July 18, 2020

A Questionable Rollover

HDFC MF recently decided to roll over, for a period of 18 months, the two closed-end equity schemes under its HDFC Equity Opportunities Fund- Series II.  The first of these schemes has been rolled over while the second is due to be rolled over a few days from now.  While rollovers are not unheard of, I question the reasons for doing so.  To keep things simple, for the purpose of this post, I’ll focus on one of these schemes i.e. HDFC Equity Opportunities Fund II 1100D June 2017 (1).  It is due to be rolled over on 21 July.  

As the name would suggest, this was launched as a ~3 year scheme.  At the time of the launch, it was pitched as “an equity scheme with portfolio hedge”.  The fund manager sought to buy put options that would minimize the downside risk.  From what I have gathered, investors were tacitly led to believe that the put options were like a safety net and that the downside risk was realistically, very limited.  Three years on, as on 15 July, the NAV of the direct plan was down by ~14% while that of the regular plan was down by ~17%.  In contrast, the Nifty 500 index was up by  ~4%. 

Part of this difference is because the put options that were bought (~6% of the initial AUM),  expired without value.  However, if we ignore the impact of buying the put options, the NAV of the direct plan is still relatively down by ~9%.  Clearly, the fund manager did not add any alpha over these ~3 years.

In the letter sent to the investors, these are some of the reasons given to explain the underperformance:

Market returns for a major part of the tenure of the Scheme were characterized by narrow set of stocks outperforming. This impacted the returns of broadbased portfolios, including this Scheme.

The performance of large caps and mid/small caps diverged sharply over the past 2 years… The Scheme being a multi cap Scheme, invested in stocks across market capitalization and thus its returns were also impacted due to this sharp divergence.

While I agree with the market-related observations, I can’t agree with the scheme-related conclusions.  A fund manager of a multi-cap scheme has the flexibility to invest wherever he/ she wants to.  Moreover, these reasons do not explain the underperformance to the Nifty 500, which is a broad-based index. 

I recognize that active equity fund management is a difficult business and to be successful, being good is not enough- you need to be lucky as well.  For that reason, I don’t relish the idea of pulling down the fund manager for the absence of alpha.  However, I find it hard to sympathize with equity fund managers who make their lives even more difficult by choosing to manage closed-end schemes, more so a scheme with a 3 year maturity.  Managing such a scheme, if not a fool’s errand, is pretty close to being one.

And how is the rollover any different from locking oneself into another closed-end equity scheme?  It begs the question: what is the fund manager hoping to accomplish in the next 18 months that he couldn’t achieve in the last 3 years or so? 

But most of all, what of the investors?  Wouldn’t they be better off by switching to an open-end scheme?

Closed-end equity schemes are an inherently investor-unfriendly product that have typically been sold by incentivizing advisors to apply their persuasive skills on gullible investors.  Indeed, in the seedy underbelly of the fund industry, closed-end equity funds have occupied a particularly odious cranny.  Should it be a surprise then that HDFC MF has offered an additional incentive (over and above existing trail commission) to distributors who successfully roll over their clients? 

Thankfully, it appears that very few investors have opted for the rollover so far.  I say this based upon the diminished current AUM of the scheme that has already been rolled over.  I hope the same happens in the scheme yet to be rolled over.  Better still, I hope the rollover doesn’t happen.

In all fairness, in the last 18 months, no fund house has launched any closed-end equity scheme.  It might be that the industry is turning a new leaf, though I doubt it.  It might be the after-effects of SEBI’s decision, less than 2 years ago, to slash the maximum expense ratio that could be charged to any scheme which in turn, capped the payouts to distributors, notably in closed-end schemes.  Regardless, I fear that more fund houses may follow in the footsteps of HDFC MF and decide to roll over their schemes.

Note:  When these schemes from HDFC MF were launched, they were benchmarked against the Nifty 500 index.  For reasons that are not clear, shortly after the launch, the benchmark was changed to the Nifty 50 index.  For the purpose of performance comparison, it makes more sense to take the Nifty 500.  For one, the investment objectives of the schemes state that they are multi-cap fundsSecondly, as the fund house itself states, the growth in the Nifty 50 does not reflect the growth in the broad market.  I might also point out, that comparing with the Nifty 50 will paint a poorer picture of their performance.

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