFOs are often more expensive than existing funds. This is because the initial marketing and promotional expenses may be loaded on to the expense ratio, which needs to be borne by the investor. For instance, a new fund may incur expenses for promoting it and mobilising assets, which is part of the expense ratio. A higher expense ratio can dent your returns.

If it is a close-ended fund, you need to exercise more caution as there will be a lock-in and you may not be able to liquidate your investment in the event of underperformance or if you need money. Given that NFOs are not everyone’s cup of tea, do not bet on it unless the theme is unique and you are completely convinced about its merits outweighing the associated risks.

The writer is an independent financial consultant

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