FT’s Loss-Making Investment In Edelweiss NCDs

On 29 September, there was a sharp rise in the NAVs of some of the 6 schemes of Franklin Templeton MF (FT) that are being wound up.  From what I can make out, in large part, this was on account of NCDs of Edelweiss Rural & Corporate Services Ltd. (ERCSL) being sold off.  These NCDs were due to mature in 2027, and had been sold off for a much higher amount than what they had been valued at, in the books. 

Some investors that I know, saw it as a reason to be happy.  What most of them didn’t realize was that the jump in NAVs was, in effect, little more than a reversal of the fall in the NAVs a few months ago, that had happened on account of a change in the way that the same security was valued.  However, more than that, there is something else that investors need to be aware of.  These NCDs have been a loss-making investment whose outcome can be clearly attributed to choices and actions by FT that were firmly criticized by SEBI. 

Given their long maturity, there was no good reason for these NCDs to have been in the portfolios of some of the schemes.  Given the terms on which the NCDs were issued, they should never have been in the portfolio of any open-end mutual fund scheme. More specifically, as I had mentioned in a recent post, SEBI’s order documented FT’s failure to enforce a put option because of the way that the NCD agreements had been written.

In a nutshell, in April 2020, FT told ERCSL that it wanted to exercise the put option and exit.  ERCSL shot down FT’s request, and there was nothing that FT could do about it.  FT had itself only to blame for that, because of the terms it had agreed upon.  

If that put option had gone through, FT ’s schemes would have got back the investment at face value, which would have been the best outcome for the investors.  Instead, FT was compelled to look for buyers in the secondary market. What made matters worse was that, soon after that rejection, the rating of the NCDs was downgraded.  The NCDs then continued to remain on the scheme books for the last seventeen months, until their sale, last week.

In that backdrop, I now suggest you look at the sale value of the NCDs, relative to their face value, and the value at the time of announcing the winding-up. 

Face value of NCDs: 600 cr
Value as on 23 Apr 2020: 593 cr
Sale value (29 Sep 2021): 473 cr

I concede that the ratings downgrade may have impacted the sale value.  But would that have mattered if the terms of the NCD agreements allowed FT to freely exercise the put option?

Now that the sale has been made, it's easier to quantify the loss.  I would urge whoever looks at the appropriateness of SEBI’s fine on FT, to think about that while passing judgment.

BAF- Balanced Advantage Fakery

A first-time investor in Indian funds, who recently relocated from the US, reached out to me with this question: “How is a ‘balanced advantage fund’ different from a dynamic asset allocation fund?”    He expanded on that saying that until recently, he thought they were one and the same- that a ‘balanced advantage fund’ was just a desi term (his words) for a dynamic asset allocation fund.  But now, after reading something, he wasn’t so sure.

The term ‘balanced advantage funds’- if I can actually call it a term- did indeed evolve as a sort of an Indianism for tactical (or dynamic) asset allocation funds after a number of such funds, one by one, adopted the words ‘balanced advantage’ as part of their name.  In part, one could attribute that to a 2017 circular from SEBI in which it drew up most of the scheme categories as they exist today.

Unfortunately, some fund houses have reduced its use to a marketing ploy.  There is at least one fund house that uses this term as a masquerade (more on that later).  Lastly, there are individuals, including journalists, who use it out of ignorance and/ or indifference.  In my experience, this lack of authentic communication has ended up confusing and misleading many investors.  I suspected that something on those lines had happened with this investor as well.  It turned out to be worse than I thought.

The investor had read a recent interview of a senior executive at one of the largest fund houses in which he made this bizarre assertion:

…as per SEBI, we can either have dynamic asset allocation or balanced advantage fund.

With all the politeness and political correctness that I could muster, I explained to the investor that what the executive had said, was utter nonsense.  As evidence, I shared with the investor, copies of the SIDs of a few schemes, all of which had the words ‘Balanced Advantage’ in their names.  This included a scheme that is managed by the fund house where the aforementioned executive is employed.  In all these SIDs, as statutorily required, the ‘type of scheme’ is mentioned as ‘dynamic asset allocation fund’.

I further pointed out to the investor that any fund with the words ‘Balanced Advantage’ in its name could have just as well had the words ‘Dynamic Asset Allocation’ in its name, and vice versa.  In fact, a dynamic asset allocation fund can be called anything else, if SEBI is willing to go along with that.  Thus, we have a few funds that prefer ‘Dynamic Equity’ in their name, and one that goes by the name of ‘Equity Debt Rebalancer’.

It seemed as if I had got across to the investor, but he had one more related question.  Why was it that in India he could find no ‘balanced’ funds, and only ‘balanced advantage’ funds?

It’s a great question, if you ask me.  To this, I would add a few more. 

• Why did SEBI emphatically limit the use of the word ‘balanced’ in fund names but saw no issue with the term ‘balanced advantage’? 
• Why has SEBI allowed HDFC Balanced Advantage Fund to be called as such, and categorized as it is, when it is indisputably managed as an ‘equity hybrid’ fund?  
• How is it that the SID of HDFC Balanced Advantage Fund mentions its scheme type as ‘balanced advantage fund’, which is in violation of SEBI’s 2017 circular? 
• Who should be held responsible for investors making poor choices in selecting a dynamic asset allocation fund, just because they aren’t privy to any of this?

To be clear, I support SEBI’s efforts in curtailing the use of misleading terminology.  However, issues and anomalies such as the ones I have pointed out, hurt SEBI’s credibility and undermine its efforts in that direction.

Dynamic asset allocation funds have the potential to do more good for lay investors than any other category.  But I think it’s worth remembering that this is also one of the most challenging categories to select a fund from, and to monitor. 

As with most hybrid funds, these funds need close scrutiny because, by and large, there are no restrictions on where the equity portfolio will be invested or how the debt portfolio will be managed.  In addition, investors need to be clear about how each fund proposes to make its tactical shifts, the limits to that, and the rationale behind that.  Investors also need to keep track of how each fund’s allocation is split between unhedged equity, hedged equity, and debt instruments. 

At the very least, fund houses should refrain from playing devious name games with investors.

SEBI’s Uncovering Of The FT Liquidity Crisis

SEBI’s order against Franklin Templeton (FT) earlier this month, and the subsequent adjudication order make for a fascinating read.  SEBI has painstakingly compiled and analyzed FT’s actions and omissions, leading to the winding up of its 6 debt funds.  It establishes, with a wealth of evidence, that what happened was much more of FT’s own making than was generally understood, or FT cared to admit.

While the orders offer a lot to take away and think about, in this post, I want to focus on some select findings on how FT’s choices contributed to the liquidity crisis.  Thanks to reporting in the mainstream media and conversations on social media, it seems to be widely recognized that on FT’s part there was inadequate due diligence in selecting issuers, and diminished oversight of existing holdings.  I want to touch upon two equally serious issues that SEBI has uncovered and which, to the best of my knowledge, haven’t got much media attention.  The first is about exit options that FT didn’t exercise. The second is the questionable terms on which many investments were made by FT. 

Exit options that weren’t exercised

SEBI quotes a communication from FT that admits that “signs of stress began to emerge” in the scheme portfolios in October 2019.  In that, FT also acknowledges that after 1 October 2019, the unlisted securities in the scheme portfolios were “no longer marketable to most other market participants.”  Logically, then, FT should have started exiting illiquid securities that offered it an option to do so.  Yet, for reasons that are somewhat murky, based on the evidence that is available, very few exit options were exercised.

SEBI cites the specific example of Franklin India Ultra Short Bond Fund which, from October 2019 to March 2020, had 8 put options that were not exercised, and which otherwise would have liquidated around 900 crore of AUM.  If one considers interest rate resets, SEBI counts 15 additional instances amounting to 4,708 crore, where that scheme did not exit even though the securities had become illiquid.

From what I can make out, FT’s primary contention is that the decision on whether or not to exercise an exit option was taken by the investment team based on their “business judgment”.  SEBI offers an unsparing response:

[FT] brings out the reasons of ‘business judgment’ to defend questionable decisions; however, it is seen that these decisions which involve deployment of public funds are barely documented.

To be fair, FT does appear to have explained its rationale to SEBI, some of which is laid out in one of the orders.  Unfortunately, it makes the decisions to not exit, look even more questionable.

Investments made on dubious terms

This aspect gets highlighted in the extracts of the term sheets shared by SEBI.  As an illustration of how problematic some of the terms were, consider the investments that FT made in certain floating rate bonds.

One peculiarity of floating rate bonds that a prospective investor needs to recognize is that when interest rates are reset (or continued), the decided rate may not be to one’s liking.  For that reason, it makes sense to prefer bonds that allow investors to exit if that happens.  It makes all the more sense if such instruments are illiquid or thinly traded.  It would be common sense for an open-end fund to only deal in such floating rate bonds.

Despite the obviousness of that, the orders show that there were multiple instances of floating rate bonds held by FT’s schemes that, in SEBI’s words, “had no explicit option available to exit on the interest rate reset date”.

What is especially troubling is that, to quote SEBI:

These deals were negotiated deals where [FT] subscribed to 100% or close to 100% of the issuance and yet had failed to pay specific attention to the term sheets of such privately placed securities.

Apparently, FT tried to justify these by saying that there was a “commercial understanding” to which SEBI makes this scathing comment:

[FT] has defended its position by citing the existence of ‘commercial understanding’ between itself and the Issuer but it needs to be borne in mind that a commercial understanding cannot be enforced in a Court of law in the absence of clearly documented covenants.

Furthermore, SEBI mentions at least one instance where such a “commercial understanding” appears to have failed.  This pertains to floating rate bonds issued by Edelweiss Rural & Corporate Services Ltd. (ERCSL), maturing in 2027.  To quote SEBI:

[FT] had informed ERCSL that it was willing to exit on the next interest rate reset date (i.e. June 30, 2020) and had appraised the Issuer in advance to plan for the prepayment. However, the Issuer vide communication dated April 30, 2020, had informed [FT] that under the terms of the Agreement, the discretion of issuance of interest rate reset notice is solely at the option of the Issuer and it had decided not to propose a revised rate.

From what I can see, based on the latest portfolios, the 5 schemes that held these bonds a year ago, continue to do so.  It remains to be seen if FT will come to some real understanding with ERCSL before 2027.

The Franklin Templeton Tragedy- One Year On

It is the first anniversary of one of the darkest days in the history of mutual funds in India.  Whatever anyone else might say or think, in my eyes, what happened one year ago was a tragedy of such a magnitude that it put not just Franklin Templeton and SEBI, but the whole industry to shame.  But where exactly are we, one year on?

When you redeem your investments in a debt fund, you can typically expect the money to be credited to your account the next business day.  It’s been one year now and investors in the 6 debt schemes of Franklin Templeton that were shut down are yet to be paid back in full.  According to a recent report, depending on which scheme they held, investors have been paid back 7% to 71% of their money.  Those numbers are a telling statement of the progress, or lack of it.

More importantly, what lessons have we learned?  That’s a question that I would urge every mutual fund investor- whether impacted or not- to think about.  While I have no doubt that the primary blame for what happened lies between Franklin Templeton and SEBI, investors can benefit only if they think deeply about what happened, and how the risk in that could have been minimized. 

From my side, I can tell you what I learned.  With no intention to sound arrogant, my learning has been to somewhat continue with the processes that I was following on my portfolio.  There have been three key rules that I used to, and still apply in allocating my money.  For those who think it might help, here are the details.

My first key rule (for as long as I can remember) has been to use a specific, qualitative approach to decide which fund houses to entrust my money with.  The second key rule has been to select schemes only if I found the risk and expenses to be acceptable.  By their very nature, both of these rules call for ongoing monitoring.  So it was that until November 2019, while Franklin Templeton made my list, most of its so-called ‘yield-oriented’ schemes didn’t.

That’s when I decided to limit my exposure to only one of those ‘yield-oriented’ funds.  I held it until the day it shut down, and I continue to hold it ever since.  Truth is, I haven’t regretted that one bit.  That’s partly because it was (and is) just the kind of investment I wanted, and I had no need to cash it in.  In my opinion, it has been a reasonably well-managed fund and shutting it down was uncalled for and driven by reasons that haven’t been transparently disclosed.  In addition, I must add that part of my lack of regret was also because of my third rule- to diversify in whatever way possible: across asset classes, fund houses, schemes, fund managers, and even across registrars.  You may think I’m being paranoid, and maybe I am.  But I am determined to do what gives me most peace of mind. 

There has been a key change, though, to the way I now apply these rules.  Earlier, I would prioritize fund house selection over diversification.  That is no longer the case.  I have come to believe that adequate diversification deserves the highest priority over anything else.  What that means is that I will invest in as many fund houses as meets my requirement for adequate diversification, even if they don’t meet my quality standards.  This excludes a select set of fund houses that I have black listed.

This was brought about largely by the way that the people at Franklin Templeton conducted themselves in the days leading to, and following the shut down.  Over the years, I have seen a number of instances of fund houses making dubious decisions.  However, I can’t remember anything quite as shocking as what the the people at Franklin Templeton did.  As one example, consider the shoddy treatment they meted out to their FoF investors. If the people in such a storied institution could rapidly or impulsively stoop to levels vastly unbecoming of any fiduciary, then it would be hard for any quality check to factor that in.

This may sound like an over-reaction but what they did, reminded me of what William Bernstein wrote about mutual fund companies spewing “more toxic waste into the investment environment than a third-world refinery.”