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. 

What I Learnt From Kotak Select Focus

Up until two weeks ago, I knew very little about Kotak Select Focus Fund.  I knew who managed the fund.  I was aware of the astounding growth in its AUM- from just over 300 crore at the start of 2014, it had become one of the largest equity funds in the country.  I also knew that in a few days from now, it would be renamed Kotak Standard Multicap Fund.  But that was all that I knew.  Frankly, I didn’t feel the need to know much more.  Experience and common sense have guided me to stay away from fund houses and schemes that grow rapidly in terms of AUM. 

Then, quite out of the blue, thanks to circumstances too convoluted to describe here, I was compelled to take a closer look at this scheme.  In this post, I present some of the lessons that I learnt in the process.

Lesson 1: Some funds have a strategy, other funds just copy that strategy

In the marketing material of Kotak Select Focus, I saw a strong emphasis on the scheme’s “unique” strategy.  Yet when I examined its portfolio, it appeared that the bulk of the fund’s portfolio was imitating the portfolio of Kotak Opportunities Fund, which had been launched 5 years before Kotak Select Focus.  Going back all the way to 30 September 2012 (the earliest date for which portfolio disclosures with ISIN were available), I could see significant overlap in the portfolios of these two schemes.  The table below gives a glimpse of that.

Kotak Select Focus: Portfolio Overlap with Kotak Opportunities

	No. of Common Stocks	% of Common Stocks	% of AUM in Common Stocks	Exact Portfolio Overlap
30 Sep 2012	37	65%	78%	73%
30 Sep 2013	43	91%	94%	82%
30 Sep 2014	37	77%	83%	75%
30 Sep 2015	39	74%	79%	70%
30 Sep 2016	39	76%	83%	70%
30 Sep 2017	37	66%	76%	66%

Compiled from statutory portfolio disclosures made by Kotak Mahindra MF.

These numbers are all the more stunning when you consider the fact that in the case of both these schemes, there are very few restrictions on the market capitalization of the stocks that they can invest in.  The fund house could easily have created distinctive portfolios for both these funds yet, for some reason, it chose not to.

So why did the fund house launch Kotak Select Focus in the first place?  Why have they been touting its strategy as being unique?  And if they didn’t have anything unique to offer, then why didn’t they merge the schemes?   I put these and some other questions to the fund house but I am yet to get any answers.   For now, I am inclined to infer that while there was a unique strategy for Kotak Opportunities, the strategy for Kotak Select Focus was to largely mimic that strategy.

Lesson 2: Star ratings and return rankings can be awfully misleading

This is not a new lesson for me: it’s just that after seeing the star ratings of Kotak Select Focus, it was put into sharp focus (no pun intended).

One of the many problem areas with star ratings is the way in which rating agencies classify schemes.  Regardless of a scheme’s investment objective, Value Research and Morningstar have their own view on how to classify it.   What’s more, their classification can change from time to time.  The recent reclassification of Kotak Select Focus by Value Research illustrates the confusion that it can cause.

For most of the scheme’s existence, Value Research classified Kotak Select Focus as a multi-cap fund.  A few months ago, it reclassified it as a large-cap fund.  The impact on its star rating was immediate.  From a 4 star fund, it became a 5 star fund.  That’s because under the new classification, it was compared with large-cap funds (and not multi-cap funds).  Also, its return ranking changed immediately.  For those who find that difficult to follow, here’s a simplified snapshot (using data from Value Research) that may help to explain the difference:

• As on 30 Apr 2018, based on trailing 5 year returns among large-cap funds (regular), Kotak Select Focus was ranked No.2 (out of 85 funds).  If it had been classified as a multi-cap fund, it would have been ranked No.14 (out of 57 funds).
• As on the same date, based on 3 year returns among large-cap funds (regular), Kotak Select Focus was ranked No.3.  If it had been classified as a multi-cap fund, it would have been ranked No.24.

Lesson 3: Fund performance can sometimes be very hard to swallow

I have come across countless reports that have praised the “consistent performance” of Kotak Select Focus.  In my opinion, these reviewers have failed to see how utterly extraordinary, exceptional and magical the performance of this scheme has been.  Let me explain.

Let’s take the rolling 1 year returns since the scheme’s inception.  Kotak Select Focus gave higher returns than Kotak Opportunities  about 83% of the time. If you go further and consider rolling 3 year returns, it beat Kotak Opportunities 98% of the time. If you consider rolling 4 and 5 year returns, it beat Kotak Opportunities 100% of the time. 

Now, think about this.  When two funds have such persistent similarity in their portfolios, they have an equal chance of outperforming each other.  So how is it that Kotak Opportunities never beat Kotak Select Focus over any 4 or 5 year period, even once?  From where I come, if something like that happened, it would be considered spooky.  That would be all the more so, given that both funds have had the same fund manager for quite some time now.

But that’s not all.

Kotak Select Focus even outperformed the two large-cap funds managed by the fund house (Kotak 50 and Kotak Classic Equity) over almost every rolling 3, 4 and 5 year period.  What’s even more astonishing is that this included periods over which large-cap indices did better than mid-cap indices and broad market indices.  In other words, Kotak Select Focus beat those schemes even at times when those schemes should have rightfully given better returns.  As one of my collaborators called it, “that’s a gravity defying performance.”  I agree.  That’s nothing short of the stuff you see in superhero movies.

So how is it that this fund has had such a casino-beating winning streak, if I may call it that? 

While I would love to hear what the fund house has to say about that, given the lack of response from them to my earlier questions, I am not sure if I’ll know anytime soon.

Special thanks to Robin Jehangir for his invaluable inputs.

More Rating Mystery

After my earlier post, about two weeks ago, I was not expecting to have something to write about fund ratings this soon.  It seems I was wrong.

On Thursday, CRISIL announced that it had placed its rating of JPMorgan India Treasury Fund under “Notice of Withdrawal” based on a request by the fund house.  By itself, this would seem to be a straightforward development.  After all, no fund house, in its right mind, would want to use a BBBmfs rating.  But the release didn’t stop at that.  For reasons best known to CRISIL, in this release, it also chose to explain its current rating, updating its explanation in the last release with a reference to the segregation of the Amtek Auto investment.  This is what triggered this post.  I reproduce below a section of the release that I am unable to make sense of. 

On September 28, 2015, JPMAMIPL had allowed redemption in the scheme, following segregation of the specified security in the
scheme’s portfolio upon receipt of unit holders’ approval. This resulted in intensified redemption pressure in the scheme, and therefore, an increased weightage of the specified security. The downgrade in the scheme’s rating reflects the expected increase in the weighted average credit score for the portfolio.

The rating remains on ‘Watch with Negative Implications’ as CRISIL expects the redemption pressure on this fund may remain elevated. Should the redemption pressure exceed current expectation, the weightage of the specified security in the portfolio will increase significantly, further weakening the scheme’s credit quality.

As far as I have been able to make out, these are the facts of the segregation:

• As soon as the segregation was approved, the NAV of the scheme fell to reflect the segregation of the said security.
• Investors in the scheme on the date of the segregation took a hit on the value of their investments.  Investors who invest after that date will remain unaffected by the segregation. 
• If the value of the segregated security is recovered, only the investors who were there on the date of the segregation have a claim on that value. 

What this means is that there is no further downside on account of that security to existing as well as new investors.  To put it differently, an investor who is going to buy into the scheme, in effect, will not be buying into that security.

Thus, if a rating has to be given on the portfolio now, why would this security have any bearing on that rating, no matter how much the portfolio shrinks?

Rated AAAmfs

The recent downgrades of JPMorgan India Treasury Fund by CRISIL have left me wondering about the usefulness of its ratings for bond funds.  As CRISIL puts it, its rating of a scheme reflects “the likelihood of timely receipt of payments from the investments” made by it.  Schemes with a AAAmfs are considered to have “the highest degree of safety regarding timely receipt of payments from the investments that they have made”.  According to CRISIL, its ratings “serve as a tool to investors for selecting funds with a suitable risk-return criterion.”  These also provide “an independent opinion” on the credit risk associated with a fund’s portfolio.

All of this matches with my own expectations from a fund’s rating.  My issues begin when I look beyond the letter, and into the spirit of what a fund’s rating implies.  The core of my dilemma is this: when it comes to an individual bond, I recognize the possibility of a highly rated bond being significantly downgraded overnight.  But when it comes to a portfolio of bonds, I find it difficult to accept that there can be compelling reasons for a major downgrade overnight. In this post, I try to make my case.

Let me start by giving below the month-by-month share of lower rated securities (i.e. other than Sovereign/AAA/A1+) held by JPMI Treasury Fund:

	AA+	AA	AA-	C	Unrated
Jan	7%	16%	3%	0%	6%
Feb	6%	10%	3%	0%	0%
Mar	5%	19%	13%	0%	0%
Apr	0%	13%	6%	0%	0%
May	0%	7%	12%	0%	0%
Jun	0%	7%	12%	0%	0%
Jul	0%	6%	10%	0%	0%
Aug	0%	3%	7%	6%	0%

JPMI Treasury Fund enjoyed a AAAmfs rating from before the start of the year, and this was reaffirmed in May.  It enjoyed this rating despite having around 37% of its March-end portfolio in securities rated lower than AAA.

Then, on September 1, CRISIL downgraded the fund to A+mfs (it subsequently dropped this to BBBmfs).  Going by its rating rationale for the September 1 downgrade, CRISIL did not have the latest portfolio composition at the time of taking that decision.  If, therefore, one had to go by the July portfolio and speculate what the August portfolio would have looked like (after the Amtek Auto downgrade), this is what my guess would have been:

	AA+	AA	AA-	C	Unrated
Aug	0%	6%	5%	5%	0%

Frankly, I find it difficult to reconcile the rating profile of the securities in the fund with CRISIL’s rating of the fund.  CRISIL’s process may well be, as they claim, “derived scientifically”.  But to me, as an investor, there is a contradiction with my perception of what fund ratings imply, at least in spirit.  I expect a portfolio rating to warrant a major downgrade only if a large portion of the portfolio has been significantly downgraded or is likely to be so downgraded.

CRISIL explains the September 1 downgrade, saying that this was “on account of significant weakening in the credit risk profile of an underlying security.”   It goes on to say this: “Earlier, the scheme’s credit score had cushion to absorb some deterioration in the credit risk profile of the said underlying security. However, with the recent sharp weakening in the credit risk profile of the security, the credit score for the portfolio has been adversely impacted.”

I don’t dispute any of this.  But if the downgrade of a single security can cause such a significant downgrade in an entire portfolio’s rating, then it would seem to me that the risk of a concentrated holding in a single security was not factored in determining the rating.  In my view, it should have been a factor.  Put differently, if the downgrade of a single security can push the rating of a fund down by several notches, then I am not sure if a fund’s rating can be of much use to an investor.