January 13, 2019

Stock Caps In Index Funds

Last week, SEBI made a groundbreaking announcement, defining the criteria for an equity index to be eligible for being tracked by an index fund or an ETF.  Among other things, it capped the weight of a single stock in such an index at 25% (35% in the case of a sectoral/ thematic index). It also capped the combined weight of the top three constituents in such an index at 65%.  I may be wrong but I don’t think that there is any precedent worldwide for such a regulatory intervention.  In this post, I share my initial thoughts on this.

2018 was a very good year for those rooting for index funds and ETFs in India.  For the first time since 2013, a comparable ETF (actually, 3 ETFs) gave a higher return than any actively managed, diversified, domestic equity fund.  And almost all actively managed, large cap funds underperformed the BSE Sensex and Nifty 50 (in terms of returns).  However, there were some uncomfortable questions that lurked beneath the surface.  For instance, were it not for the superlative returns of a handful of stocks, would such outperformance by index funds and ETFs been possible?  And how was one to look at the fact that there was a difference of over 2.5% in the returns of the best performing and worst performing Nifty 50 index funds?

There were also questions about the construction and maintenance of indices.  For example, what was one to make of the massive churn that some indices went through?  By my count, in April last year, the Nifty Midcap 100 had 46 of its constituents changed at one go while the Nifty Smallcap 100 had 55 of its constituents changed at one go.  Then, there was the question about the suitability of Vakrangee to be part of the (erstwhile?) Nifty Quality 30 Index and what that said about strategy indices per se.  But it would seem that the thing that caught SEBI’s attention the most was the absence of caps on individual stock weightings in most indices, and how that might impact investors in funds that tracked these indices.

Having caps on exposure to individual stocks is a key part of prudent portfolio management.  Some indices have such caps, most do not.  Since index funds are intended to replicate indices, the absence of such caps exposes investors in index funds to concentration risk.  While this risk has always been known, it is only in recent years, with the rise of the FAANG stocks, that the global conversations around this have begun somewhat seriously.  But there are some parts of the world where this has already become a hot button issue.  For instance, in South Africa, media giant Naspers currently makes up 22% of the JSE Top 40 Index and 18% of the JSE All-Share Index.  What’s more, its weighting in the former index is greater than all of the super sectors that make up that index; in the latter it is greater than all but one.

In India, while the broad based indices are not under immediate threat of such a domination, some thematic/ sectoral indices are already being questionably influenced by their top constituents.  For example, in the Nifty Infrastructure Index, L&T alone has a weight of 36%.  Similarly, in the Nifty Bank Index, HDFC Bank alone has a weight of 36%.  If you add the weights of ICICI Bank and Kotak Mahindra Bank, these 3 banks make up 68% of the index.  Then there is the Nifty PSU Bank Index in which SBI alone has a weight of 72%.  More importantly, each of these indices has one or more index funds / ETFs tracking it.  In this backdrop, SEBI’s decision would appear to be necessary or, at the very least, justified.  Personally speaking, I have would have preferred the caps to be lower.  Still, it’s much better than not having any caps.

One of the arguments that I heard against SEBI’s decision was that the construction and maintenance of indices is the domain and prerogative of stock exchanges and index companies, and that the regulator has no business or authority to decide the rules that govern an index. It isn’t an argument that is altogether without merit but, strictly speaking, SEBI hasn’t directly asked stock exchanges or index companies to make such changes.  What it seems to have done is to indirectly put pressure on them by placing the onus of compliance on fund houses.  As I read it, if an index doesn’t meet the criteria set by SEBI, it can’t be the basis of an index fund or an ETF (at least, one that is managed by an Indian fund house).  In other words, if an index company values the business that comes from licensing its indices to Indian fund houses, it will have to comply with SEBI’s requirements.  Of course, the index companies are free to keep their current indices as they are, and create separate indices exclusively for Indian fund houses.  But if they do, well, we might be in for interesting times.

There is also the question of how this might impact the performance of indices.  I don’t have the means to do back testing but I am sure, sooner or later, someone will tell us how such changes, had they happened in the past, could have impacted historical returns.  For now, my guess is that after SEBI’s announcement, active equity fund managers are feeling a little bit relieved.

September 16, 2018

The IL&FS Debacle

It began around a week ago with the steep downgrade of IL&FS and some of its subsidiaries by three credit rating agencies.  That, in varying degree, impacted investors in an estimated 32 schemes across 11 fund houses.  Then late last week, IL&FS failed to honour a mere 50 crore maturity of its commercial paper (CP).  From what I can make out, within the next 10 days, 175 crore of the IL&FS group’s CPs held by mutual funds are due to mature.  It is anybody’s guess if they will honour those obligations. Regardless of what happens, and whether a fund house invested in the group’s securities or not, this debacle should give all fund houses, as well as SEBI, a lot to mull over.  There is also plenty of food for thought for investors.

Can credit rating agencies be trusted?
From A1+ to A4: I can’t remember the last time that a company was downgraded overnight this sharply.  One day, it had the highest rating possible, and the next, it was rated as being on the brink of default.  The rating agencies may claim that they had given indications in August that a downgrade could be on the cards.  But it seems to me that there were grounds for multiple, smaller downgrades, much before that.

The biggest fallout of this could be a loss of trust in credit ratings.  Will we ever be able to look at a AAA/ A1+ rated company and believe with confidence that our money is safe?  How is an investor to then trust the credit quality of a debt fund?  While the rating agencies may have tarnished their own credibility, their actions could impact the growth of debt mutual funds.  

Didn’t fund managers know what was going on?
While there is good reason to blame the rating agencies, I find it hard to believe any fund manager who pleads ignorance about how bad things were.  If nothing else, the yields on the instruments certainly suggested that something wasn’t right.  Here’s one example. 

On 28 August, a certain fund house bought a CP of IL&FS with a residual maturity of 62 days at a yield of 9.25%.  On the same day, that fund house also bought a A1+ rated CP of Indiabulls Commercial Credit with a maturity of 59 days.  The yield: 7.85%. 

Looking at those specific transactions also made me wonder if it was a coincidence that the Indiabulls investment was bought by that fund house in its liquid fund while the IL&FS investment was bought in its credit risk fund.

Let’s talk about concentration risk
About three weeks ago, on a certain online investment forum, someone asked investors on the forum about the things that they considered in selecting a liquid fund.  Most responses dwelled on the credit quality of the portfolio and expense ratio as the key factors.  But there was one reply that was markedly different.  According to that person, the thing that mattered to him most was “concentration risk of non-sovereign holdings”.

It was the mix of credit risk and concentrated holdings that was at the heart of the JPMorgan-Amtek Auto and Taurus-Ballarpur fiascos.   Despite that, the risk of having large positions in individual companies is still not widely well-understood- by investors, or even by fund managers.  I’d say that the IL&FS debacle makes the case that having a concentrated position in a single company can be a bigger risk than credit risk.  Based on August-end data, at least 4 schemes (including one liquid fund and one ultra short term fund) had near double-digit percentage exposures to IL&FS and its worst-hit subsidiaries, with several more close behind.  If I go back a month, I can add more schemes to that list.

For investors, monitoring the exposure of a scheme to a single company, particularly in debt funds, is not easy.  Unlike equity funds, debt funds often have multiple instruments of a single company.  I think it would help if SEBI made it mandatory for schemes to disclose the maximum percentage holding of any single company/ group of companies whose ratings are interlinked.  Personally, I would like SEBI to go one step further and bring down the single-company exposure limits for debt funds, perhaps more so for liquid and ultra short term funds.  The way I see it, investors in debt funds are generally less prepared for the risks of funds holding concentrated positions than, say, investors in equity funds. 

How should junk bonds be valued?
The IL&FS downgrade has once again brought to the forefront the challenges associated with valuing junk bonds.  As I have written in the past (see here and here), this is a contentious issue on which there is no industry-wide consensus.  By and large, fund houses mark down junk bonds by 25%, but not necessarily so.  It can become especially problematic if the instruments have a very short residual maturity, as was the case this time around.  Let me explain with an example.

As on 31 August, Principal Cash Management Fund (a liquid fund) had 9.8% of its portfolio in CPs issued by IL&FS Financial Services.  4.4% was in a CP that matured on 10 September while 5.4% was in a CP that will mature on 24 September.  On Saturday, 8 September, ICRA downgraded these instruments to junk status.  Being a liquid fund, the next NAV to be declared was for Sunday, 9 September.  The question before the fund house now was of how to value its IL&FS investments for the purpose of that NAV.

From what I have gathered, notwithstanding the downgrade, the fund house was confident of getting back its money, some of which was due just one day later.  So from that point of view, some might argue that there was no need to mark down the investments.  Yet SEBI regulations stipulate that each day’s NAV has to reflect the realizable value of the underlying investments.  In that light, a mark down was unavoidable.

Eventually, the fund house decided to mark down its IL&FS investments by 25%.  As a result, the NAV on 9 September fell by 2.3%.  The very next day, on 10 September, when they got back the first tranche of their money as expected, the NAV jumped up by 1.2%.  Unfortunately, those gains were not available to anyone who had exited based on the NAV of 9 September. 

Before you jump to any conclusion, here are a couple of points worth noting.  One is that the fall in the NAV of  Principal Cash Management Fund was in no small measure linked to the percentage exposure taken by the scheme to the IL&FS securities.  If its percentage exposure had been less, the fall would have been less.  The second relates to a scheme managed by another fund house which held a CP of IL&FS that matured last week.  After the downgrade, this fund house decided to mark down its holding to a lesser degree, compared to what Principal MF did.  As it turned out, it did not receive its money back from IL&FS on the due date and had to mark down its holding further.  In effect, the brunt of the fall was borne by investors who stayed invested in the scheme. The saving grace, if I may call it that, was that its exposure to that CP was less than 3%.

I can’t see a perfect solution to this problem.  But I think it would help if SEBI enforces more consistency in the process of valuing junk bonds.  If I understand correctly, currently CRISIL and ICRA provide scrip level valuation for investment grade securities with residual maturity of over 60 days.  There is a case to extend this to all debt securities, including junk bonds.

September 02, 2018

Can Distributor Commissions Impact Direct Plan Expense Ratios?

When it comes to distributor commissions, there are two sets of guidelines/ rules in particular, that fund houses are expected to follow.  The first defines the limits of how much can be paid from a mutual fund scheme to any distributor.  The second stipulates that the cost of commissions paid to distributors not be charged to investors in direct plans.  So, on the face of it, it would appear to be legally impossible for expense ratios of direct plans to be impacted by these commissions.  However, despite being sandwiched between these limitations, fund houses have a way around this. 

While most of the commissions to distributors are paid from the respective mutual fund schemes (and are clearly reflected in the expense ratios), in the case of many fund houses, there are also significant amounts paid that these fund houses cannot (or do not want to) show in the accounts of the respective schemes.  These commission payments are then made from the books of the AMCs.  If you take the top 3 AMCs (by AUM), it would appear that in 2017-18, such commission payments accounted for almost 60% of the overall expenses of these AMCs and made up over 28% of the fee that they charged for managing their schemes (a.k.a. management fee). 

The way I see it, one would have to be pretty na├»ve to believe that these payments to distributors did not influence the management fees charged by the AMC to the mutual fund schemes (including direct plans).  Based on what I saw of the financials of the top 3 fund houses, if these commission payments were not to have been made, as a rough estimate, the expense ratios of the direct plans of their equity funds, on an average, could have been lower by around 0.35%.

But even when one considers commission payments made from the mutual fund schemes, not everything may be above-board.  Here’s an example of something that I saw recently, and which I found questionable.

Over the past month or so, it appears that a number of AMCs, across several schemes, reduced the commissions that they were paying to distributors from these schemes.  In itself, this reduction in distributor commissions should have brought down the expense ratios of the regular plans of the concerned schemes.  But rather than pass the benefit of that reduction to investors,  the AMCs decided to correspondingly increase their management fees.  Obviously then, there was no reduction in expense ratios of the regular plans where this happened.  What’s worse is that this action resulted in an increase in the expense ratios of direct plans. 

To illustrate how this played out, let me put before you the break-up of the expense ratios of a certain hybrid fund, up until a few days ago, before these were changed.

Expense Ratios: Before Changes

Regular Plan Direct Plan
Management Fee 0.67%
Commissions 1.10%
Base TER
1.77% 0.67%
Other Expenses
0.33% 0.05%
0.12% 0.12%
Total TER 2.22% 0.84%

TER: Total Expense Ratio.  Management fee is charged by the AMC while commissions are paid to distributors.  GST is calculated @18% on the management fee.  Information for Base TER, Other Expenses and GST has been taken from AMC disclosures.  Management Fee and Commission have been inferred from the available information.

Then, a few days ago, it appears that the fund house decided to reduce the element of commissions in the base TER from 1.10% to 0.90%.  But, as I said above, rather than give the benefit of this reduction to investors, the AMC chose to increase its management fees.  After the change, this was the break-up of the scheme’s expense ratios:

Expense Ratios: After Changes

Regular PlanDirect Plan
Management Fee0.87%
Base TER
Other Expenses
Total TER2.26%1.08%

TER: Total Expense Ratio.  Management fee is charged by the AMC while commissions are paid to distributors.  GST is calculated @18% on the management fee.  Information for Base TER, Other Expenses and GST has been taken from AMC disclosures.  Management Fee and Commission have been inferred from the available information.

If you compare the two tables, you will notice that as a direct consequence of the  AMC’s decision to pocket the entire reduction in commissions, the expense ratio of the direct plan jumped up. 

As I mentioned earlier, this is not an isolated case.  Over the past month or so, I noticed several schemes across multiple fund houses where, in varying degrees, something similar had happened.

The expense ratio is typically described as an indicator of what a fund house charges.  Call me cynical if you like, but I look at the expense ratio as a means to know if a fund house is fleecing me.  Thanks to SEBI’s disclosure requirements, more than ever before, it has become easy to access and analyze expense ratios, and to understand how some fund houses adjust/ manipulate expense ratios to shaft investors.  It’s in our own interest to take advantage of the availability of this information.

July 09, 2018

Baffling Trades In ICICI Securities

Why would a fund manager buy shares of ICICI Securities in the IPO and then sell them off at a loss, two months later? 

As many of us would know, since its IPO in March, the stock price of ICICI securities has seen a sustained fall.  At no point, thus far, has the price come back to its IPO price of 520.  If I take the month of May in particular, the price ranged between a high of 421 and a low of 352.  Yet in that same month, fund managers across 10 9 schemes that acquired the stock in the IPO, brought down those holdings or exited them completely.  All put together, these fund managers sold off shares worth 96 91 crore at the time of the IPO, at a loss of somewhere between 19% to 32%.

The table below lists the schemes that took this hit.

Schemes that sold shares of ICICI Securities in May 2018

No of shares
bought in IPO

Price: 520
No of shares
sold in May
Price: 352-421
HDFC TaxSaver981,120508,500
Axis Long Term Equity Fund480,788480,788
Reliance Growth Fund288,456288,456
Reliance Banking Fund192,304192,304
Edelweiss Maiden Opportunities Fund-196,18096,180
UTI Multi Cap Fund96,15296,152
Edelweiss Long Term Equity Fund96,15286,183
Kotak Bluechip Fund63,44863,448
Kotak Equity Savings Fund30,74430,744
UTI Banking and Financial Services Fund288,4843,957

Data Sources: BSE, NSE, RupeeVest.

The way I see it, a couple of months is just too short a period for a long term investor to have drastically changed one’s view on this stock.  So what else could explain the actions of these fund managers? 

One view is that the fund managers may have been forced to do this on account of scheme reclassification.  That doesn’t make sense to me because the stock fitted comfortably into the portfolios of all of the schemes on the list above.  Another view is that this might have been done to meet redemptions.  But the extent to which most of these fund managers reduced their positions makes me doubt that.  As it happens, one of the schemes on the list is a closed-end scheme while three others are ELSS.  A third view is that the fund managers may have decided to cut their losses.  While that’s not implausible, it strikes me as an approach that a trader would take and not something that a fund manager would do. 

As I took a closer look at the numbers, something else emerged.  This pertains to three two fund houses whose schemes are listed above: Kotak Mahindra MF, Reliance MF and  UTI MF.  It turns out that in the same month, while their schemes listed above reduced or exited their holdings, there were other schemes managed by these fund houses where the exposure to ICICI Securities was increased.  In the case of the latter two fund houses, the shares sold in one scheme were identical to the shares bought in another scheme, suggesting the possibility that these might be inter-scheme transfers.

Fund houses that took contradictory action on ICICI Securities in May 2018

Action taken
No of shares
Kotak Mahindra MF
Kotak Bluechip FundSale63,448
Kotak Equity Savings FundSale30,744
Kotak Emerging Equity SchemePurchase154,828
Reliance MF
Reliance Growth FundSale288,456
Reliance Banking FundSale192,304
Reliance Focused Equity FundPurchase192,304
UTI Banking and Financial Services FundSale3,957
UTI Multi Cap FundSale96,152
UTI Value Opportunities FundPurchase96,152

Data Source: RupeeVest.

Frankly, I can’t think of any good reason why a fund house would have sold its loss-making investments in one scheme only to buy those shares in another scheme. 

In fact, looking at all of this, makes me question the credentials of the concerned fund houses and fund managers to manage long-term investments.  I came upon all of this information, quite by accident.  But now I wonder that beyond ICICI Securities, where else may something like this have happened, and how often it might have happened.  I guess that unless these fund houses/ fund managers decide to open up about this, we may not know.  Personally, I think that investors in these schemes should press hard for answers.

Correction: The original version of the post incorrectly identified UTI Multi Cap as a fund that had sold shares of ICICI Securities.  That scheme was merged into UTI Value Opportunities Fund.  I apologize for the inaccuracy.

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