Observations On Recent Fund Returns

The last ten months or so have been an extraordinary period for those whose fortunes are linked to the stock markets.  It isn’t often that frontline indices fall by close to 40% and then completely recover from there, all within such a short span of time.  If I am not mistaken, it was way back in 1990-91 that we last saw something quite like this. 

But leave aside the rarity of that: there is a fair bit to take away from fund returns over these past ten months.  In this post I’d like to offer a few assorted observations that stood out for me.  Some are high-level observations while some are scheme-specific.

All calculations are for the period 14 January (Nifty 50 TRI: 17,349) to 6 November (Nifty 50 TRI: 17,392).  Unless mentioned otherwise, the calculations pertain to direct plans.  Data sources: Value Research and FundzBazar.

The inconsistencies of Index Funds
As one might expect from the dates that I mentioned, point-to-point, index funds and ETFs tracking the major domestic indices- Nifty 50, Sensex and Nifty 500-  gave little to no returns.  If you look beyond those indices, the returns across other non-sectoral index funds and ETFs are both much better, and much worse.  On the positive extreme, the lone ETF tracking the Nifty 50 Shariah index gained ~19%.  On the negative extreme, the CPSE ETF fell by ~28%, and Bharat 22 ETF fell by ~25%.  Dubious diversification, perhaps?

Luck, skill, or something else?
Over this period, actively managed Large-cap funds gave returns ranging from +8.3% to –10.9%.  However, Value Research and other websites, list one other open-end large-cap scheme that gave a return of –11.4%.  Strictly speaking, this is a Focused fund with a mandate to invest in stocks regardless of their market cap.  Be that as it may, going by this scheme’s month-end portfolios, through these ten months, on an average, 97% of its equity holdings were large-cap stocks.  If you think it is worth including in the list of large-cap funds, then consider this: it is managed by the fund house that also managed the large-cap scheme that gave the highest return.

Differences across Dynamic Asset Allocation Funds (DAAFs)
More than any other category, DAAFs have the freedom to adjust their allocation in a way that preserves value when markets crash, and cashes in on market recoveries and rises.  Leading from that, these funds have been frequently positioned as a sort of panacea.  Thus, these past ten months represent an excellent period to look at what DAAFs can accomplish.  It turns out that, over this period, the returns of these funds ranged from +17.8%  to –12.6%.  So, what explains this vast difference? To some extent it was on account of stock selection which, contrary to the spiel on the importance of asset allocation, isn’t an insignificant variable.  In addition, and quite obviously, it had to do with the differences in when and how much the funds shifted from equity to debt and vice versa.  To be fair, no one can perfectly time the market, so I personally didn’t expect any fund to shift its allocations perfectly.  However, the evidence suggests that some of the funds got that right a lot better than others.  

ICICI Prudential Equity & Debt Fund
Over this period, this scheme gave a return of -8.4% which made it one of the worst performing Aggressive Hybrid funds.  What’s more, its return was worse than that of any of the open-end, actively-managed, diversified pure equity funds from ICICI Prudential.  Its return looks even more disturbing when you dissect its asset allocation.

Going by this scheme’s month-end portfolios, over these ten months, its average allocation to cash and debt instruments was around 30%.  If we assume a return of 10% (that’s what the fund house’s short duration fund has delivered), that would imply that the equity holdings gave a return of –16.3%.  In contrast, the worst performing, open-end, actively managed, diversified pure equity scheme from the fund house, gave a return of -7.8%.  That raises the question: was this hybrid scheme pursuing a divergent and riskier equity strategy than all other pure equity schemes from this fund house?  If so, why?

SBI Dynamic Asset Allocation Fund
This is one of the most unique and well-meaning funds across the industry, and it breaks my heart to say that over these ten months, it utterly failed to live up to its promise.  For those who don’t know, its equity allocation seeks to mirror the Nifty 50/ Sensex while the debt allocation is exclusively held in the 10 year g-sec. As I stated earlier, point-to-point, over these ten months, the Nifty 50 and the Sensex delivered little or no return.  Thus, the contributors to this scheme’s return had to be the return from the cash and debt component (SBI MF’s 10 year g-sec ETF gained 8.8%), and whatever gains it could make by switching from equity to debt when the market peaked (and as it rose again), and from switching from debt to equity around the bottom of the market.  Unfortunately, all of this came to nought.  For reasons that only the fund house can really explain, this scheme’s return was –0.2%, which is just a tiny bit better than that of the Nifty 50 index fund managed by the fund house: –0.6%.  The only explanation that I can think of is that the algorithm used by the fund house, did a terrible job of deciding the switches between equity and debt.  Talk of good intentions going bad.

Correction: An earlier version incorrectly stated that the 10 year g-sec gained 10.8%. Actually, it was SBI MF’s 10 year Constant Maturity g-sec fund that gained 10.8%.  SBI MF’s 10 year g-sec ETF gained 8.8% over the period.

Perfect Timing

A short post on something that caught my eye. 

On 6 July, there was a unusually sharp jump in the NAVs of a few debt funds.  Topping the list was JM Low Duration Fund whose NAV rose by an astounding 19.9%.  Next was a cluster of three funds from Principal MF and two funds from HSBC MF whose NAVs went up in the range of 5.6% to 8.6%.

As far as I can make out, the jump in the NAVs can largely be attributed to the sale of defaulted DHFL NCDs that had matured last year.  Until recently, defaulted debt securities couldn’t be traded after their maturity.  However, last month, in a landmark move, SEBI came out with an operational framework for enabling transactions in such securities.  This decision paved the way for these NCDs to be traded (assuming one could find a buyer). 

From what I’ve been able to gather, following that, on 6 July, these funds were able to sell their NCDs at around 22% of their face value.  Since these securities carried a ‘nil’ value in the books (on account of being completely marked down), the entire sale value qualified as gains for the fund.  Hence, the huge jumps in NAVs.  In fact, in the case of some funds, thanks to the fall in their AUMs, this rise has taken their NAVs above where they were at the time that DHFL defaulted last year.

As interesting as I found this, there was something else that held my attention that bit more, and which will explain the title of this post.

I mentioned earlier that there were two funds from HSBC MF that saw their NAVs shoot up on 6 July.  These were  HSBC Short Duration Fund (up by 8.3%) and HSBC Low Duration Fund (up by 7.7%). 

On 23 June, which was the date that SEBI announced the operational framework, HSBC Low Duration Fund had an AUM of 76.5 cr.  Its AUM had consistently remained in the range of 75-78 cr since the start of the month and continued to remain so till 25 June.  Then, on 26 June, there was a huge inflow (estimated at ~16 cr) as a result of which the AUM spiked up to 92.5 cr.  From then onwards (up to the 6 July NAV jump), the AUM remained in the range of 93-95 cr.  That leads me to believe that the increase in AUM on 26 June was driven by a single large investor (or a group of investors acting collectively) who was/ were betting big on this scheme.  Sure enough, they’ve made a killing.

This throws up a few questions.

What made the investor(s) choose this particular scheme?  Was the timing just a coincidence?  Or was it shrewd thinking on the part of the investor(s)?

As it happens, just about two months ago, I had seen a somewhat similar example of impeccable timing.

Two months ago, on 8 May to be specific, HSBC MF had completely marked down its aforesaid DHFL holdings.  That day, the NAV of HSBC Low Duration Fund fell by 9.7% while that of HSBC Short Duration Fund fell by 9.0%.  In the case of the latter scheme, this was preceded by a very notable change in the AUM.

Over the two business days before the day of the fall, there was a ~19% drop in the AUM of HSBC Short Duration Fund.  On 4 May, the AUM was 271.3 cr.  On 5 May, it fell to 245.2 cr.  On 6 May, it was down to 219.9 cr.  7 May was a non-business day.

Once again, were those large redemptions merely a coincidence? 

I wouldn’t want to insinuate anything but I must confess that in both instances, the timing looks unbelievably perfect to me. 

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.”

How Short is ‘Short Term’?

What should one expect to be the average maturity of a debt fund that has the words ‘short term’ in its name?  And what if the fund has the words ‘ultra short term’ in its name?  Is it fair for a debt fund with the words ‘medium term’ in its name to have a shorter maturity than one that has the words ‘short term’ in its name, especially if both are managed by the same fund house?

These questions came to the forefront in the course of a conversation I had with an investor last week.  A couple of days earlier, he had made an investment in ICICI Prudential Ultra Short Term Plan, with the intention of withdrawing it in a few weeks’ time.  The day after making the investment, he discovered, much to his shock, that the said scheme had an average maturity in excess of 2 years.  No doubt, he didn’t do enough research before investing.  Nevertheless, in my opinion, for a fund house to maintain an average maturity of over 2 years in a scheme with the words ‘ultra short term’ in its name, is deceptive, to say the least. 

In a way, I had touched upon these questions in my post, Naming Schemes, over a year ago.  In that post, I had noted (without naming) how the maturity of JM Short Term Fund had swung between 1.5 years (in April 2014) and 8.5 years (in January 2015).  I had also noted (again, without naming) that the duration of Birla Sun Life MF’s Medium Term Plan, at the time, was shorter than the durations of its Short Term Fund and Short Term Opportunities Fund.  My conversation with that investor last week brought back some of those memories.  So after we had spoken, I took a look around to see what had changed.  I give below some facts that caught my attention.  All data is as on 31 Aug, and excludes Gilt schemes and ‘floating rate’ schemes.

• Schemes with the words ‘medium term’ in their names had average maturities that ranged from 10 months to 6.2 years.
• Schemes with the words ‘short term’ (and not ‘ultra short term’) in their names had average maturities that ranged from 1.5 months to 5.6 years.
• Schemes with the words ‘ultra short term’ in their names had average maturities that ranged from 1.5 months to 2.3 years.
• Reliance Short Term Fund had a maturity of 3.1 years whereas Reliance Medium Term Fund had a maturity of 1.4 years.
• Birla Sun Life MF’s Short Term Opportunities Fund had a maturity of 5.6 years, its Medium Term Plan had a maturity of 4.4 years, and its Short Term Fund had a maturity of 2.9 years.
• UTI Short Term Income Fund had a maturity that was nearly identical to the maturity of UTI Medium Term Fund at around 3 years.
• Invesco MF’s India Medium Term Bond Fund had a maturity of 10 months.  In contrast, its India Ultra Short Term Fund had a maturity of 1 year and its India Short Term Fund had a maturity of 5.2 years.

In my post, Naming Schemes, I had pointed out that in the US, a scheme whose name includes the words, ‘short-term,’ is required to have an average maturity of no more than 3 years.  In India, as far as I know, we still don’t have any such regulations.  But given the diversity and ingenuity that fund houses have shown in interpreting terms such as ‘short term’, ‘medium term’ and ‘ultra short term’, I’m not sure if merely having regulations will help investors.