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.” 

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.

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.

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.

Will Someone Please Think About The Affected FT Investors?

I just finished reading the Karnataka High Court judgement.  I am a slow reader, hence it took me a while.  Based on my limited grasp of legalese, the foremost thing that stood out for me is that this judgement has asserted the need for investors’ approval as a pre-requisite to the winding up of an open-end scheme.  Unfortunately, investors are not guaranteed the best, or even a good outcome.  And for some investors, there is also the possibility of more delay in their plight being resolved.

The single most sacred right of an investor in an open-end fund is to be able to redeem his/her investments at fair value, and at will.  I believe that this is a right that every fund house, and indeed SEBI, should seek to preserve at all cost.  Seen from that angle, the decision to wind up 6 schemes, especially the way it played out, represents a joint failure on the part of Franklin Templeton (FT) and SEBI in that it robbed investors of their right to redeem at will.  The one saving grace about this decision was that it was better than doing a fire sale of the securities.

As for the legal petitions, they may well have been with the best of intentions, but it seems that the plight of the investors was never a matter of direct consideration before the court.  Instead, it appears that the lawyers of the petitioners were more keen to argue about technical aspects of the mutual fund regulations, about the role of SEBI, and about the legality of the actions of FT AMC and the trustees of the affected schemes. 

However, in this judgement, I see one bright spot.  I see the court’s criticism of SEBI as a positive, that allows it a free reign to do whatever it thinks is right, for the sake of protecting investors.  Add to that the fact that the court did not allow the course of action chosen by FT to go ahead, even if on a technicality.  Put together, these two things, in my humble opinion and limited understanding, provide FT and SEBI a way to go back to the drawing board and think about a better course of action than the one previously chosen.

I think it is imperative for them to do so, for investors to have faith in the open-end structure that is the lifeline of most mutual fund investors.  It is convenient to dismiss this episode, as some have, as a one-off incident that affected investors in a single fund house.  It is easy to say that this was triggered by the hubris and overconfidence of a single CIO.   None of that can wish away the possibility of similar events happening again.  More importantly, none of that can take away the fact that what happened is a deep tragedy for investors, and one whose memory is likely to persist for a long, long time.

When disaster strikes in the real world (or rather, outside the financial world), we hear of ex-gratia payments made to the affected.  Not for a minute am I suggesting that we have something similar for financial disasters.  But it’s worth considering why such payments happen.  In my view, those payments are a tacit acknowledgement that such disasters are, first and foremost, a tragedy, and should be treated as such, and that the cause and attribution can be analyzed later.  I would urge FT and SEBI, and indeed all of us, to look at what has happened in the same way.

Special thanks to Robin Jehangir for his invaluable inputs.

The Lament Of A Mutual Fund Specialist

Guest Post

For 22 years I have been helping investors design and nurture their portfolios using mutual fund schemes.  I have also suggested fixed deposits- in banks, with the Post Office and with companies.  However, most of my advice has centred on  mutual funds.  Mutual funds are a bona fide investment option- arguably the most versatile investment option there is, anywhere in the world.  I am registered with the Association of Mutual Funds in India (AMFI). Thus, I have always positioned myself as an investment advisor.

But SEBI now has a problem with that because I am not registered with SEBI as an investment advisor.   It wants me- and others like me- to stop calling ourselves as such.  It could have just told us not to use the word ‘registered’.  It could have told us to clarify that we only offer advice on mutual funds.  No, no, no- it wants us to altogether stop calling ourselves as investment advisors. 

That’s like telling a wood craftsman that just because he specializes in home furniture, he can only call himself a carpenter.  I think that’s unfair and disrespectful.  My lawyer thinks that’s illegal. 

It isn’t easy to offer advice on mutual funds.  I am a specialist in this area.  I practically live, breathe, sleep mutual funds.  At the risk of sounding arrogant, I declare that SEBI would be hard pressed to find ten individuals more capable than me to advise an investor on mutual funds.

When I asked for guidance on all of this from people in AMCs, their replies were useless.  Rather than a solution, I got replies like: “What can we do? This is SEBI’s decision.” “It won’t change the way investors think about you.”   Of course now AMFI has come up with a solution.  The problem is that it is an idiotic solution.

Among other things, AMFI wants me (and all advisors registered with it) to clearly state that we are ‘distributors’.  The people who came up with this idea don’t realize that ‘distributor’ is a term that is best understood by people within the mutual fund industry.  What is an investor to make of my being a ‘distributor’? 

Letting me call myself a ‘mutual fund advisor’ would have been nice.  Letting me call myself a ‘mutual fund consultant’ would have been acceptable.  Barring me from doing so and instead asking me to denote myself as a ‘distributor’ is ridiculous.

So, no thank you, AMFI- I will not label myself in that manner.  Instead I will now officially designate myself as a ‘mutual fund specialist’.  If someone at AMFI or SEBI has a problem with that- I pray that the wrath of God descend upon those who prevent me from honestly pursuing my chosen profession and correctly positioning myself.

See, I am a peace-loving person and I don’t like quarrelling.  But the heart of the problem is that the people at SEBI don’t know how to really stop mis-selling.  Because it is convenient, they have painted all mutual fund advisors- good and bad- with the same brush.  They treat us with the same scorn that they have for stock tip marketeers.  They suspect that we are guilty till proven innocent.  And the ineptitude of AMFI in this regard hasn’t helped either.

The truth is that a much more amicable and meaningful solution could have been achieved just by understanding the advantages of the commission-based structure on which mutual fund advisors are compensated.

Thanks to that structure, when someone comes to me for advice on mutual funds, that advice is free.  Yes, free.  I don’t make money from the advice.  I make money if and only if you invest via me.  Most importantly, you get all the advice without any obligation to invest via me.

If someone has doubts about the schemes that I recommend, they can always ask me the reasons for my recommendation and also how much commission I get from those schemes.  Everything is transparent.  And like I said, until you are satisfied, you are under no obligation to invest via me. 

If SEBI really wants to help investors seek quality advice, then it should urge investors to bear all of this in mind in dealing with any commission-based advisor. That will help investors much more than attaching labels to advisors can, or will. 

There’s one more thing.  It is because of the fact that commission is calculated as a percentage of AUM, that I can easily offer even a small investor the same quality of advice that I give big investors. The big investors are subsidizing the small investors and I tell my big investors that.  Mind you, as I said earlier, because there is no obligation, a big investor is free to decide how much to invest via me.

I think it is high time SEBI and AMFI recognized all of this and accorded more respect to mutual fund advisors. 

The Risky Search For Yield

With bank interest rates at long-term lows, many investors are getting their first real taste of reinvestment risk.  Unfortunately, it can lead to far more hazardous consequences than what the textbooks suggest.  From what I have seen in the past, a lot of investors find it hard to accept low yields for what they are.  They end up taking more risk than they understand and are capable of weathering- something an investor should never do.

This time around as well, I have come across a number of people who, chasing a desperate desire for high yield, have made dubious investment choices. In this post, I’d like to present a few cautionary examples.  I’ve divided these investors into three broad categories.

Past Performance Chasers
The common factor across investors in this group is that they are first time debt fund investors who have been hooked by the general performance of debt funds over the last 1-2 years.  They have no grasp on how those astonishing returns came about.  Notwithstanding the statutory disclaimer, they believe that past performance is some kind of indicator of future returns.  As a result, they expect that debt funds will generally outperform bank fixed deposits.

Their fund choices are varied.  Hence, the manner and degree that they run the risk of being disappointed varies. Based on that, I could further divide them into a few smaller groups.

• Investors who opted for high credit quality funds with very short durations, without realizing that the net yields of those funds are lower than the interest rates of comparable bank deposits.
• Investors with little or no understanding of credit risk, who opted for high yield funds.  Remarkably, perhaps shockingly, some were unaware of the happenings surrounding IL&FS, DHFL and Franklin Templeton.
• Investors with no understanding of interest rate risk, who opted for gilt funds, believing this to be the safest category of mutual funds for a first time investor.

Duration Migrants
These are investors who have had some experience with debt funds, typically in the ultra short and low duration categories.  They have clear credit quality preferences and within that, have looked for funds with the best yields.  After seeing yields drop at the short end of the curve, they decided to switch to longer duration funds.  While they are aware of interest rate risk, their understanding of that risk leaves a lot to be desired. 

As one example that illustrates their thinking, consider this exchange that I had with someone who recently invested in a certain Banking and PSU debt fund.

Me: Are you aware that this fund currently has a modified duration of around 5 years?

Investor: I matched the duration to my own time horizon.  I need this money only after 5 years.  That ensures that there will be no interest rate risk.  And since interest rates will inevitably go up, I will also gain from the increased yields.

Me: Let’s say that sometime next week, RBI hikes rates and the yields go up by 0.25%.  Let’s further say that the modified duration and the yields thereafter remain unchanged for the entire 5 years that you are invested.  Compared to the current net portfolio yield, will your overall return be lower or higher?

Investor: For almost the entire tenure, I’ll be getting a higher yield.  Obviously, my return will be higher than the current yield.

Me: I think you need to check your maths.  When the yields go up by 0.25%, your NAV will fall by approximately 1.25%.  It will take around 5 years for the enhanced yield to just make up for that fall.  Do remember, this is assuming that rate hike happens sometime next week.  If it were to happen one year from now, it will take 5 years (or whatever the modified duration is, at the time) from that point, for the enhanced yield to just make up for the fall.  In effect, just to get the current yield, you’d need to hold the investment for around 6 years.  If that rate hike were to happen 3 years from now,  you’d need to hold the investment for around 8 years.

Blinded By Bonds
The common thread across these investors is that they have been tempted by supposedly high yields to invest directly into bonds in the secondary market. While they fear credit risk enough to stick to bonds of reputed companies, they are unfamiliar with the basic nature of bonds.  I came across a particularly troubling example of this in investors who have bought a certain bond of SBI that is maturing in 2026, and which carries a coupon of 9.95% p.a.

It seems to be a very popular bond among individual investors.  Apparently, the primary attraction is the yield to maturity which, based on the last traded price, is around 8.60% p.a.  However, it appears that this bond carries a call option in March, next year.  More to the point, if my calculations are correct, the yield to call over the past month at least, has been consistently negligible or even negative.  In other words, if SBI chooses to call back this bond, there are investors who will get back less than what they invested- possibly hundreds, if not thousands of investors. 

From what I can make out, these investors are ignorant about the importance of yield to call and yield to worst.  What’s more, none of the bond platforms that I saw, highlighted either of these.

When I raised this with an investor, his response was a counter-question: “Will SBI really call back this bond?”  Personally, I can’t see a reason why SBI would want to continue paying a 9.95% coupon in the current low yield scenario.  For the sake of those investors, I can only hope that SBI’s humanitarian considerations outweigh its commercial considerations.

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 funds.  Secondly, 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.

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. 

Yield vs. Return

An investor reached out to me with questions related to a certain floating rate fund.  The fund had reported its May-end net portfolio yield (i.e. after expenses) to be ~6.5% p.a..  How was it then, he asked me, that over the month of June, it had shown an annualized return of ~23% p.a.?  If it was, as he suspected, somewhat linked to the last round of rate cuts by RBI, then why was it that other funds that had relatively higher yields as well as higher duration, hadn’t gained as much as this fund?

His suspicion was not without merit.  Such a difference in return over yield is usually seen at times when RBI cuts interest rates.  It’s just that, this time around, bond yields have been taking their time to adjust to the cuts.  While RBI cut rates in March and May, some of the expected fall in yields played out only over June. 

However, there are a couple of things that the investor overlooked.

Firstly, the fall in yields in June wasn’t uniformly across the yield curve, or issuers, and there were some striking differences in returns across funds and fund categories.  For instance, the category that gave the best return was that of corporate bond funds yet the best performing fund across categories was a credit risk fund.  While the categories of short and medium duration funds did better than ultra short and low duration funds, gilt funds, despite their much longer duration, gave lesser return than all these categories.  In a nutshell, it boiled down to the individual securities that a fund was holding. 

In that light, if I look at the May-end portfolio of the aforementioned floating rating fund, some part of its extraordinary gains in June would have been driven by a ~100 bps fall in yields of two AAA bonds, with 3-4 years left to their maturity, and which made up ~10% of the portfolio.  In addition, some gains would have resulted from a 30 to 55 bps fall in the yields of perpetual bonds that the scheme was holding, and which made up ~18% of the portfolio.  In the aftermath of what happened with Yes Bank, across-the-board, yields of perpetual bonds shot up and have remained high ever since.  Only in June did those yields show signs of softening.

I must point out that all that I said just now assumes that those securities continue to be held in the fund’s portfolio.  We will know for sure, once the June-end portfolio is disclosed.

Secondly, at a more conceptual level, while the portfolio yield of a debt fund is the single most important indicator that an investor should examine and track, it has its own limitations.  Yes, it can give clues as to the level of credit risk in a fund, as well as roughly indicate what might be the immediate return that one could expect.  However, yields change daily whereas fund houses disclose the yields only at the end of each month.  Thus, in a period of sharp changes in yields, the last month-end yield will be of limited use.

In addition, if a fund holds illiquid or thinly traded securities, then the fund’s yield may not be a true measure of how the market may value its portfolio.  Selling those securities can well bring about gains or losses to their portfolio values.

To illustrate this point, I’d like to take the example of a fund whose reported net yield as of May-end was ~12% p.a. but which ended up giving a negative return over June, and not because of any markdown or default.

This scheme held a certain security that alone made up almost a third of the portfolio, and which was valued at an estimated yield of ~16% p.a..  For some reason, the fund manager chose to sell some of that security in June.  As it happens, the sale was made at a yield of 28% p.a..  In other words, the fund got a lot less money than what the security had been valued at.  That led to the NAV falling by ~1.5% that day, and that alone was enough to wipe out whatever gains the reported yield would have brought about over the entire month.

To be fair, this may be an extreme example.  Still, it should help drive home the perils of blindly relying on a  fund’s portfolio yield.

The Agony Of Being A Franklin Templeton FoF Investor

By a former Franklin Templeton employee

I have a significant investment in one of the 6 “yield oriented” funds that Franklin Templeton (FT) has decided to wind up.  But it’s my investment in Franklin India Dynamic Asset Allocation Fund  of Funds (FT DAAF) which, despite being comparatively smaller, has caused me much more pain.  Indeed, I will not be surprised if most investors in this, and FT’s other domestic fund of funds (FoF), share this feeling. In this piece, I want to put on record what they have had to endure.  While I shall briefly touch upon my first-hand experience as an investor, I write this more as an observer. Please note that all references here to FoFs are to domestic FoFs.

On Friday, 24 April, I put in a request to switch out of FT DAAF.  For those who may not know, it invests its debt allocation into Franklin India Short Term Income Plan, one of the 6 funds being wound up.

To be honest, before I put in the request, I wondered how was it that this FoF was open for subscription/ redemption, when one of its underlying funds had been shut down.  I couldn’t find any information or fine print.  And when I put in my switch request on the FT website, I can’t remember seeing any cautionary note, either.

The next day, I was in for a shock.  The NAV of this hybrid fund had dropped by over 16%.  This was way, way more than the fall in the NAVs of the underlying funds.  Clearly, there was more to it than met the eye.

After much enquiry and searching, it came to light that FT had applied an “illiquidity discount” of 50% on the NAV of the underlying debt fund.  Quite frankly, this felt like a stab in the back.  But that feeling was quickly overshadowed by what I felt on seeing the fall in the NAV of another FoF: Franklin India Life Stage Fund of Funds- 50s Plus Plan.  As the name might suggest, it is targeted at people in their fifties or older. It tends to have an 80% allocation to debt funds, so it’s quite like a conservative hybrid fund.  You can therefore understand my shock on seeing that its NAV had fallen by over 25%.

It is worth bearing in mind that these funds are not ordinary products.  These are solutions/ quasi-solutions and are positioned as such.  Thus, morally, if not legally, I believe that there is a greater fiduciary responsibility on Franklin Templeton in the way they are structured and managed.  In that backdrop, I’d like to present a few points.

Firstly, it is worth asking as to why did most of these FoFs have such a high exposure to those “yield oriented” funds?  In fact, one of the FoFs can only invest its debt allocation into “yield oriented” funds.  In that respect, one could say that their very design was dubious.  But then it is also worth asking that, as the credit quality of these funds deteriorated over the past 12 months or so, why did FT not make appropriate changes to these FoFs?  I must point out that around 6 months ago, several amendments were made to one of the FoFs: FT DAAF.  The underlying equity fund was changed, as was the basis for the debt:equity allocation.  Yet FT persisted in continuing the underlying “yield oriented” debt fund.

Secondly, when FT took a decision, a few months ago, to allow for segregated portfolios (or side pocketing) across its debt funds, why did it not include the FoFs?  Sure, there would have been difficulties in doing so but then did FT really make a serious effort?  And if it wasn’t possible, why did it not then consider amending the allocations of those FoFs towards high credit quality funds?

As a case in point, look at what happened when the Vodafone holdings were marked down in January this year.  Investors in the underlying “yield oriented” debt funds got the benefit of segregated portfolios.  On the other hand, investors in the FoFs were left in the lurch, having no choice but to take a hit on their investments.  

Which brings me to the current issue, which actuated this piece.

For starters, without getting into the legality of it, was the idea of an “illiquidity discount” in itself the best solution that FT could think of?  Indeed, was it even in the best interest of investors (as FT likes to frequently proclaim)? 

Far from it. 

The decision to shut the 6 funds wasn’t taken overnight.  FT could have simultaneously worked on transitioning FoF investors into high credit quality funds.  In the worst case, they could have temporarily shut these schemes till the transition was over.  What FT has done is to virtually force the illiquidity discount on its FoF investors. 

Be that as it may, I wonder what is the basis of a 50% discount. These were not individual bonds- these were funds managed by FT itself.  What’s more, such a stiff discount throws open the possibility of short term investors jumping into these schemes and diluting potential gains for the existing investors. 

And having done what they did, couldn’t they have clearly communicated this to FoF investors?  The decision to apply this discount was taken on the night of 23 April.  As far as I can make out, there was no mention of this in any press release.  The only public document that I have seen was a plain paper note on their website which states that effective 24 April 2020, the “illiquidity discount” would apply.  That document appears to have been uploaded on 24 April at 11:23 pm.  That’s more than 24 hours after FT’s valuation committee decided on this “illiquidity discount” and over ten hours after the cut-off time for redemptions/ switches on 24 April.  While I would dispute the lawfulness of the “illiquidity discount” per se, applying it on the NAV of 24 April is especially questionable.

But personally what I find most striking in all of this is the pettiness of the amount involved.  All together, these FoFs hold merely ~1% of the AUM of the 6 “yield oriented” funds.  I struggle to see how FT’s actions can be fair and equitable to the investors in these FoFs.

I mentioned earlier that I felt as if FT had stabbed me in the back.  But if I keep aside my experience as an investor and look at the present episode as an ex-employee, I actually feel an even greater pain, and some sadness.  The Franklin Templeton that I remember, when I worked there many years ago, was a firm that truly empathized with its investors.  I used to take great pride in being a part of this firm.  I sincerely hope that all of this is a mistake and that FT rectifies this injustice to its FoF investors.

The Real Sting Of This Market Crash

As one might expect, the stock market crash this year has been compared with the fall in 2008-09.  If I leave aside the macro differences (about which I am not smart enough to comment), one simple but persistent point of comparison has been the fall from the peak.  In 2008-09, at the bottom of the fall, the BSE Sensex closed ~60% below the peak.  In 2020, at the lowest point thus far, it closed ~38% below the peak.  Consequently, many people feel that, at this point, the present crash isn’t as severe as the 2008-09 fall. 

While I don’t argue with that comparison, to me, a better indicator of the severity of what has happened, is the number of years of growth/ returns that have been wiped out.  If we go by that, the ~38% fall in 2020 appears to be a lot more severe than the ~60% fall in 2008-09.  Here is some evidence.

In 2008, the BSE Sensex attained its peak closing on 8 January.  The Price Return Index (PRI), which most people follow, closed at a level of 20,873, while the Total Return Index (TRI) was at a level of 25,756.  14 months later, on 9 March 2009, the BSE Sensex hit rock bottom (PRI: 8,160; TRI: 10,216).  Looking back from there, the TRI first crossed this level on 27 September 2005.  What this means is that the 14 month fall of ~60% wiped out roughly 2 years and 3 months of growth and dividends.  To put it differently, as on 9 March 2009, a one-time long-term investor in an index fund (tracking the BSE Sensex) would have lost, all-in-all, up to 3 years and 5 months of his/ her investment tenure, with no return to show for that period.

Now let’s look at what happened this year.

The BSE Sensex had its peak closing this year on 14 January (PRI: 41,953; TRI: 61,231).  The lowest closing point, thus far, was roughly 2 months later, on 23 March (PRI: 25,981; TRI: 38,017).  The TRI had first crossed this level way back on 31 October 2014.  What this means is that as on 23 March 2020, the 2 month fall of ~38% had wiped out 5 years and 3 months of growth and dividends.  Or to put it as previously, as on 23 March, a one-time long-term investor in a BSE Sensex index fund would have lost up to 5 years and 5 months of his/ her investment tenure, with no return to show for that period.

But what of investors who did SIPs?

Sadly, the difference is a lot more.

If you had started a SIP in a BSE Sensex index fund, 7 years before the market bottomed out in 2008-09, then at that point, (~60% below the peak), you would have been sitting on an annualized return of over 8% p.a.

On the other hand, if you started that SIP 7 years ago, then as on 23 March 2020, the value of your investment would be less than what you cumulatively invested.  Since then the markets have moved somewhat upwards, and that SIP might currently be showing a marginally positive return. 

In that backdrop, there are several things worth thinking about.  Here are a couple of them.

Firstly, there’s our perception of risk.  While investing in equities, were we thinking of risk in the way as shown above?  If not, I’d say that there is a case for us to do so.  Fact is, this risk is inherent to investing in equities and cannot be wished away.  Its magnitude may vary.  As it happens, many years ago, after the Tech bubble burst (followed by 9/11), the BSE Sensex fell to a level that it had first touched over 9 years earlier.  None of this matters if we exit at a relative high, so to speak.  If we are fortunate, we may get to do so.  But of our own, many of us can’t, and that brings home the importance of having a well-thought-out asset allocation.

Secondly, there’s our perception of SIPs.  These are largely sold, and bought, based on optimistic assumptions/ projections of returns, with little or no discussion of risks.  Pitches such as “SIP karo, mast raho” are at best, dubious, and at worst, dangerous.  SIPs are primarily a saving strategy, not an investment strategy.  They are not a substitute for a proper asset allocation.

The Vodafone Valuation Controversy

The facts are reasonably well known so I’ll only briefly summarize the background. 

For some time now, there has been a cloud over the ability of Vodafone Idea to honor repayment of NCDs issued by it.  This cloud became darker after a Supreme Court order last week.  However, the rating agencies didn’t change their ratings on the company.  For reasons best known to them, the NCDs continue to be rated ‘investment grade’.  Among the fund houses holding these NCDs, most of them marked down their holdings by roughly half or so.  Franklin Templeton went ahead and marked down its holdings completely, sparking a bit of outcry over the resultant NAV fall, and a debate over the wisdom of its actions.

Was Franklin Templeton right in completely marking down the Vodafone Idea NCDs? 

Opinions are clearly divided.  There are those who feel that it was the best way to protect the interests of most investors.  There are others who claim that a complete mark down was neither fair nor warranted, and was a sort of overkill.  What makes it complicated is that only in hindsight will we know if it was necessary or not.   

What is undeniable is that when it comes to mark downs in open end debt funds, no matter what action any fund house takes, there are some investors who will be impacted more than others.  Take this case, for example.  In funds houses that partially marked down their holdings, investors who stay invested are at risk of facing a greater negative impact than those who exit: they most certainly face a greater uncertainty.  In the case of Franklin Templeton, investors who stay invested have no further downside (related to these NCDs) while investors who exit will have to certainly bear the brunt of the mark down (unless, of course, there’s a reversal before they exit).

In short, there was no perfect solution.  Thus, I cannot fault any fund house for the action that they took.  However, I would like to believe that there could have been a win-win scenario had the fund houses explored that and had SEBI agreed to that.  Maybe the fund houses did and, if so, I’d be curious to hear what SEBI’s response was.  But what exactly am I referring to?  I would have liked to have seen the creation of a side pocket.

Sure, there would have been practical difficulties in doing so.  I am also aware that as per the rules, side pocketing a rated security can be effected only in the event of a downgrade below investment grade.  But I submit that side pocketing is too vital a tool to be restricted in the way that the current guidelines do.  It is also too vital to be inextricably linked to what rating agencies perceive to be ‘investment grade’.  Imagine if side pocketing had been allowed to happen in this instance.  I doubt if there would have been much debate or outcry. 

Allowing side pocketing is undoubtedly one of the most important measures instituted by SEBI to protect the interest of debt fund investors.  But there is a good case for expanding the scope of its usage (e.g. currently it doesn’t help investors in Fund of Funds that hold side pocketed debt funds).  There is also a case for giving fund houses more discretion.

I recognize that, going forward, if Vodafone Idea does get downgraded to below investment grade, fund houses can still create a side pocket.  But its effectiveness would depend on the extent of mark down, the date of creation of the side pocket, and the amount of inflows into each fund between the date of mark down and the date of creating the side pocket.  And it would benefit only those who are invested on the date that the side pocket is created.

On the other hand, what if Vodafone Idea is not downgraded?  What if the payments come through on time?  The mark downs can’t continue indefinitely.  And neither can all investors stay invested, waiting for the papers to mature.  Yet, if a side pocket were to have been created, there wouldn’t be a cause for worry.

Still, it is SEBI’s decision to make.  At the very least, I hope that this case makes SEBI consider the value of side pocketing beyond the current letter of the law. 

Open end debt funds are a singularly complex investment option.  As I have noted earlier, though they invest in debt instruments, they distort the very traits of those instruments that make them appealing to investors.  They carry a wide variety of risks but, as I have also previously written, probably the scariest part about them is that there are some risks that are hard to fathom or even give a name to.

Dead Weight In Debt Fund Portfolios

As if monitoring debt fund portfolios wasn’t already hard enough, there is now one more thing that investors need to watch out for.  It’s what I call portfolio ‘dead weight’:  investments that have matured but continue to be shown in the portfolio as having some value.  If that sounds cryptic or baffling, or if you’re just wondering why that should matter, read on while I explain.

Let me take the mutual fund investments in DHFL as an example.  You may remember that DHFL NCDs were downgraded to ‘default’ status in June on account of a delay in interest payments.  Most fund houses marked down their holdings of DHFL NCDs by 75%, regardless of when the NCDs were going to mature.  The idea was that when the money was repaid, the fund houses would write back the amount they had marked down.

But what if the payments don’t come through, or are just inordinately delayed?  As it happens, mutual funds holding DHFL NCDs that matured over the past two months, haven’t got their money back.  And going by the early cut of the ‘resolution plan’ submitted by DHFL, the money is going to take a very long time coming.  Until recently, if something like this happened, all fund houses would have completely marked down the value of these investments.  Not this time around.  In the case of DHFL NCDs (and who knows what else), most fund houses have taken the view to keep the value of these investments unchanged. 

Now think about what that means.

Apart from the fact that no income can be accrued from these NCDs, whatever chances of offloading them in the market were there, stand vanished (or considerably diminished) after the maturity date passed.  So, in effect, by being shown to have some value, these investments are inflating the NAV and the AUM of the schemes. 

To look at it differently, the good news is that for now, the investors in these schemes have been spared from seeing a further fall in the NAV (on account of these NCDs).  The not-so-good news is that until the amount gets repaid, there will be the looming threat that this amount may be written off, anytime, without giving any notice.  If and when that happens, the scheme NAV will take a fall.  Since many of these are open-end schemes, they carry the additional risk of the AUM potentially shrinking.  The more the AUM shrinks, the more will be the fall- if and when it happens.  And that’s what investors need to really watch out for. 

In the latest portfolio disclosures, I noticed schemes where the current DHFL ‘dead weight’ is over 10% (in one instance, I estimate it to be ~17%).  If the AUM of these schemes shrink, those numbers could jump up significantly.  Remember, this excludes NCDs which are yet to mature (which, if the DHFL draft resolution plan can be relied upon, are additional ‘dead weight’ in the making).

How can you know if a portfolio is holding securities that are past their maturity?

There is no industry-wide ‘dead weight’ database, so to speak.  Hence, this information can only be gathered from individual fund house/ scheme portfolios.  Even so, you have to hunt for this information.  I can’t yet say about the fact sheets but in the more detailed monthly portfolio disclosures (available on fund house websites as Excel workbooks), these investments may or may not be listed alongside the other investments of the portfolios.  If they aren’t, then the cumulative value of these investments (and their contribution to a scheme’s AUM) will have been added up and hidden under the bigger head of ‘Net Current Assets’ or ‘Net Receivables’ or something similar. 

However, if you scroll down any scheme sheet, you may see these investments listed/ referenced in the footnotes to the scheme’s portfolio.  There is no uniformity in the way this information has been disclosed, and some fund houses have presented this information a lot more clearly than others.  Bear in mind, though, I have come across at least one instance where a fund house has not yet disclosed this information in any shape or form. 

I think this is a very important disclosure and if SEBI supports the existence of such ‘dead weight’, it should take a close, hard look at how to ensure compliance, clarity, and uniformity.  I am aware that in a recent circular, SEBI specifically asked all fund houses to provide this information.  From what I gather, there appears to be some confusion among fund houses over the format and whether this should be a part of the monthly portfolio disclosures or only the half-yearly portfolio disclosures.  It would be truly useful if this information is provided on a monthly basis, and is clearly presented in all portfolio disclosures, including in the fact sheet. 

I must point out that the DHFL example stands out because at the time that the downgrade happened, most fund houses had not put in place a mechanism for creating so-called side-pockets (or segregated folios).  In the event of a bond being downgraded to ‘default’ status, the creation of a side-pocket is arguably the best way to protect investor interests and avoid the occurrence of ‘dead weight’.

Clarification: On reflection, I feel that my assertion that at least one fund house has not disclosed its exposure to 'dead weight' securities in the latest monthly portfolio, could have been much better phrased.  This assertion is related to a single fund house. It is based on information from sources that I consider to be reliable, and is not contradicted by my observations of the latest monthly portfolio disclosure.  I expect this to be confirmed once the half-yearly portfolios are available, upon which, I will update this post.

Observations On The Essel Mess

Guest post by Norman Evan

Remember the 30 September deadline for some FMPs and other debt funds to have got back the money they’d invested in Essel group companies?  That date has come and gone, and things haven’t played out the way some mutual fund managers thought, or led investors to believe.

If you don’t remember or haven’t been following the story, it involved limited purpose, private companies linked to the Zee promoters.  Sprit Textiles, renamed as Sprit Infrapower and Multiventures.  Edisons Utility Works, renamed as Edisons Infrapower and Multiventures.  Continental Drug Company, renamed as Konti Infrapower and Multiventures.  There are more, but you get the idea.  If you lifted their corporate masks (or veils, if you like), I guess all these companies would look pretty much the same.

These companies had borrowed money from various mutual funds.  The borrowing was on largely similar terms. Most of the NCDs that were created, ticked all the boxes that would unnerve a risk-averse bond investor.  Zero coupon bond.  Check.  Backed by shares.  Check.  Rating by Brickworks.  Check.

As we’ve seen time and again, the mutual fund managers were either suckers for a good yield or had their own interests or agenda.  These NCDs had no place in mutual fund portfolios.  Certainly not in FMP portfolios where a lot of them landed.

Then, some months ago, there were the first signs of dark clouds looming.  It looked like the Zee promoters wouldn’t be able to pay back some of the money on time.  But if everyone went about selling the shares which backed the NCDs, they’d  get much less than what they hoped for.  So they all sat down and hatched up a plan.  They decided to give the Zee promoters time till 30 September to come up with the money.

So what happened?

One, not all companies paid up.  Why?  I guess only the Zee promoters or their associates can tell us that.  Konti paid back in full.  Edisons and Sprit paid back some of the money but there’s a fair bit still left to be paid back.

Two, the repayment has been pretty arbitrary. Kotak MF got paid back all that they were owed.  But Birla MF and HDFC MF have a lot less to smile about.  And while Kotak MF might brag about how their decision to give time to the Zee promoters has been vindicated, I’d say they got lucky.  Unless they arm twisted their way to get the payment. 

Talking about arbitrary repayments, this is becoming quite the thing.  Back in June, FT got fast track payments for their investments with the DHFL promoters.  Other mutual fund managers whose DHFL investments were more investment-worthy and repayment-worthy than that of FT, have been left holding a lemon. 

Three, there’s the mystery of dual ratings.  Brickworks, in its infinite wisdom, has downgraded some Sprit and Edisons NCDs to a D rating while it has downgraded other NCDs from the same companies to BB-.  Why?  It would seem that wherever payment was due, but didn’t happen, they did a downgrade to D.  But where payment was not yet due, they decided that those NCDs weren’t yet ripe for a complete downgrade.  Is this what happened with IL&FS or DHFL? No.  So why did this happen in this instance?  Read this rating rationale for the Sprit downgrade and see if you can figure that out.  I can’t.

To continue with Sprit as an example, it had NCDs outstanding to the extent of 1064 cr or so.  Of this, 211 cr was due as on September end.  The company paid back 100 cr- fine.  The 111 cr that it didn’t pay back was downgraded to D.  But the 853 cr which isn’t yet due, was only downgraded to BB-.  And that’s what makes my head explode.  Sort of.  These guys couldn’t pay back 111 cr but the rating agency seems more optimistic that they’ll pay back the 853 cr.  It just takes my breath away.

Could it be- could it just be- that this may have something to do with the impact it has on scheme NAVs?  A D downgrade would mean writing off 100% of the investment value while a BB- means writing off just 25% of the value.  You have to admit- AMCs do have a rather cozy relationship with rating agencies.

When Scheme Differences Are Erased

SEBI’s decision to create clearly defined scheme categories (and to limit fund houses to one scheme per category) was a big step towards empowering investors to make better scheme choices.  It’s been a year since that came into effect and for the most part, it’s been a success.  Unfortunately, some funds houses have found (or are finding) ways to wipe out the differences between schemes across different categories.  While there is a need for SEBI to step in, investors also need to be vigilant, else we could end up holding a scheme that is quite different from what we expected it to be. 

In this post, I want to share a few examples of the variety of ways in which fund houses have attempted to blur the differences between schemes in different categories.  I have presented these in the form of a short quiz.  There is a link to the answers at the end of the post.

Q1: Deceptive Descriptions

Given below are the descriptions of two open-end equity funds managed by a certain fund house.  These descriptions have been taken from the fund house website.  One of the schemes is classified as a ‘Mid Cap’ fund.  Based on these descriptions, can you identify which one of these is the real ‘Mid Cap’ fund?

Fund A:

An open ended equity scheme predominately investing in mid cap stocks

Fund B:

…is primarily a Mid-cap fund which gives investors the opportunity to participate in the growth story of today's relatively medium sized but emerging companies which have the potential to be well-established tomorrow.

Q2: Deceptive Advertising

Given below are masked banner ads for two equity schemes managed by a single fund house.  One of these schemes is classified as a ‘Focused’ fund, while the other is classified as a ‘Multi Cap’ fund.  If you had been able to read the detailed descriptions (which are in smaller print), you might have been able to know which ad is for which scheme.  But since these are website ads, which many will have seen (or will see) on mobile devices, the headlines become all the more important.  Based on the headlines, can you identify which of these is the actual ‘Focused’ fund?

Fund C:

Fund D:

Q3: Deceptive Allocations

Going by SEBI’s definition, in the so-called ‘Balanced Advantage’ funds, the equity/ debt allocation is required to be managed “dynamically”.  While some may consider that term to be all-encompassing, from what I have gathered, the purpose of having this category is to group those funds where the equity/ debt mix will be decided through a process of tactical asset allocation.  As it happens, at least one fund house either has an extraordinarily restrictive interpretation of what ‘dynamic’ means or has chosen not to make tactical calls.  The equity allocation of its ‘Balanced Advantage’ fund has remained in a remarkably narrow band and has had little resemblance to that of any other ‘Balanced Advantage’ fund.  But it has had more than a passing resemblance to the equity allocation of the ‘Aggressive Hybrid’ fund managed by the same fund house.  Given below is the unhedged equity allocation for the last 12 months for the two schemes.  Based on this information, can you identify which of these is the ‘Aggressive Hybrid’ fund and which is the ‘Balanced Advantage’ fund?

Q4: Deceptive Risk Profile

‘Credit Risk’ Funds are required to have at least 65% of their portfolio in securities that are rated AA or lower.  It is generally expected that these funds will carry a higher credit risk than any other class of debt funds.  Given below is the latest rating profile, yield, and maturity of the portfolios of three debt funds, managed by a single fund house.  Based on this information, can you identify which of these is the ‘Credit Risk’ fund?

	Fund G	Fund H	Fund I
Portfolio Composition by Rating
Sovereign/ AAA/ Cash	16%	15%	12%
AA+	9%	9%	11%
AA and lower	75%	76%	77%
Average Maturity (years)	3.1	3.4	2.9
Portfolio Yield	11.7%	11.4%	11.7%

If you’d like to see the answers, click here.

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.