Why fund houses really launch NFOs

As the stock market soars, it’s not just the IPO market that is buzzing with a line-up of new issuers, the market for new fund offers (or NFOs) is hyper too. When an AMC makes a slick pitch for a new fund, it’s hard not to give in. But then, if an AMC has just discovered a great new money-making opportunity in international investing,

ESG or housing stocks, there’s no reason why it cannot put it to work in the dozens of schemes its already manages.

As an investor, you, should be extremely selective while buying into NFOs because AMCs have many business reasons for rolling out NFOs, that they’re not be telling you about.

Higher fee

AMCs make their revenues and profits from expenses that they charge to their schemes as a percentage of assets under management (AUM). NFOs allow AMCs to take home a larger fee for every Rupee of money managed than older and larger schemes. This is one big reason why AMCs like NFOs.

SEBI’s slab-based limits on TER ensure that the fee that an AMC charges you declines sharply as a scheme grows. Before 2019, mutual funds were subject to just four slabs on TERs. Equity schemes could charge 2.5 per cent of assets for assets upto Rs 100 crore, 2.25 per cent for the next ₹300 crore, 2 per cent for the next ₹300 crore and 1.75 per cent for all assets over and above that. Debt schemes were required to charge 0.25 per cent less in each slab.

From April 2019, SEBI decided to re-align the slabs and lower them. It capped TER for equity schemes at 2.25 per cent on the first ₹500 crore of assets, 2 per cent on assets between ₹500 and ₹750 crore, 1.75 per cent on assets beyond that up to ₹2000 crore, 1.5 per cent from ₹5000 crore to ₹10,000 crore, with further cuts beyond this.

This change has had the effect of reducing the fees that leading AMCs take home every year from their bigger and older schemes. To illustrate, a ₹5,000 crore equity fund earned roughly ₹90.5 crore in annual fees in the old structure but only ₹86.1 crore in the new one.

More important, the slab structure also makes attracting money into new schemes a much more lucrative proposition for the AMC than getting it into older funds.

Fresh inflows of ₹500 crore into an existing ₹5,000 crore equity fund now fetch an AMC just ₹7.5 crore in fees, while an NFO mopping up ₹500 crore earns it a cool ₹11.25 crore. A higher fee pads the wallets of fund managers and helps the AMC pay higher commissions to its distributors to drum up support for a NFO.

Size fatigue

Fund houses won’t readily admit it, but too much popularity can prove a dead-weight on scheme returns.

Small-cap equity funds when they amass assets beyond ₹5000 crore, for instance, can struggle to build new positions or exit old ones without impact costs. When a market correction pops up, they can struggle to find enough market liquidity to absorb their sales. While size problems are acute for small-cap funds, other equity categories face it too. A multicap fund that overshoots ₹15,000 crore in assets, for instance, can have trouble retaining its ‘multicap’ character as small-cap bets can get more difficult to make.

When a value or contra fund grows too big, it may find it tough to deploy its entire corpus in sound but cheaply valued stocks.

Large schemes therefore end up making compromises like having more index names or holding more cash, which dilutes returns. AMCs try to manage the size problem by regulating flows or completely gating them for limited periods. But beyond a point, the opportunity loss in terms of AUM and fees begins to hurt.

NFOs are a neat way to get around this. When a popular scheme becomes too big to outperform, AMCs subtly divert their loyal investors (and distributors) to a new scheme that can start out afresh and make more nimble market moves owing to its size.

NFOs with broad themes like economic revival, value or even ESG are often attempts by an AMC to make up for the flagging track record of a flagship scheme, with a new kid on the block.

Survival tactic

The Indian mutual fund industry operates on the principle of survival of the fittest. With open end funds dominating, investors have been prompt to pull out money from laggard schemes that chronically lag peers or benchmarks to invest in better performers. This has led to situation where a few AMCs that manage outperforming schemes garner the lion’s share of new inflows. With AMCs that manage middling funds or poor performers getting hardly any inflows, they’ve taken the NFO route. Rolling out an NFO that offers visions of great returns in future is after all much easier than repairing the battered track record of a bunch of older schemes.

Category curbs

If you’ve been wondering why there are hardly any plain-vanilla fund launches nowadays, with most NFOs playing esoteric themes this is thanks to SEBI’s new rules on fund categorization. In early 2018, SEBI decided that Indian AMCs were offering just too many open end funds to investors, confusing them. It therefore brought in new rulers that allowed AMCs to offer just 36 specific categories of open-ended schemes. It also decreed that every AMC could run only one scheme in each of these 36 categories. While this has forced AMCs to consolidate, merge and streamline their 800 odd open-ended schemes to fit into the new slots, it also deprived them of the opportunity to expand their AUMs further. Given that the category curbs don’t allow AMCs to offer more than one multicap, large-cap, large and mid-cap, mid-cap and small-cap equity fund to launch any more diversified equity schemes, they’re been going all out to unearth new thematic ideas that can side-step these curbs (thematic is the only category where an AMC may have multiple schemes).