June 21, 2021

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.

April 23, 2021

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.” 

March 08, 2021

About Target Maturity Debt Funds

This week will see the NFO of a target maturity debt fund, that has also been billed as India’s first debt index fund.  Open-end target maturity debt funds are a product category that merits serious consideration, and one that we should see a lot more of.  However, based on some of the commentary that I have seen in the media (mainstream and social), as well as what I’ve been hearing from advisors and investors, I feel that some of the wider understanding could be enhanced, and expectations tempered. In this post, I want to touch upon a couple of less-talked-about points.

It might be worth mentioning that open-end target maturity debt funds were first launched in India over two decades ago.  Back in the day, they used to be referred to as ‘serial plans’.  Unfortunately, this category (like some others) didn’t quite take off.  Perhaps it was an idea whose time had yet to come.

The first point that I want to bring up is that, conceptually speaking, such a fund doesn’t have to be an index fund or an ETF and even if it is structured as such, it may not be purely passively managed.  From what I have gathered, unlike equity index funds and ETFs, it is quite common for bond index funds and ETFs worldwide to not replicate the complete set of index constituents.  Instead, they follow what is referred to as a ‘sampling’ approach whereby the fund manager seeks to match the more fundamental characteristics of the index such as credit profile, duration, and yield.  To be fair, in India, SEBI has put in guidelines that limit the deviation from index constituents.  But it still leaves room for some degree of active bond selection. 

As a point of contrast, take the original ‘serial plans’. These were typically single-security gilt funds whose maturity coincided with the maturity of the underlying security.  Consequently, despite not being index funds, they were perfectly passively managed.  The same can also be said for any fund that follows a hard-coded list of issuers, and a pre-defined credit and maturity profile.  Thus, a part of me wonders if the index structure currently in vogue, might just be a way to work around the inflexibility of SEBI’s open-end scheme categorization.  Regardless, with the growing interest from investors, advisors, as well as fund houses, it may be worthwhile for SEBI to expand the existing scheme classification to include this category. 

The second point that I want to talk about is the predictability of return in these funds, as represented by the yields that are reported.  No doubt, this is a prominent reason to invest in these funds.  However, investors need to be careful in relying upon the disclosed yield.  For one, there is the question of how the yield might be impacted if there are large flows into or out of the fund.   For another, there is the extent of the gap between the maturity of the fund’s underlying securities and the actual maturity of the fund.  As an example, in the case of one existing fund, I noticed that around 10% of the portfolio is scheduled to mature 7 months or more, before the actual maturity of the fund.  As and when those bonds mature, it is a moot question as to whether the fund will be able to earn the same yield as what it is getting on those bonds today. 

In this context, it might be worth looking at the evidence shared by BlackRock in the US, with respect to its target maturity iBonds ETFs that have matured.  Among other things, it shows the difference between the initial net yield and the final return that investors got.  So far, the difference across all matured funds has ranged from +0.19% pa to -0.30% pa.  In absolute terms, that may or may not seem much but when seen relative to the yields (and the time horizon), that is certainly not a small difference.  For example, one of its ETFs started off in December 2014 with a net yield of 2.64% pa.  When it matured 6 years later, the total return to investors was 2.35% pa.

As a side note, I don’t know what to make of the fact that SEBI doesn’t allow fund houses to offer any indicative yield on FMPs yet it seemingly has no issue with the disclosure of yields on open-end target maturity funds.  All things equal, FMPs offer a more predictable return than these funds.

December 09, 2020

How Should Affected FT Investors Vote?

This has reference to the forthcoming vote by investors in the six schemes that Franklin Templeton (FT) has proposed to wind up.

There is a lot of publicly voiced advice on this, and almost all of what I have seen, is encouraging or urging a ‘Yes’ vote.  On its part, FT seems to also endorse that choice.   Presumably to make sure that the message is not lost, FT has framed the vote as being about an “orderly winding up”. 

In my limited understanding of the law, the vote is supposed to be for approving the winding up.  Period.  Adding the prefix “orderly” adds an element of bias to the process.  Is it legal?  I don’t know.  And what exactly does “orderly” mean?  It is certainly not an absolute term that can be defined unambiguously. 

Regardless, how “orderly” will the winding up be, is something that time will tell us.  There is certainly a fear amongst many of us, that a ‘No’ verdict may end up being not as “orderly” as a ‘Yes’ verdict.  Yet it is possible that a ‘No’ verdict could end up being very “orderly”.  If that sounds hard to believe, consider this comment made by someone on an online forum (lightly edited for clarity):

FT may say that a 'No' majority will lead to chaotic redemptions but that may not necessarily happen. Firstly, some of the funds have gained enough cash to ward off reasonable redemption pressure. And while this may sound bizarre, the schemes that are cash positive, also have the ability to borrow and pay off- and who knows, SEBI might become more generous about those limits. Secondly, FT has options to control redemptions. It can somewhat limit the amount redeemed per folio. It can also ward off redemptions by applying an illiquidity discount like they did in the case of the FoFs- which, by the way, seems to have worked. The one big problem with a 'No' majority is that there are too many ifs and buts.

Doubtless, the circumstances today are quite different from those in April, and which led to FT’s decision.  Is the change significant enough to merit re-opening one or more schemes?  As I said previously, only time can tell us.  Irrespective, the point about the Fund-of-Funds is especially interesting. 

For those who may not know or have forgotten, this is a reference to those schemes that are further invested in one or more of the affected six schemes.  Take for example, Franklin India Dynamic Asset Allocation Fund of Funds (FT DAAF).  This has exposure to Franklin India Short Term Income Plan (FT STIP), which is one of the six schemes. 

Right after the winding up was announced, the fund house applied, what I consider to be a high-handed, arbitrary “illiquidity discount” on that holding.  As on the date that happened, the AUM of FT DAAF was 768 crore.  As on 8 December, the AUM was 784 crore.  It would seem that there has been no rush for redemptions in the fund.  I am not saying that this is evidence that the discount was effective, but it is certainly worth thinking about.  I must confess, though, that the devil in me is tempted to hope for a ‘No’ verdict in any one scheme, just to see if the argument of extreme redemptions holds. 

So, what does this mean for investors, and should it affect the way they vote?

Permit me to go back to the person I quoted earlier, and offer something that he had to say on this.

As with any decision involving voting, we have to make our own individual choices and hope that the eventual outcome, even if different, doesn't impact us too badly. We can endlessly speculate about the best choice- but unfortunately, there is no single choice that will appeal to everybody. It depends on a person's circumstances and even which of the 6 schemes he/she is stuck with. For example, I personally know a few people who would genuinely benefit more from a 'No' majority.

Then there is the final result, and what happens after that. A 'Yes' majority will definitely bring far more certainty to what will happen after that than a 'No' majority. But that doesn't mean that a 'No' majority is necessarily a bad outcome. Equally so, it is not necessarily a good outcome. It all depends.

I concur with this view.  We ought to vote in a way that reflects the best possible balance between our conscience and our needs, and then find the strength to live with the outcome.

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