Sector-thematic NFOs: Beware lack of track record, concentration risk

To capitalise on the bull market, mutual fund houses launched 202 new fund offers (NFOs) in 2024, a record high, according to data from Morningstar. This was the first time NFOs crossed the 200-mark in a calendar year. Investors, however, should carefully scrutinise these offerings rather than succumb to hard-selling tactics.

 

Why the upsurge in NFOs?

 

The Indian market has witnessed a prolonged bull run. “A large number of new investors joined the equity markets during this period. NFOs are one means through which asset managers try to capture market share,” says Kaustubh Belapurkar, director-manager research, Morningstar Investment Research India.

 

Several new fund houses have been launched. “They came out with NFOs to complete their product suite,” says Vidya Bala, co-founder, Primeinvestor.in.

 

Most equity NFOs belonged to the sector-thematic or the passive fund category. “The Securities and Exchange Board of India’s (Sebi’s) rules restrict fund houses from having more than one fund per diversified equity category. The established fund houses already have funds in these categories. It is only in the sector-thematic and the passive space that they can launch multiple products as long as the sector-theme or the index is unique,” says Bala.

 

She adds that the passive segment offers unlimited scope for launching new funds, as index providers can always create new indices. With growing awareness, demand for passive funds has also risen, prompting fund houses to launch more products.

 

Risks of sector-thematic NFOs

 

All NFOs lack a performance track record, and investors often have no clarity on the style of fund management. “Investors also run the risk that the investment thesis may not play out as projected by the fund house,” says Abhishek Kumar, a Sebi-registered investment advisor and founder, SahajMoney.com.

 

Sector-thematic NFOs come with additional risks. “Many of the thematic funds that have been launched recently have been very narrow, limited to just one or two sectors,” says Belapurkar. Such funds carry high concentration risk, with a small number of stocks accounting for the bulk of the portfolio.

 

Investors often chase sectors and themes that have done well recently. “That may be precisely the wrong time to enter these funds because the cycle could be set to turn for them,” says Belapurkar.

 

Their cyclical nature demands precise timing of entry and exit, says Bala, and that in turn requires careful monitoring. Many retail investors may not have the expertise to do so.  

 

What should investors do?

 

Avoid most NFOs if established funds with proven track records from the same category are available. “Most sector-thematic NFOs should also be avoided because of the timing risk in them,” says Belapurkar. He advises investing in a sector-thematic NFO only when the investor is keen to invest in a specific theme or sector for which no fund exists.

 

According to Bala, investors must have deep knowledge of the sector or theme they wish to invest in and confidence in its ability to perform in the current market.

 

Finally, Bala warns against adding too many funds to the portfolio by investing in a large number of new launches. Kumar also cautions against investing in NFOs for quick gains solely due to the marketing blitz that accompanies these launches.

   

Passive fund NFOs: Key risks and smart strategies

 

Risks

 

-  No performance track record available; tracking error and difference are also not available

  -  Fund’s risk profile may not match investor’s appetite; alpha and momentum funds, for instance, should be avoided by conservative investors

  -  Factor-based funds may not outperform their parent market-cap based indices

  -  High historical returns of index may not continue post-launch due to factors like liquidity issues in stocks that have to be picked and fund inflows-outflows 

What should you do?

 

*  Invest in a factor-based passive fund only after it demonstrates sound performance over a full market cycle

  *  Restrict investment to a small portion of your satellite portfolio