August 29, 2017

Hazards Of Hybrid Funds

At the end of last week, the trailing 12 months return of one of the balanced funds managed by ICICI Prudential MF (I-Pru) was 5.5%.  In itself this may not mean much, but look at this along with the following information:

  • Over the same period, the returns of the open end, domestic, diversified equity funds managed by I-Pru ranged from 7.7% to 23.2%, while the returns of its debt funds ranged from 6.8% to 11.3%.
  • Going by month-end disclosures over the past 12 months, the balanced fund had, on an average, 82% of its portfolio in equities.

Thus, a hypothetical investor who had the misfortune of investing 82% of his/ her portfolio into the worst performing equity fund (in terms of returns) and the balance into the worst performing debt fund, would have seen a return of 7.5% over this period.  So how is it that this balanced fund was able to generate a return of only 5.5%? 

Frankly, I can’t think of any generous explanation for this.  Even the fact that this fund had a higher expense ratio than almost all of the other funds managed by I-Pru, can hardly explain the difference in these numbers.

For whatever you may find this to be worth, this particular balanced fund also happens to have a patchy record in protecting downside risk during market falls/ crashes.  By my estimate, in the 2015-16 fall, this fund gave a worse return than 35% of pure equity funds across the industry while in the 2008-09 crash, it gave a worse return than 76% of pure equity funds (including sector funds).

This may be an extreme example, but the instances of hybrid funds giving questionable returns are far more frequent and widespread than one may realize.  As quick and dirty evidence, consider this: when I zipped through the performance numbers of the past 12 months, I counted 25 hybrid funds that gave less returns than every single equity fund and debt fund of their respective fund houses.  When I increased the time frame to cover the returns over the past 36 months, I counted 23 hybrid funds that gave less returns than every single equity fund and debt fund of their respective fund houses.  In my counting, I tried to avoid including funds which have exposure to gold.

For those who may like another, more specific example, let me share with you some information that recently came my way, regarding Axis Hybrid Fund – Series 5.  This is a closed end scheme which can have up to 30% of its portfolio allocated to equities.  It was launched in July 2013 with a tenure of 3.5 years, at the end of which it was rolled over.

At the time of its launch, 3 year AAA bonds  were yielding between 8.5%-9.5% p.a., and over the original tenure of the scheme, the BSE Sensex TRI grew by over 11% p.a. Despite this, the fund managed a return of just 6.2% p.a.  What makes this number even more dubious is the fact that over that same period, the debt funds managed by the fund house gave returns ranging from 8.6% p.a. to 10.4% p.a. while their equity funds gave returns ranging from 12.5% p.a. to 23.6% p.a.  If instead of investing in this hybrid fund, investors had put 80% of their money in their worst performing debt fund and the balance in their worst performing equity fund, they would have got a return of 9.4% p.a.  Once again, I cannot think of any charitable explanation for that fund to have given a return of 6.2% p.a.

But that’s not all.  Along the way to earning those meagre returns, investors were exposed to extreme fluctuations.  In calendar year 2014, the fund gave a return of 21.6% while in 2015 and 2016 its returns were –2.1% and 0.2% respectively.  From what I can make out, the pattern of questionable returns and extreme fluctuations continued in subsequent, similar schemes launched by the fund house.

Generally speaking, neither do I invest in hybrid funds, nor do I recommend them.   There are three things, in particular, that make me uncomfortable.  The first is the fact that most hybrid schemes do not stipulate what sort of equity shares will they invest into (large cap, mid-cap etc.) or what sort of credit quality or average maturity will the debt portion of the portfolio have.  The second is the practice of having separate fund managers for the equity and debt components of these funds.  In my opinion, a few exceptions aside, it results in each fund manager being accountable in a limited way with no one being ultimately accountable for the fund’s performance.  The third is the tendency of many fund houses to have disproportionately high expense ratios for these funds. 

Thus, when I look at performance numbers such as those mentioned above, I find it hard to believe that these are just on account of bad luck.  I prefer to take the view that the absence of a rigid investment framework, combined with limited accountability, has resulted in many hybrid funds being managed recklessly.

August 21, 2017

Watch Out For Clandestine Portfolio Changes

In May this year, Birla MF (now, Aditya Birla MF) announced changes in the names of three of its ‘MIP schemes’: BSL Monthly Income, BSL MIP, and BSL MIP II- Savings 5 Plan.  What is noteworthy about these changes is that these were intended to mask some of the most brazen portfolio changes that I can remember seeing in any scheme in recent times.  Thankfully, two months later, SEBI shot down the name change decisions, forcing the fund house to “reinstate” the original names.  Unfortunately, despite SEBI’s intervention, the portfolio changes continue to remain, largely unnoticed.

In this post, I’d like to spotlight some of those changes and make the case for stricter regulation of scheme portfolio changes.  Equally importantly, what I share here, should serve as a cautionary tale for investors on the need to closely monitor the portfolios of the schemes that they invest into.  Note: This post has been pieced together from publicly available information and conversations with people supposedly in the know.  I reached out to the spokesperson of the fund house for its side of the story but for reasons best known to him, there was no response from his side.

The roots of the name changes of the abovementioned schemes can be traced back to January this year, when someone on the investments team at Birla MF initiated the idea to launch three debt schemes that would have significant exposure to instruments rated lower than AA.  As the idea was bounced around, it was felt that launching new schemes would be time consuming and expensive and, as an alternative, it was proposed that three of the existing MIP schemes be converted into pure debt schemes.  The fund house had four MIP schemes that had been around for several years but only one of those schemes had seen its AUM grow somewhat consistently.  The other three schemes, despite being in existence for an average of 16 years, had a combined AUM of just under 650 crore (as on December 31 2016).  More to the point, in their existing form, these three schemes did not seem to have much of a future.  Thus, it made sense for the fund house to explore the possibility of converting these schemes.  On the flip side, though, there was at least one key obstacle that would have to be overcome.  Converting a MIP scheme into a pure debt scheme would mean, as some would say, a change in the asset class of the scheme, and ran the risk of being rejected by SEBI.  Apparently, a few months earlier, SEBI had turned down a similar proposal by another fund house.

In order to manoeuvre this idea past SEBI, the fund house hit upon a plan to present it, not as a series of scheme conversions, but as a set of scheme name changes.  But to make a credible case, some groundwork needed to be done.  This was to be in the shape of two sets of changes that would be made to the portfolios of these schemes.  The first involved removing the equity exposure of these schemes.   The second involved reworking the portfolios so that there was a greater allocation to debt instruments that were rated lower than AA.  Thus, in March 2017, the work on restructuring the portfolios of these schemes began.  By the end of the month, the portfolios looked very different from those at the end of the previous month (or any earlier month).  The changed portfolios continued through April 2017, and the groundwork for the name changes was in place.

It is in the magnitude of changes made to the scheme portfolios that one can truly understand the lengths to which the fund house was prepared to go to accomplish its questionable objective.  To help you get a sense of that, I have given below a table which shows the extent to which each scheme’s portfolio was invested in equities, and in debt instruments rated lower than AA, before and after the change.  To present a fair picture, for the investments before the change, I have taken the average portfolio holdings for the 12 months from March 2016 to February 2017 while for the investments after the change, I have taken the average portfolio holdings for the months of March 2017 and April 2017.

BSL Monthly
Savings 5
Average % of Portfolio in Equities
      March 2016 – February 2017 16% 17% 11%
      March 2017 – April 2017 0% 0% 0%
Average % of Portfolio in Securities Rated A+/ A/A-
      March 2016 – February 2017 9% 9% 9%
      March 2017 – April 2017 41% 43% 43%

Based on month-end portfolio disclosures.  All percentages are calculated on invested portfolios to avoid impact of cash holdings.  Data source: Prudent Corporate Advisory Services Ltd.

By any measure, this would seem to be a radical transformation in the portfolios of these schemes.  If I were an investor in these schemes, seeing such a sudden and drastic shift would make me seriously consider exiting these schemes.  At the very least, I would expect an explanation from the fund house.  Yet, as far as I can make out, no communication was sent to investors intimating them about these changes.  It makes me wonder about the adequacy of the regulations that govern mutual funds that a fund house can get away with making such sweeping changes to the portfolio.  I would argue that making changes of such a magnitude should be subject to the same requirement as is changing the fundamental attributes of a scheme i.e. investors must be given the option to exit without any penalties. 

As for the fund house, I am sure that it would contend that it was acting within the law, and it would be right about that.  I question its sincerity to the spirit of the law, and its morality.  I look at its actions as trampling upon the trust of its investors.

July 28, 2017

Another Baffling Scheme Merger

Mutual fund scheme mergers should be straightforward stuff, or so I thought. 

In a post, last year, I noted my surprise at the demise of Sundaram Growth Fund on account of its merger with Sundaram Select Focus.  For quite some time, Sundaram Growth Fund had been the flagship equity scheme of Sundaram MF and at the time of the merger, it had a 19 year track record with a CAGR of over 15%.  Shortly before that, Sundaram MF had effected another merger: that of two of its MIP schemes.  In another post, last year, I had questioned the merits of this merger on multiple counts, not the least of which was that investors in the less riskier MIP scheme, so to speak, were asked to shift into the more riskier MIP scheme, and without being adequately briefed on the risks in doing so.  To be clear: in both instances, my puzzlement wasn’t with the mergers per se but with the choices made by the fund house related to the mergers.  And now, a few months ago, Sundaram MF, yet again, merged two of its schemes in a manner that has left me perplexed. 

The merger I refer to is that of Sundaram Banking and PSU Debt Fund (S-BPSU) with Sundaram Flexible Fund Short-Term Plan (S-Flex).  In my limited understanding, there was no real reason for these schemes to co-exist in the first place.  Despite claims in the SID that the differentiating aspect of S-BPSU was that it was “the only Scheme in Sundaram Mutual Fund having the mandate to invest predominantly in Debt and Money Market instruments issued by Banks, PSUs and PFIs”, as far as I can make out, for the two years that they co-existed, both S-BPSU and S-Flex had similar portfolios in that respect.  Hence, I’m inclined to believe that the launch of S-BPSU in 2015 was an exercise in duplication, and that the recent merger brought an end to that.  While I will let better minds than mine elaborate on the reasons for their co-existence, I would like to move straight into what I think is the most curious aspect of their merger. 

Right after S-BPSU was merged into S-Flex, S-BPSU should have ceased to exist.  But that’s not quite what happened.  Instead, on the very same date, S-Flex was renamed as – hold your breath - Sundaram Banking and PSU Debt Fund. Lo and behold- S-BPSU was born again!

Right off the bat, this throws up the question: why didn’t they simply merge S-Flex into S-BPSU (rather than vice versa)? 

One answer to this appears to be that the AUM and investors under S-Flex were far more than S-BPSU.  But that still doesn’t explain the need for the change in the name.  Also, consider this: the trailing 1 year return (at the time of announcing the merger) of S-Flex (regular plan) was 7.81% while for S-BPSU (regular plan) it was 9.87%.  This was despite the fact that the expense ratio of S-Flex was less than S-BPSU by 0.33%.  Given that both schemes had supposedly similar portfolios, if that is any indication of their relative performances, it would appear that the better performing scheme was merged into one that hadn’t performed as well.

There is another answer that has been offered by a couple of industry insiders, though without specific evidence.  Hence, you are free to regard this as speculation.  According to them, schemes that are branded as “Banking and PSU Debt” funds, constitute an important sub-category among debt schemes, and have come into being primarily in response to the needs of some big-ticket investors.  Furthermore, they have suggested that many of these investors prefer schemes with a significant track record and AUM.  The erstwhile S-BPSU had neither, while the new S-BPSU has both.  Based on that, it is their view that the merger may have been effected in this manner to acquire these characteristics at one go.

Frankly, I don’t know what to make of all of this: to me it is simply baffling.  Perhaps, Sundaram MF might want to clear the air on this.

July 14, 2017

Of Commissions and Biases

At the end of each financial year, AMFI discloses on its website, the commissions paid across fund houses to key mutual fund distributors.  Looked at, in the right way, this information can give investors, as well as industry insiders, a lot to think about.  It can also be a source of trivia and gossip.  This year, for instance, thanks to a write-up in at least one newspaper, and reports on other financial portals, there was some buzz on social media about the rising number of “crorepati mutual fund distributors”.  I am not an expert on these matters but I can’t help feeling that the so-called journalists and reporters would have had a much more news-cum-gossip-worthy story on their hands if they had chosen instead to report on the presence of Reliance Gas Transportation Infrastructure Limited in the august list of top mutual fund distributors.  I suspect that it would have been most interesting for their readers to know why a company that is engaged in the business of construction and operation of pipelines for the transportation of natural gas, also acts as a mutual fund distributor, and was ranked among the top 50 in terms of Gross Inflows in 2016-17, and among the top 100 in terms of average AUM and commissions received.  I have my own theories about this but I’ll park those for another day, and instead get straight to the purpose of this post i.e. to spotlight a few of my more substantive observations in AMFI’s latest Distributor Commissions report.

Seen in conjunction with what individual fund houses report, AMFI’s report can be particularly useful as a starting point to understand how unbiased the advice of a distributor might be.  While prudence would suggest that a distributor should not over-expose clients to a single fund house, having a bias towards one particular fund house, in itself is not dubious.  It depends on the motives for the bias, the extent of the bias and which is the fund house towards which the distributor is biased. 

Take State Bank of India, for instance.  In 2016-17, it ranked second among fund distributors in terms of net inflows, and seventh in terms of commission received.  It is, by far, the most prominent PSU bank distributor of mutual funds.  Yet the fact is that 99% of its commission came from SBI MF.  This would seem to indicate that the mutual fund distribution activities of State Bank of India exist only to promote SBI MF.  Put differently, it would appear to be foolish to walk into a branch of State Bank of India and expect to get unbiased advice across multiple fund houses.  But then, while State Bank of India may be entitled to adopt a strategy to only promote SBI MF, it raises a rather troubling question (in my mind, at least): if the mutual fund distribution division of State Bank of India is, in effect, an extended arm of SBI MF, then how fair is it to their clients, to offer regular plans, instead of direct plans?

The State Bank of India model is one that most, if not all, PSU bank distributors, that have their own fund houses, have sought to follow.  But what of the top private-sector bank distributors such as ICICI Bank, HDFC Bank and Axis Bank? 

In my conversations with people at these banks, I get the impression that they like to proudly position themselves as multi-fund house distributors.  In the process, I have heard terms such as “unbiased advice” and “one stop shop for all mutual funds” being thrown around.  And as proof of the diversity in fund houses and schemes offered, some shared with me copies of the monthly fund recommendations that they send to their clients.  Yet when I look at the Distributor Commissions reports, a different picture seems to emerge.  Consider the following, all relating to the year 2016-17:

  • HDFC Bank, which had the highest average AUM among all distributors, received 44% of its commission from HDFC MF
  • Axis Bank, which had the second highest average AUM among all distributors, received 61% of its commission from Axis MF
  • ICICI Bank, which had the fourth highest average AUM among all distributors, received 69% of its commission from ICICI Prudential MF

Based on these numbers, the claims to offer “unbiased advice” would appear to be hogwash.  It would seem that these banks are not vastly different from SBI or other PSU Banks in promoting the interest of the fund houses that they have sponsored, or are associated with.  And hence, here, too I find myself questioning the fairness of these banks towards their clients in offering them regular plans instead of direct plans.

While the above named banks are among the leaders of the mutual fund distribution community they are, by no means, the only ones exhibiting such significant biases.  Also, the element of bias is not restricted only to firms that have promoted fund houses.  One of the more startling examples that caught my attention relates to a distribution firm that is not associated with any fund house.  It calls itself a “wealth management boutique”, and ranks among the top 100 distributors in terms of average AUM during 2016-17 and among the top 70 distributors in terms of commissions earned.  But more than any of that, I was struck by the fact that in 2016-17, it received 70% of its commissions from a single fund house: JM Financial MF (JM MF).  Not only that, it appeared that this firm was way more biased towards JM MF than even its own associate distribution firm, JM Financial Services.

When I shared my observations with one of my frequent collaborators, he asked me this question: “How widespread are these biases?” 

He happens to be  registered with SEBI as an investment advisor (RIA), and the way he asked the question, it seemed as if he wanted to see if my findings could help make a stronger case for RIAs.  At first, I tried to dissuade him from pursuing that line of thought but when he insisted, I decided to humor him.  In his way of seeing things, the receipt of at least 40% of one’s commissions from a single fund house was the key indicator of a questionable bias (there were a couple of other criteria as well, too lengthy to describe here). So, following those criteria, (and based on the data of the 687 distributors covered in the 2016-17 report) I put before him my findings in a nutshell:

  • 32% of the key distributors appear to have a questionable bias
  • These distributors were credited with a combined average AUM of 227,395 crore in 2016-17

He seemed to like my findings because I saw a smile light up on his face.  But then I said something else and his smile vanished completely.

“By the way,” I said, “that wealth management boutique that I mentioned earlier… the one which earned 70% of its commission from JM MF… well, that firm also happens to be a RIA.”

May 07, 2017

Hidden Facts About Bond Fund Performance

Last week, someone drew my attention to a write-up that had appeared on a website that is frequented by distributors.  I was told that that piece “forcefully and decisively” made the case for debt funds over fixed deposits.  It had been written by someone who has had significant experience in the business.  It had been sponsored by a top fund house and had been applauded by a former CEO of another fund house.  Hence, I approached it with a fair degree of enthusiasm.  When I read it, my impressions were somewhat different.

While it was certainly forceful, I felt that it was presumptuous, and was built around questionable assumptions. Its centrepiece was a table with an ambiguous caption that stated that it was based on data of “some popular accrual schemes”.  In that table, there was no mention of which schemes were considered or how many.  All that the author gave was a summary of the returns from those schemes and flaunted those against the return from a SBI term deposit.  Leave aside the fact that he ignored the quarterly compounding on the deposit.  Consider this: unmistakably, one of those schemes was a fund which, over the period in question, had, on an average, just 6% of its portfolio in AAA rated investments.  Yet he thought it fit to compare its return with that from a AAA rated bank deposit.

As I reflected on the incongruity of that, one thought led to another, at the end of which I felt like indulging in a similar comparison but with a very different objective.  More specifically, I felt tempted to examine as to how often have bond funds across the industry given a better return than that from a SBI deposit.  Most bond funds have the mandate to go beyond AAA rated securities.  In addition, most also have some flexibility (in some cases, a lot) with respect to their average maturity.  So it would be reasonable to expect most bond funds to beat the return from a SBI deposit, most of the time.  Yet something told me that that might not actually be the case.  In a small way, I had done something similar in the past, and that enabled me to quickly set the parameters of my examination as below:

1. To compare the returns from funds currently categorized by Value Research as ‘Short Term’ and ‘Ultra Short Term’ with the return from a 1-year SBI deposit for a retail investor.  For the sake of simplicity, I decided to consider only calendar year returns from 2005 onwards (i.e. the earliest calendar year for which data is easily available on Value Research).  I also decided to consider only Regular Plans and to ignore loads, if any.

2. To compare the returns from funds currently categorized by Value Research as ‘Income’, ‘Credit Opportunities’ and ‘Dynamic Bond’ with the return from a 3-years SBI deposit for a retail investor.  For the sake of simplicity, I decided to consider rolling 3-years returns based on calendar years from 2005 onwards.  Here too, I decided to consider only Regular Plans and to ignore loads, if any.

Here, then, are my observations:

Short Term Funds and Ultra Short Term Funds vs. 1-year Bank Deposit

Total No.
of Funds
No. of Funds Beating
Bank Deposit
% of Funds
Bank Deposit
2005 39 8 21%
2006 44 38 86%
2007 48 31 65%
2008 64 54 84%
2009 72 5 7%
2010 80 5 6%
2011 90 81 90%
2012 91 64 70%
2013 97 53 55%
2014 101 59 58%
2015 103 24 23%
2016 104 96 92%

Fund Data Sources: Value Research, Morningstar

Additional Observations:

  • Of the 39 funds that have been in existence since 2005, not a single fund gave a better return than a SBI deposit across all 12 calendar years.  12 funds gave a better return than the bank deposit in 8 years or more with 2 of these doing so in 10 of the 12 years. On the flip side, 11 funds underperformed the bank deposit in 7 years or more.  One fund underperformed the bank deposit in 10 of the 12 years.
  • Of the 97 funds that have been in existence over the last 4 calendar years, only 15 funds gave a better return than a SBI deposit in all 4 years.  51 funds outperformed the deposit in 2 out of these 4 years while 13 did so in only 1 year.  2 funds underperformed the deposit in each of the last 4 calendar years.


Income Funds, Credit Opportunities Funds and Dynamic Bond Funds vs. 3-years Bank Deposit

Total No.
of Funds
No. of Funds Beating
Bank Deposit
% of Funds
Bank Deposit
2005 - 2007 37 21 57%
2006 - 2008 38 27 71%
2007 - 2009 40 16 40%
2008 - 2010 45 5 11%
2009 - 2011 49 0 0%
2010 - 2012 55 46 84%
2011 - 2013 62 21 34%
2012 - 2014 66 27 41%
2013 - 2015 73 32 44%
2014 - 2016 77 66 86%

Fund Data Sources: Value Research, Morningstar

Additional Observations:

  • Of the 37 funds that have been in existence since 2005, not a single fund gave a better return than a SBI deposit across all 10 3-year periods examined.  5 funds outperformed the SBI deposit in 7 (or more) of the 10 periods.  On the flip side, as many as 15 funds underperformed the SBI deposit in 7 (or more) of the 10 periods.  One fund underperformed the SBI deposit in each of the 10 periods.


I don’t know about you, but looking at these numbers has given me a lot to think about. 

For one, it makes me think why is it that despite the flexibility in deciding the credit quality and average maturity of the portfolio, so many funds, so often underperformed a AAA rated deposit.  For another, it makes me wonder what might these tables look like if the returns were to be adjusted for credit risk and interest risk.  It also makes me curious about how the underperforming funds might be justifying their expense ratios. In fact, I surmise that, in some instances, the existence of the funds themselves may be hard to justify. 

I have long believed that, by and large, investors do not keep enough checks on the portfolios and performance of bond funds.  In equity funds, the benchmark indices are well-tracked by most investors.  Most sophisticated investors go a step further and examine the sectors and the stocks held.  They also use risk-adjusted measures such as Sharpe Ratio and Sortino Ratio to get a better sense of performance.  In bond funds, by contrast, most investors have no idea about their benchmarks, let alone their suitability, and their performance.  Beyond the credit ratings, most investors are clueless about what fund managers hold.  And it doesn’t help that there are no widely accepted measures of risk-adjusted return that meaningfully capture credit risk and interest rate risk.

Put differently, I believe that bond fund managers have had it relatively easy.  Their performance is rarely scrutinized with the rigour and intensity that that of equity fund managers is.  And (thus far) they don’t face any discernible threat of investors opting for index funds.  They have also been fortunate that bank deposits do not offer income by way of capital gains (with its attendant tax benefits). 

I think that these numbers should give bond fund managers, too, a lot to think about.  As for investors, maybe its time to clamour for passively managed bond funds.

May 01, 2017

Two More Audacious Debt Funds

In response to my last post about the fund that I referred to as ‘Rainbow Fund’, a reader wrote in to say that there were two other debt funds that carried higher risk than that fund.  In his words, these were “the ultimate high risk debt funds”. 

Frankly, such a claim, even if correct, may not have been enough for me to consider doing a post. I might have simply responded to him by email, offering my thoughts.  But there were three things about the funds that he made reference to, that stood out for me.  Firstly, these funds are managed by a fund house that I have believed to have one of the best risk management processes in the industry.  While I was aware that these particular funds were pushing the limits of prudent credit risk, I had not imagined that anyone would compare them with Rainbow Fund.  Secondly, these funds are much, much larger than Rainbow Fund, and hence, there is a lot more investors’ money at stake.  Thirdly, and you can laugh at me, I do not believe in coincidences, and this was the second person to write to me, asking me to do a post about these funds.

Just over a year ago, I received a painstakingly detailed email from a gentleman who wanted me to caution readers against investing in these very funds.  According to him, he had personally invested in these funds but had inadvertently not seen their portfolios at the time of doing so.  Later on, when he did look at the portfolios, he was shocked by what he saw.  He then withdrew his money even though doing so attracted an exit load.  In his email to me, he presented a lot of evidence to support his view on these funds’ riskiness.  While I found a lot to appreciate in it, I also sensed that it was beyond my ability to transform his research into a post that would do justice to his efforts.  For that reason, I suggested that he approach a capable financial journalist instead.  Looking back, I feel that I should have perhaps invited him to do a guest post.

In that backdrop, the intent of this post is to offer my quick take on these funds through the same window which I used to examine Rainbow Fund.  This is, by no means, a comprehensive assessment.  For the purpose of this post, I will refer to these funds as ‘Strip Fund’ and ‘Scorpio Fund’.  Here are some of the facts, based on the disclosed portfolios as on 31 March 2017:

% of Portfolio in Securities Rated A+/ A/A- 41% 68% 74%
% of Portfolio in Securities Rated BBB- 2% 3% 3%
% of Portfolio in Unrated/ Privately Rated Securities 25% 7% 1%
Yield Range of Unrated/ Privately Rated Securities (% pa) 12% – 16% 13% 13%
% of Portfolio in ZCBs Rated A+ or below 6% 24% 24%
% of Portfolio in Unrated/ Privately Rated ZCBs 25% 6% 0%

ZCB: Zero Coupon Bonds

Though the table focuses mostly on credit risk, it gives a glimpse of some of the challenges in trying to assess the relative riskiness of funds.  For instance, if one only considers unrated/ privately rated securities, then Rainbow Fund appears to be taking more risks.  Yet, if you combine these with securities rated A+ or lower, it would appear that Rainbow Fund is taking less risks than the other two funds.  One way to get a clearer picture is to look at the yields of the underlying instruments, particularly those which are unrated/ privately rated.  In that respect, Strip Fund and Scorpio Fund score marginally over Rainbow Fund.

There are other data points, too, which favour these funds but in my opinion, these are all small differences.  The credit quality of the portfolios of all three funds crosses the limits of what I consider to be prudent levels, by a significant margin.  And I find the extent of their exposure to low-grade ZCBs to be disturbing.  I don’t know what the investors in these funds think about all of this but for their sake, I hope that they are at least aware of these facts.

In all fairness, I must point out that both Strip Fund and Scorpio Fund enjoy a high Analyst Rating from Morningstar.  I am not sure if that will continue though, given the dip in the credit quality of their portfolios since the last assessment.

Correction: The exposure of Scorpio Fund to ZCBs Rated A+ or below was originally incorrectly mentioned as 29%.

April 20, 2017

A Whole New Level of Risk

In the quest for generating higher returns on debt funds, some fund houses have been pushing the limits of prudent and acceptable credit risk.  For most, it has been in the extent of their exposure to low-grade securities.  For some, such as Taurus MF and the erstwhile JPMorgan MF, it has also involved adding concentration risk to the mix.  As I noted in an older post, at one time, the top 2 holdings of the erstwhile JPMI Short Term Income Fund accounted for 34% of the portfolio (with Amtek Auto alone accounting for 18%).  More recently, Taurus Ultra Short Term Bond Fund and Taurus Short Term Income Fund each had, at one point, over 20% of their portfolio in CPs of BILT and its subsidiary, BGPPL.  But the endeavours of these fund houses pale in comparison with the risks taken by a certain other fund house in managing one of its debt funds.  For the purpose of this post, I will refer to this fund as ‘Rainbow Fund’.

To me, the fund house behind this fund has never inspired enough confidence to examine its schemes, let alone invest in them.  Rainbow Fund was brought to my attention a couple of days ago, thanks to a friend who is also a long-time industry observer.  Apparently, it had been the subject of some talk because of the fact that despite significant exposure to lowly-rated securities, it was highly rated by Value Research (VR).  Since I am familiar with the VR rating methodology, I don’t see this as a contradiction.  If anything, I am amused by the fact that according to VR, Rainbow Fund carries “below average risk”.  But when my friend mentioned that its portfolio yield was as high as 11% pa, that piqued my curiosity and I decided to take a closer look. 

It turned out that a month ago, the yield was 11.61% pa while a year ago it was 12.46% pa.  Of course, such yields are a reflection of the exposure to low-grade securities.  Sure enough, I saw that as per the latest disclosure, 43% of Rainbow Fund’s portfolio was in securities rated A+ or lower.  But then there was an additional 25% in unrated securities.  And as scary as those numbers are, here’s what really stunned me: as per the disclosure, all the unrated securities were zero coupon bonds that were scheduled to mature between Jan 2019 and Nov 2021.  As far as I could make out, most of them did not have any put option and those that did, were only in 2019 or later.

In case the importance of that eludes you, it means that over and above the risks of investing 43% of the portfolio in lowly-rated securities, by investing in unrated zero coupon securities the fund house had risked not just its principal but the entire interest that it stood to earn as well.  By my estimate, if any of these securities were to default, the impact on an investor would be around one and a half times of what it would have been in the event of a default of a regular return security of similar yield.  But what is most alarming to me is that an investor can simply get out of the fund before any of these securities mature and in the process, pass the entire risk on to the remaining investors. That has the potential to create chaos.  While the fund has put in stiff exit loads as a deterrent, their usefulness is a matter of debate. As I see it, all it would take is a certain number of investors to exit for the remaining investors to realize the pointlessness of staying in the fund.

Some years ago, a wise man shared with me his thoughts about those who take risks.  “There are those who play with fire,” he said, “And then there are some who dance with fire.”  Looking at the portfolio of Rainbow Fund, this fund house seems to be doing a tango.

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