Weekly Musings – NFO Pick (Kotak Special Opportunities Fund)

18 Jun 2024 , 09:45 AM

WHAT IS A SPECIAL OPPORTUNITIES FUND AND WHY?

A special opportunity or special situation theme has been common in hedge funds for a long time. It is only recently that mutual funds are also offering this theme as part of their offering. As the name suggests, this is a sector agnostic approach with the focus on special situations. Special situations can be just focused on the company or an event or even some disruptive change in the industry. Some of the events that can create a special situations opportunity for mutual fund investment are major government policy change, shift in industry economics, consolidation / fragmentation of players, M&A including corporate restructuring, changes in management, change in control, demerger or hiving off units, buybacks. Such special situation themes can either be top-down or it can be bottom-up.

But, what is the need for a special situation fund. Here are some strong reasons in favour of having a special opportunities (special situations) fund.

• Special situations are tough to grasp for common investors. It is better if experienced fund managers can crystallize and interpret it in the form of investment decision.
• While special situations can generate alpha, identifying them, getting in at the right time and managing the risk are complex and nuanced for most retail investors.
• Most investors treat special situations in the same way as thematic and sectoral funds. These special situation fund are sector agnostic and are based on opportunities alone.
• One question investors ask is whether such funds are diversified enough. They are focused, but they can generate alpha through special situations.

Let us now turn to some examples of special situations for such funds based on past data.

MAJOR SPECIAL SITUATION OPPORTUNITIES IN INDIA

If we look back, there are several such opportunities that have come by and which could have been capitalized.

• The decision by the Indian government to substantially in-source defence procurement was a game changer for Indian defence stocks. The results are there in the performance.
• The passage of RERA and the GST Act led to a big shift of business from the unorganized sector to the organized sector; redefining the organized real estate opportunity in India.
• In pharma and IT; the shift to product patents and withdrawal of tax benefits in early 2000s redefined these industries and made them globally competitive.
• Electronic outsourcing and EMS business became a big opportunity in India after the Product Linked Incentive (PLI) scheme was launched by the government.
• Cement is another case where the big theme in recent times has ben consolidation of capacities and that has benefited the top-3 largest players in a big way.
• In bottom-up cases, the demerger of cement and paper business of Orient Paper resulted in a 100-fold increase in the market cap over the last 12 years.
• Debt reduction has been another special situation to add value. JSPL, Reliance Industries and DLF are all cases of company value gaining from sharp debt reduction.

The list can go on, but the moral of the story is that such special situations can either be top-down or bottom-up; and can be fairly profitable if executed properly.

WHAT TO KNOW ABOUT KOTAK SPECIAL OPPORTUNITIES FUND NFO

Let us first understand what will be the investment approach of the Kotak Special Opportunities Fund.

• The investment universe would be the top stocks with sectoral business leadership and will be selected through an intense process of research from a 360-degree perspective.
• The approach to stock selection will be market agnostic; across all market caps and also across various sectors and themes.
• The final identification would be done through a bottom up approach where the company will be studied in depth with the macro environment as its ratification.
• Finally, the stock selection will be based on the GARP model i.e. focus will be on companies offering high growth at a reasonable price (momentum plus value).

Let us quickly turn to what kind of investors should be looking at investing in the Kotak Special Opportunities Fund.

• Special situations is a high risk strategy, so it is best for investors willing to take that higher level of risk involved in identifying such special situation stocks.
• From an asset allocation perspective, these special funds don’t fit into goal pegging. However, they are good for adding that extra bit of alpha to the portfolio.
• The horizon of investment obviously has to stretch to a period of 5-7 years since there will be hits and misses in such special situations. Investors must be prepared for that.

Ideally, this fund is not suited for a safe journey towards life goals. However, in a tough market, they can add that much-needed alpha to the portfolio.

PERFORMANCE OF FOCUSED FUNDS IN INDIA

When we evaluate the special situations fund or special opportunities fund, what is the benchmark used. There are no available benchmarks as they are classified as part of sectoral / thematic funds and are very few in numbers. However, one way is to look at a proxy and we have taken focused funds as a near proxy; looking at returns across 1-year, 3-years, and 5-years to get a comparative perspective. Being complex funds with an intricate strategy, we have chosen a more reflective regular plan. Therea are a total of 26 such focused funds in India, managing an AUM of ₹1,40,811 Crore. The ranking below is on returns since inception.

Scheme Name	Return (%) 1-Year	Return (%) 3-Years	Returns (%) Launch	Daily AUM (₹ in Crore)
Mahindra Manulife Focused Fund	50.83	23.93	29.90	1,482.39
Invesco India Focused Fund	65.02	23.93	29.01	2,706.30
Edelweiss Focused Fund	40.38	27.44	27.44	840.41
HSBC Focused Fund	36.76	15.90	24.61	1,686.24
Canara Robeco Focused Equity Fund	33.86	18.95	20.66	2,412.07
Union Focused Fund	30.43	15.78	20.29	418.05
Tata Focused Equity Fund	37.67	18.79	19.51	1,755.26
Kotak Focused Equity Fund	37.27	17.85	19.37	3,503.96
SBI Focused Equity Fund	32.73	15.27	19.26	34,747.68
Mirae Asset Focused Fund	18.86	10.70	17.85	8,144.77
360 ONE Focused Equity Fund	39.01	20.75	17.15	7,433.33
HDFC Focused 30 Fund	43.20	27.75	16.50	12,958.80
Sundaram Focused Fund	32.83	16.19	15.63	1,097.23
UTI Focused Fund	35.69	15.60	15.60	2,697.63
ICICI Pru Focused Equity Fund	46.81	23.27	14.98	9,172.92
Nippon India Focused Equity Fund	34.08	18.07	14.97	8,335.65
Quant Focused Fund	51.73	20.96	14.92	1,070.40
Franklin India Focused Equity Fund	39.68	20.70	14.82	11,967.52
Axis Focused Fund	25.33	7.97	14.75	13,932.82
Aditya Birla Sun Life Focused Fund	34.92	16.49	14.74	7,504.24
Motilal Oswal Focused Fund	28.13	12.93	14.54	1,920.64
Baroda BNP Paribas Focused Fund	44.16	19.99	12.99	676.88
DSP Focus Fund	43.16	16.57	12.26	2,484.47
Bandhan Focused Equity Fund	35.31	16.34	11.91	1,599.22
LIC MF Focused Fund	26.45	14.97	11.42	139.44
JM Focused Fund	47.93	22.87	4.21	121.87

Data Source: AMFI

The table above provides the performance of focused Funds over different time frames. Please not that focused funds may not exactly mirror a special situations fund, but come close enough in terms of focus, in-depth and differentiation. Here is a quick review.

• Let us first look at the returns on Focused Funds over a 1-year period. On a 1-year returns basis, Focused Funds  generated maximum returns of 65.02% and minimum returns of 18.86%, which is fairly appreciable. The average returns over a 1 year period are 38.16%. Dispersion on a one year basis is high; but that is due to the differentiated approach. Out of 26 funds, 11 fund did better than benchmark on 1-year returns. That gives an alpha success probability of 42.3% to beat the index on 1-year returns.
• Let us now turn to the returns on Focused Funds over a 3-year period. On a 3-year returns basis, Focused Funds  generated maximum returns of 27.75% and minimum returns of 7.97%, which showed wide dispersion. The average returns over a 3-year period are 18.46%. Dispersion on a 3-year basis is very high; but that is due to the differentiated approach. Out of 26 funds, 10 fund did better than benchmark on launch returns. That gives an alpha success probability of 38.5% to beat the index on launch returns.

A word of caution here. We have used focused funds as a proxy; and they may not exactly gel with the returns of special situations funds; although they are likely to be representative of the risks and the return potential of such funds. The performance shows that it is an idea that has worked although the dispersion in returns is quite high. It is meant for investors willing to take on that added risk for the sake of alpha.

GLANCE AT THE KOTAK SPECIAL OPPORTUNITIES FUND NFO

Here are some details of the Kotak Special Opportunities Fund NFO you must know to decide on investing in the fund.

2024. The NFO of Kotak Special Opportunities Fund opens for subscription on June 10, 2024 and will close on June 24, 2024. Being an open-ended equity oriented thematic fund (special situations), it will reopen for sale and repurchase anywhere between 3 days and 15 days of NFO closure. While the fund has no lock-in period (other than the conditional exit load disincentive), it is suggested to hold such Funds for a period of 5 years and above to get full benefits of the logic working in favour of the investors.
2025. On the Standard SEBI Risk-O-Meter, the Kotak Special Opportunities Fund will be ranked as a Very High Risk Fund. The high risk is an outcome of the predominant exposure to equities that the Kotak Special Opportunities Fund will have. In addition, there is also the risk of the fund entering the market is at all-time high levels. The fund will be based on back-tested special situation theorems; which would also bring in the risk of fund manager bias. Desired portfolio results may not, hence, match with the intent.
2026. The Kotak Special Opportunities Fund is about long term capital appreciation through the use of equity. The situation will be leverage on stocks likely to benefit from special situations; and can either be top-down or bottom-up in its approach. Being an equity fund, it has to maintain at least 65% exposure to equity. However, the Kotak Special Opportunities Fund plans to allocate, at least, 80% to special situation equities.
2027. Investors can invest in the NFO of Kotak Special Opportunities Fund in minimum size of ₹100 and in multiples of ₹100 thereof. This also applies to switch-ins during the NFO while additional purchases can be in such multiples too. SIP purchases must also be of ₹100 and above. There will be no exit load for redeeming up to 10% of your holdings at any time. For holdings beyond 10%, there is an exit load of 1% imposed, if the exit is before 1 year from the date of allotment of units. Beyond 1 year, there is not exit load. However, investors are advised to hold Focused Funds for a minimum period of 5-7 years to get full benefits of the special situations theme.
2028. The Kotak Special Opportunities Fund does not give any guarantee on returns, being an equity oriented and market risk driven fund. Despite the best efforts of the research team and the fund managers, returns would still be uncertain. The fund has the discretion to spread across equity, debt, derivatives, and liquid assets to enhance the risk-adjusted returns; keeping a base minimum exposure of 80% to equities at all times.
2029. The Kotak Special Opportunities Fund NFO will offer the growth option and the IDCW (income distribution cum capital withdrawal) option. Within the IDCW option, the fund will offer dividend payout and the dividend reinvestment option. The Kotak Special Opportunities Fund will offer investment via the Regular Plan or through the Direct plan.
2030. The performance of the Kotak Special Opportunities Fund will be benchmarked to the underlying Nifty 500 TRI index.. The TRI (total returns index) is more reflective as it includes the impact of dividends and capital movement. The benchmark will used to evaluate fund performance; although it is advisable to also consider risk-adjusted return measures like Sharpe and Treynor for a granular picture of risk.
2031. The fund manager for the Kotak Special Opportunities Fund will be Devender Singhal, who currently manages 23 funds for the Kotak AMC. In addition, Arjun Khanna will be focussing on managing overseas investments.
2032. The Kotak Special Opportunities Fund will be classified as an equity fund for tax purposes; as long as its equity exposure is above 65%, which is the intent. The short term capital gains (held for under 1 year) will be taxed at 15% while long term capital gains (held for over 1 year), will be taxed at a flat rate of 10% beyond a minimum threshold exemption of ₹1 Lakh per financial year. There will be no indexation benefits on long term capital gains.

The Kotak Special Opportunities Fund NFO offers an opportunity for investors to participate in a flexi-cap equity fund with a limited portfolio stock, predominantly adhering to the special situations or special opportunities condition.