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. 

July 01, 2019

A Most Eventful Month For Debt Funds

To say that the month gone by was extraordinary, would be an understatement.  It shone a whole new light on the riskiness of debt funds.  And for some debt fund investors, it was catastrophic.  While there has been ample media coverage on most of what happened, in this post, I’d like to talk about some of the less-reported stuff that stood out for me.

Let me start with the downgrades.  We all know about DHFL.  We probably know about Sintex as well.  But there were two other companies whose downgrades threw up a few questions for me- Wadhawan Global Capital (WGC) and  Cox & Kings.  There were only a handful of schemes holding debt of these companies, and in all but one of those schemes, investors were not impacted.  Still, these questions are pertinent given how much credit rating agencies influence debt fund returns.

WGC is the parent company of DHFL, and I talked a bit about it in an earlier post.  I had mentioned that its rating was linked to that of DHFL and that it was downgraded along with it between February and May (although with an inconsistent time lag).  I had pointed out that when DHFL was downgraded to ‘default’ on 4 June, WGC wasn’t. After a questionable delay, on 21 June, the new rating for WGC was released.  But guess what?  Its rating wasn’t downgraded to ‘default’.  Instead, in what I consider a sleight of hand, its rating was delinked from DHFL and was independently assessed as BB.  But why the long delay?  This wasn’t a complex company that needed deep evaluation.  Did the delay have anything to do with some stake sales that were to came through (and eventually came through)?  Would the rating have been the same if it had been done right after the DHFL downgrade?  Was such a delay justified?  Was the delinking from DHFL justified?

There’s more: one fund house held around 300 cr of NCDs issued by WGC that were due to mature in 2020 and 2022.  Since WGC was untouched by the DHFL downgrade, its schemes holding these NCDs weren’t impacted either.  Not only that, if reports are to be believed, this fund house managed to sell back its entire WGC holding (or at least a large part of that) to the DHFL promoters, before it eventually got downgraded to BB.  In some quarters, the move was hailed as a masterstroke by the fund manager.  Frankly, I don’t know if it would qualify as skill, luck, or something else.  Regardless, assuming this information to be correct, I’d be curious to know what made the promoters of DHFL fast track this repayment and prioritize it over repayments to other creditors, especially in light of their inability to honour DHFL maturity payments later in the month.

As for Cox & Kings, for those who may not know, the company defaulted on repayment of commercial paper due on 26​ June, to the extent of 150 cr.  Fortunately for mutual fund investors, only one scheme was impacted.  However, what I found intriguing is that just two days before the default, one of the credit rating agencies had reaffirmed the rating of the company’s 2000+ cr CP program as A1+, the highest rating that can be given.  As someone said, it’s getting hard to know what to make of ratings any longer.

On account of the downgrades (mostly DHFL), June was a month of widespread negative returns across debt funds.  By my count, 159 schemes ended up with negative returns.  14 of these fell by 10% or more, of which 4 schemes fell by 40% or more.  If my numbers are correct, the simple average return of all debt funds (including gilt and liquid funds) put together was –0.24%.  To my mind, this hits home the need for quality in diversification across debt funds.  Blindly diversifying oneself wouldn’t have been enough.

If I drill down into individual categories, unsurprisingly, the worst affected category was that of credit risk funds.  Again, if my numbers are correct, this category had an asset-weighted return of  -0.71%.   But this was by no means the only category with a negative asset-weighted return.  There were 3 other categories: low duration (-0.58%), medium duration (-0.58%), and short duration (-0.29%).

Among the schemes that gave negative returns, there were two schemes that particularly grabbed my attention.  The first was BOI Axa Credit Risk Fund which fell by over 44% in June.  It was the subject of a post that I wrote a couple of years ago, where I had called it out for the level of risk it was taking. Sadly, some of my fears about this scheme have come true.  Investors who are in the scheme since its inception (over 4 years ago) are now sitting on a loss of over 30%.  If I am not mistaken, it has been impacted by more downgrades than any single scheme.  What worries me is that the worst may not be over for this scheme.

The other scheme is a somewhat obscure FMP managed by ABSL MF: Series OW (1245 days). It fell by ~6.7% in June.  It was hit by both the DHFL downgrade as well as the IL&FS downgrade.  From what I can see, it also appears to be holding NCDs of one of the Essel group promoter companies.  What caught my eye is that according to Value Research, it has now given negative returns in 5 of the first 6 months of this year.  I haven’t yet investigated this in detail but it certainly adds a new angle to the riskiness of debt funds.

When bond prices fall, yields go up.  So is there an opportunity in this crisis, to capture the accrual from high yields?  That’s a question I’m hearing in some circles.  The June-end portfolio yields are yet to be disclosed.  If the May-end yields and back-of-the-envelope calculations are anything to go by, I will not be surprised if there are a dozen schemes or more with yields in excess of 13%.  Some of the likely high-yield schemes are closed for subscription.  A few others have exit loads.  But the opportunity, wherever it exists, comes with the risk of further downgrades and write-offs.  And if there are too many people seizing the opportunity, there could be a dilution.  Still, it’s something worth thinking about.  In any case, for those of us who are already invested, the yields offer a glimmer of a silver lining in the gloomy cloud of June.  But we also need those side pocket changes, real fast.

June 20, 2019

You Can’t Always Believe What Fund Houses Tell You

“Investors should beware of lies, half-truths and dangerous nonsense.”  This was a piece of advice from someone who represents an institutional investor, that came in the course of an exchange we had, earlier this week.  As it happened, a day or so before, I had seen a cautionary tweet by a well known investor on similar lines.  However, the context of our conversation was somewhat different.  While we talked a bit about general opinions aired in the media, our exchange was largely about pronouncements made by fund houses. 

There is nothing new about fund houses making inaccurate statements.  But there are some who feel that the manner in which certain fund houses are increasingly trying to mess with our perceptions, is a cause for concern.  Sadly, there is very little that is done by way of fact-checking, and such assertions are rarely called out.  That means it’s pretty much up to each of us to be on our guard. 

Here are three instances from recent memory that came up in our conversation.  I would suggest that you look at them as illustrative of a larger problem more than an indictment of the individual fund houses.

ICICI Prudential MF

In a recent piece published in The Economic Times, its spokesperson was quoted as saying:

We had nil exposure to debt papers of IL&FS…

The specific context of the statement is not clear- it may have been about their debt funds in general or it may have been about their credit risk fund.  Also, it is not clear as to what point in time is being referred to.  Regardless, I think it needs at least one piece of additional context- that ICICI Prudential, in fact, held paper of IL&FS Financial Services in two of their FMPs that matured a couple of weeks before the downgrade happened, last year.  As per the last disclosed portfolios of these FMPs, in each of these FMPs, the exposure to IL&FS Financial Services was in excess of 13%. I’ll leave it to your imagination to think about what might have happened if the FMPs and NCDs were to have matured just two weeks later.

Mirae Asset MF

A few months ago, Mirae Asset courted controversy over the decision to reclassify its multi-cap fund as a large-cap fund.  There is nothing that can be accomplished by a large-cap fund that cannot be accomplished by a multi-cap fund, and there was no basis for such a step to be initiated in the interest of investors.  Still, the fund house persisted in defending the indefensible.  In many quarters, it was felt that this move was connected to the forthcoming launch of its focused fund, which would have a multi-cap orientation.  The fund house denied this.  In a piece that appeared in The Economic Times, its spokesperson was quoted as saying:

We are coming up with a focused fund which should not be confused with a multi cap scheme.

Barely three weeks later, in a piece that appeared in Mint, this was how he was quoted describing the focused fund:

It is a true-blue multi cap with no sector or segment bias.

For whatever it is worth, it seems that as per the last portfolio disclosure, 19 of the 28 stocks in the new fund are also part of the erstwhile multi-cap fund (now large-cap fund), with a portfolio overlap of 45%.

Kotak Mahindra MF

Kotak Mahindra was recently in the spotlight for withholding part of the maturity payments to some of its FMP investors.  This had been triggered by its questionable exposure to Essel group companies and complexities arising out of collecting on that debt (I call it a default).  As I had written in an earlier post, one of its spokespersons was quoted as making a series of bizarre statements, most notably this:

I tend to disagree that it is a call gone wrong…

But more than any single statement, the entire argument made by the fund house, of acting in the interest of investors, was dubious, and circumvented key facts.  The fact that the decision to invest into debt instruments secured by shares was something they foisted upon investors.  The fact that they went beyond accepted norms of prudence in having concentrated exposures with up to 20% of some portfolios in Essel group companies.  The fact that they increased that risk by opting for zero coupon bonds.  The fact that the mess they eventually faced, could very well have been anticipated and avoided.  I can go on.  Thankfully, someone on Twitter called them out with a blistering tweetstorm.  Here’s the link.

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