When AMC launches a new mutual fund, it is done through NFO. NFO stands for New Fund Offer. This NFO is not the same as an IPO. However, many people are made to believe that this mutual fund is the best investment opportunity for them and not investing in it will be a great loss. Thus, many people invest in NFOs without understanding the company’s goals for bringing them about and without realizing how the mutual funds align with their investment goals. The main aim for investing should be to have your investments align with your goals and do thorough research before any new investment. This blog lists the reasons behind AMCs launching new NFOs and why one must or must not invest in them.
Reasons for launching NFO
1. Higher expense ratio
The mutual funds are managed by an expert fund manager along with an Asset Management Company (AMC). The AMC and the fund manager allocate, manage and advertise the mutual funds to gain maximum returns and handle risks. For all these tasks one needs to pay an Annual Fund Operating Expense to the AMC, which is known as the Expense Ratio. This Expense Ratio is in the form of a percentage and one need not hassle about its different components.
Components of Expense Ratio
An expense ratio comprises of various costs for running the mutual fund. The AMC recovers these expenses from the mutual fund investors on a daily basis. But, this expense is revealed to the investors only once on a bi-annual basis. Thus, the expense ratio has an important impact on your returns. The Expense Ratio has following components:
1. Fund management fees
The mutual funds are managed by expert fund managers who use their high education levels, fund management experience and professional credentials to formulate the best investment strategies, before the actual investment in assets. Thus, they charge compensation for this expertise known as Management Fees or Investment Advisory Fee. This is approx 0.5-1% of the mutual fund’s assets, annually.
2. Administration costs
This is the expense of running the fund. Thus, this includes record-keeping customer support, registration, and communication costs. This varies from AMC to AMC, and is charged as a percentage of the fund assets.
3. Distribution’s commission
There are two methods of investing in mutual funds. One is through an app while other is through a bank/agent which pitches you for their mutual funds. In the latter case, one has to pay the bank/agent some charges for their work which is called distributor’s commission.
4. Advertisement expenses
Since AMC has mutual funds as the only source of income, most of them charge their shareholders a fee to market and advertise all the fund to investors. These fees together equal the percentage of assets which is deducted from the fund.
Expense ratio slabs as per SEBI (2019 onwards) Equity schemes
SEBI has set guidelines according to which AMCs can charge expense ratio on their mutual funds. This structure was revised in 2019 as follows:
|AUM (in crores)||Max Expense Ratio|
|0.05% reduction for every addition of Rs 5000 crore|
There is a mutual fund of AUM Rs 5000 crore.
On the first Rs 500 crore, expense ratio can be maximum 2.25% = Rs 11.25 crore
Next Rs 250 crore, expense ratio can be maximum 2% = Rs 5 crore
On next Rs 1250 crore, expense ratio can be maximum 1.75% = Rs 21.9 crore
On remaining Rs 3000 crore, expense ratio can be maximum 1.6% = Rs 48 crore
Thus, total expense ratio charges comes to Rs 86.15 crore. This is also the maximum expense ratio any mutual fund can charge in India with an AUM of Rs 5000 crore.
Therefore, Total Expense Ratio (TER) = (86.15/5000) X 100 = 1.72%
This TER is also available to see in all mutual fund investment apps.
Now, since AUM of mutual funds fluctuate daily, the expense ratio is deducted on a daily basis even though it’s an annual figure. To find the daily expense ratio just divide the TER by 365.
Thus, per day expense ratio value for this fund = 1.72%/365 = 0.0047%
Why does AMC launch new NFO?
Suppose an AMC already has a mutual fund with AUM worth Rs 5000 crore and it gets new investment of Rs 500 crore. If it used that 500 crore on the existing mutual fund, it could charge 1.5% expense ratio on it as per the slab rate. However, if it launched it as a new mutual fund then it could charge 2.25% expense ratio on it as per slab rate. Thus, in first case expense cost would come to Rs 7.5 crore and in second case to Rs 11.25 crore. Hence, it is important to know if the AMC has launched an NFO just to earn more money or it is actually a good investment opportunity.
2. Size matters
Suppose there is a small-cap fund with AUM worth Rs 5000 crore. Since it is small-cap fund by nature it will invest majorly in small investment companies. Hence, the fund manager will come across some hindrances. Small cap companies have limited tradable shares and cannot invest big amounts. So even if the fund manager knows that the small companies has great opportunity to double its 100 crore investment into 200 crore in a short term, he still will not be able to buy more than 100 crore worth of shares in it. So the profit of 200 crore for full fund of 5000 crore, will only generate 4% returns. Thus if the size of a small cap fund increases then its probability to generates more returns decreases.
In the same place, mid-cap and large-cap funds have more liquidity to generate more returns. But every mutual fund hits a certain point where although their AUM is large, they cannot generate big returns on it. As a result, they may either restrict new investors in the fund for a limited period or put a cap on the SIP amount. Since it is important to control the AUM. In such cases, AMC can decide to launch an NFO.
3. Hiding bad performance
If an AMC has a few mutual funds which have been performing badly in the last couple of years, then it fears that more people will not invest in it looking at its past records. Hence, it may launch an NFO hyping that its the next big deal to invest in.
SEBI Limitations on mutual funds
- There can be maximum 36 categories of mutual funds. More than that, one AMC cannot launch newer mutual funds. These can be a mix of small-cap, mid-cap and large-cap funds.
- There can only be one mutual fund per AMC in one category. If an AMC already has large-cap fund then it cannot start a new large-cap fund.
- However, thematic mutual funds can have more than one mutual fund in them, since these can be of different themes each. The aim should be to identify if the AMC actually has come up with a great thematic fund to invest in or it is just for increasing the expense ratio earning.
Should you invest in NFO?
- Do not treat NFO like an IPO. Even if you don’t subscribe to it when it launches, you can still purchase it after a few months in the stock market.
- If the NFO aligns with your needs and goals, then you can invest in it.
- But it is important to note that there are already multiple existing mutual funds, which cover all the requirements for everyone.
- New mutual funds have no track record, so it is not possible to know how they will perform in the future.
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