October 13, 2019

Dead Weight In Debt Fund Portfolios

As if monitoring debt fund portfolios wasn’t already hard enough, there is now one more thing that investors need to watch out for.  It’s what I call portfolio ‘dead weight’:  investments that have matured but continue to be shown in the portfolio as having some value.  If that sounds cryptic or baffling, or if you’re just wondering why that should matter, read on while I explain.

Let me take the mutual fund investments in DHFL as an example.  You may remember that DHFL NCDs were downgraded to ‘default’ status in June on account of a delay in interest payments.  Most fund houses marked down their holdings of DHFL NCDs by 75%, regardless of when the NCDs were going to mature.  The idea was that when the money was repaid, the fund houses would write back the amount they had marked down.

But what if the payments don’t come through, or are just inordinately delayed?  As it happens, mutual funds holding DHFL NCDs that matured over the past two months, haven’t got their money back.  And going by the early cut of the ‘resolution plan’ submitted by DHFL, the money is going to take a very long time coming.  Until recently, if something like this happened, all fund houses would have completely marked down the value of these investments.  Not this time around.  In the case of DHFL NCDs (and who knows what else), most fund houses have taken the view to keep the value of these investments unchanged. 

Now think about what that means.

Apart from the fact that no income can be accrued from these NCDs, whatever chances of offloading them in the market were there, stand vanished (or considerably diminished) after the maturity date passed.  So, in effect, by being shown to have some value, these investments are inflating the NAV and the AUM of the schemes. 

To look at it differently, the good news is that for now, the investors in these schemes have been spared from seeing a further fall in the NAV (on account of these NCDs).  The not-so-good news is that until the amount gets repaid, there will be the looming threat that this amount may be written off, anytime, without giving any notice.  If and when that happens, the scheme NAV will take a fall.  Since many of these are open-end schemes, they carry the additional risk of the AUM potentially shrinking.  The more the AUM shrinks, the more will be the fall- if and when it happens.  And that’s what investors need to really watch out for. 

In the latest portfolio disclosures, I noticed schemes where the current DHFL ‘dead weight’ is over 10% (in one instance, I estimate it to be ~17%).  If the AUM of these schemes shrink, those numbers could jump up significantly.  Remember, this excludes NCDs which are yet to mature (which, if the DHFL draft resolution plan can be relied upon, are additional ‘dead weight’ in the making).

How can you know if a portfolio is holding securities that are past their maturity?

There is no industry-wide ‘dead weight’ database, so to speak.  Hence, this information can only be gathered from individual fund house/ scheme portfolios.  Even so, you have to hunt for this information.  I can’t yet say about the fact sheets but in the more detailed monthly portfolio disclosures (available on fund house websites as Excel workbooks), these investments may or may not be listed alongside the other investments of the portfolios.  If they aren’t, then the cumulative value of these investments (and their contribution to a scheme’s AUM) will have been added up and hidden under the bigger head of ‘Net Current Assets’ or ‘Net Receivables’ or something similar. 

However, if you scroll down any scheme sheet, you may see these investments listed/ referenced in the footnotes to the scheme’s portfolio.  There is no uniformity in the way this information has been disclosed, and some fund houses have presented this information a lot more clearly than others.  Bear in mind, though, I have come across at least one instance where a fund house has not yet disclosed this information in any shape or form. 

I think this is a very important disclosure and if SEBI supports the existence of such ‘dead weight’, it should take a close, hard look at how to ensure compliance, clarity, and uniformity.  I am aware that in a recent circular, SEBI specifically asked all fund houses to provide this information.  From what I gather, there appears to be some confusion among fund houses over the format and whether this should be a part of the monthly portfolio disclosures or only the half-yearly portfolio disclosures.  It would be truly useful if this information is provided on a monthly basis, and is clearly presented in all portfolio disclosures, including in the fact sheet. 

I must point out that the DHFL example stands out because at the time that the downgrade happened, most fund houses had not put in place a mechanism for creating so-called side-pockets (or segregated folios).  In the event of a bond being downgraded to ‘default’ status, the creation of a side-pocket is arguably the best way to protect investor interests and avoid the occurrence of ‘dead weight’.

Clarification: On reflection, I feel that my assertion that at least one fund house has not disclosed its exposure to 'dead weight' securities in the latest monthly portfolio, could have been much better phrased.  This assertion is related to a single fund house. It is based on information from sources that I consider to be reliable, and is not contradicted by my observations of the latest monthly portfolio disclosure.  I expect this to be confirmed once the half-yearly portfolios are available, upon which, I will update this post.

October 10, 2019

Observations On The Essel Mess

Guest post by Norman Evan

Remember the 30 September deadline for some FMPs and other debt funds to have got back the money they’d invested in Essel group companies?  That date has come and gone, and things haven’t played out the way some mutual fund managers thought, or led investors to believe.

If you don’t remember or haven’t been following the story, it involved limited purpose, private companies linked to the Zee promoters.  Sprit Textiles, renamed as Sprit Infrapower and Multiventures.  Edisons Utility Works, renamed as Edisons Infrapower and Multiventures.  Continental Drug Company, renamed as Konti Infrapower and Multiventures.  There are more, but you get the idea.  If you lifted their corporate masks (or veils, if you like), I guess all these companies would look pretty much the same.

These companies had borrowed money from various mutual funds.  The borrowing was on largely similar terms. Most of the NCDs that were created, ticked all the boxes that would unnerve a risk-averse bond investor.  Zero coupon bond.  Check.  Backed by shares.  Check.  Rating by Brickworks.  Check.

As we’ve seen time and again, the mutual fund managers were either suckers for a good yield or had their own interests or agenda.  These NCDs had no place in mutual fund portfolios.  Certainly not in FMP portfolios where a lot of them landed.

Then, some months ago, there were the first signs of dark clouds looming.  It looked like the Zee promoters wouldn’t be able to pay back some of the money on time.  But if everyone went about selling the shares which backed the NCDs, they’d  get much less than what they hoped for.  So they all sat down and hatched up a plan.  They decided to give the Zee promoters time till 30 September to come up with the money.

So what happened?

One, not all companies paid up.  Why?  I guess only the Zee promoters or their associates can tell us that.  Konti paid back in full.  Edisons and Sprit paid back some of the money but there’s a fair bit still left to be paid back.

Two, the repayment has been pretty arbitrary. Kotak MF got paid back all that they were owed.  But Birla MF and HDFC MF have a lot less to smile about.  And while Kotak MF might brag about how their decision to give time to the Zee promoters has been vindicated, I’d say they got lucky.  Unless they arm twisted their way to get the payment. 

Talking about arbitrary repayments, this is becoming quite the thing.  Back in June, FT got fast track payments for their investments with the DHFL promoters.  Other mutual fund managers whose DHFL investments were more investment-worthy and repayment-worthy than that of FT, have been left holding a lemon. 

Three, there’s the mystery of dual ratings.  Brickworks, in its infinite wisdom, has downgraded some Sprit and Edisons NCDs to a D rating while it has downgraded other NCDs from the same companies to BB-.  Why?  It would seem that wherever payment was due, but didn’t happen, they did a downgrade to D.  But where payment was not yet due, they decided that those NCDs weren’t yet ripe for a complete downgrade.  Is this what happened with IL&FS or DHFL? No.  So why did this happen in this instance?  Read this rating rationale for the Sprit downgrade and see if you can figure that out.  I can’t.

To continue with Sprit as an example, it had NCDs outstanding to the extent of 1064 cr or so.  Of this, 211 cr was due as on September end.  The company paid back 100 cr- fine.  The 111 cr that it didn’t pay back was downgraded to D.  But the 853 cr which isn’t yet due, was only downgraded to BB-.  And that’s what makes my head explode.  Sort of.  These guys couldn’t pay back 111 cr but the rating agency seems more optimistic that they’ll pay back the 853 cr.  It just takes my breath away.

Could it be- could it just be- that this may have something to do with the impact it has on scheme NAVs?  A D downgrade would mean writing off 100% of the investment value while a BB- means writing off just 25% of the value.  You have to admit- AMCs do have a rather cozy relationship with rating agencies.

July 21, 2019

When Scheme Differences Are Erased

SEBI’s decision to create clearly defined scheme categories (and to limit fund houses to one scheme per category) was a big step towards empowering investors to make better scheme choices.  It’s been a year since that came into effect and for the most part, it’s been a success.  Unfortunately, some funds houses have found (or are finding) ways to wipe out the differences between schemes across different categories.  While there is a need for SEBI to step in, investors also need to be vigilant, else we could end up holding a scheme that is quite different from what we expected it to be. 

In this post, I want to share a few examples of the variety of ways in which fund houses have attempted to blur the differences between schemes in different categories.  I have presented these in the form of a short quiz.  There is a link to the answers at the end of the post.

Q1: Deceptive Descriptions

Given below are the descriptions of two open-end equity funds managed by a certain fund house.  These descriptions have been taken from the fund house website.  One of the schemes is classified as a ‘Mid Cap’ fund.  Based on these descriptions, can you identify which one of these is the real ‘Mid Cap’ fund?

Fund A:

An open ended equity scheme predominately investing in mid cap stocks

Fund B:

…is primarily a Mid-cap fund which gives investors the opportunity to participate in the growth story of today's relatively medium sized but emerging companies which have the potential to be well-established tomorrow.

Q2: Deceptive Advertising

Given below are masked banner ads for two equity schemes managed by a single fund house.  One of these schemes is classified as a ‘Focused’ fund, while the other is classified as a ‘Multi Cap’ fund.  If you had been able to read the detailed descriptions (which are in smaller print), you might have been able to know which ad is for which scheme.  But since these are website ads, which many will have seen (or will see) on mobile devices, the headlines become all the more important.  Based on the headlines, can you identify which of these is the actual ‘Focused’ fund?

Fund C:

Ad blacked out Fund 1

Fund D:

Ad blacked out Fund 2

Q3: Deceptive Allocations

Going by SEBI’s definition, in the so-called ‘Balanced Advantage’ funds, the equity/ debt allocation is required to be managed “dynamically”.  While some may consider that term to be all-encompassing, from what I have gathered, the purpose of having this category is to group those funds where the equity/ debt mix will be decided through a process of tactical asset allocation.  As it happens, at least one fund house either has an extraordinarily restrictive interpretation of what ‘dynamic’ means or has chosen not to make tactical calls.  The equity allocation of its ‘Balanced Advantage’ fund has remained in a remarkably narrow band and has had little resemblance to that of any other ‘Balanced Advantage’ fund.  But it has had more than a passing resemblance to the equity allocation of the ‘Aggressive Hybrid’ fund managed by the same fund house.  Given below is the unhedged equity allocation for the last 12 months for the two schemes.  Based on this information, can you identify which of these is the ‘Aggressive Hybrid’ fund and which is the ‘Balanced Advantage’ fund?

Equity Allocations

Q4: Deceptive Risk Profile

‘Credit Risk’ Funds are required to have at least 65% of their portfolio in securities that are rated AA or lower.  It is generally expected that these funds will carry a higher credit risk than any other class of debt funds.  Given below is the latest rating profile, yield, and maturity of the portfolios of three debt funds, managed by a single fund house.  Based on this information, can you identify which of these is the ‘Credit Risk’ fund?

Fund GFund HFund I
Portfolio Composition by Rating
  Sovereign/ AAA/ Cash16%15%12%
  AA and lower75%76%77%
Average Maturity (years)
Portfolio Yield11.7%11.4%11.7%

If you’d like to see the answers, click here.

July 18, 2019

A Dangerously Narrow View Of Risk

Fund houses are required by SEBI to classify the risk of each scheme as one of five levels: low, moderately low, moderate, moderately high, or high.  But what exactly should we make of a scheme whose risk level is defined by the fund house as, say, ‘moderately low’?  On the other hand, what should we make of Value Research or Morningstar telling us that the risk grade or risk rating of that scheme (relative to its peers) is, say, ‘average’?

It isn’t just their ambiguity: I would not rely on any of these labels as they largely stem from a narrow view of risk.   I believe that if we are not careful, these can lead us to make flawed assumptions about the riskiness of a scheme and, worse, act upon them. 

To illustrate the perils of relying upon these risk ratings, I’d like to take the case of a specific scheme whose risk ratings are currently poles apart from my assessment of its risk.  To be clear, this scheme is an extreme outlier: it would be hard to find a scheme quite like this.  However, the extremity of this example is what makes it useful to show the arbitrary nature of fund house risk ratings, and the limitations of the methodology followed by entities such as Value Research and Morningstar.

The scheme in question is a debt fund that has been around for over ten years.  From what I can see, for most of its existence, there has been a noticeable consistency in the way that its maturity/ duration and its credit profile have been managed.

As regards its performance, in each of the last 10 quarters, its return was above average (compared to its peers).  In 3 of the last 6 quarters, its return was exceptional.  In the month of June, this scheme gave a higher return than almost every non-gilt fund.  Its return in June was also higher than its return in any of the preceding 12 months.

The fund house has classified its risk as ‘moderately low’.  On the other hand, both Value Research and Morningstar have currently given it a risk grade/ rating of ‘average’ and an overall rating of 5 stars (based on the performance of its direct plan, growth option).

So, what’s the problem?

Just as with some other schemes, over the past several months, this scheme saw a significant fall in its AUM.  Consequently, there is a certain illiquid NCD in its portfolio, which it hasn’t been able to sell off, whose proportion to the portfolio has zoomed up as the AUM has fallen.  As on May-end, this NCD made up 71% of the scheme’s portfolio.  As on June-end, this NCD made up 87% of the portfolio.

Take a minute to digest that, if you will, because there’s more.

That single NCD is currently rated BBB (CE) and is under “credit watch with negative implications”.  In other words, that NCD is just about making the cut for being ‘investment grade’ and is precariously close to slipping below that.  If it does, well, there’s no saying how much an investor could be impacted.  If industry practices are anything to go by, for starters, the fund house would have to mark down the value of that investment by at least 25%.  And for those who have forgotten, here’s a bit of a flashback.  Last month, when DHFL was downgraded from BBB- to D, one scheme which had 67% of its portfolio in DHFL NCDs saw its NAV fall by 53% on that single day.

So how does a scheme with a portfolio like this get a risk rating of ‘average’ or a risk level of ‘moderately low’? 

From what I have gathered, in the Value Research/ Morningstar risk ratings, factors such as portfolio concentration, even credit quality are not considered.  In contrast, consider the approach that CRISIL takes for its fund ranking.  In the case of debt funds, for example, apart from return, the ranking gives weightage to elements such as asset quality, interest rate sensitivity, liquidity and company concentration, among other things.  As it happens, moneycontrol.com, which apparently uses CRISIL’s ranking, has given the abovementioned fund an overall rating of 2 stars.  While I am not suggesting that CRISIL’s process is perfect, it is certainly a lot better than anything else that I have seen.

On the other hand, in the case of the fund house classification, the issues may be more complicated.  For one, fund houses are currently bound by the way in which SEBI has defined the risk levels.  For another, product labelling is practically a one-time exercise.  Personally, I don’t see much utility to having such a risk classification, certainly not in its present form.  Regardless, I would prefer that fund houses gave investors a list of things to check before investing and also highlight issues that warrant caution. 

In any case, investors would do well to not blindly go by star ratings or risk ratings.  If we choose to use them, at the very least, we should understand their limitations. 

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