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.

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.” 

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.

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 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 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.

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 Most Eventful Month For Debt Funds

To say that the month gone by was extraordinary, would be an understatement.  It shone a whole new light on the riskiness of debt funds.  And for some debt fund investors, it was catastrophic.  While there has been ample media coverage on most of what happened, in this post, I’d like to talk about some of the less-reported stuff that stood out for me.

Let me start with the downgrades.  We all know about DHFL.  We probably know about Sintex as well.  But there were two other companies whose downgrades threw up a few questions for me- Wadhawan Global Capital (WGC) and  Cox & Kings.  There were only a handful of schemes holding debt of these companies, and in all but one of those schemes, investors were not impacted.  Still, these questions are pertinent given how much credit rating agencies influence debt fund returns.

WGC is the parent company of DHFL, and I talked a bit about it in an earlier post.  I had mentioned that its rating was linked to that of DHFL and that it was downgraded along with it between February and May (although with an inconsistent time lag).  I had pointed out that when DHFL was downgraded to ‘default’ on 4 June, WGC wasn’t. After a questionable delay, on 21 June, the new rating for WGC was released.  But guess what?  Its rating wasn’t downgraded to ‘default’.  Instead, in what I consider a sleight of hand, its rating was delinked from DHFL and was independently assessed as BB.  But why the long delay?  This wasn’t a complex company that needed deep evaluation.  Did the delay have anything to do with some stake sales that were to came through (and eventually came through)?  Would the rating have been the same if it had been done right after the DHFL downgrade?  Was such a delay justified?  Was the delinking from DHFL justified?

There’s more: one fund house held around 300 cr of NCDs issued by WGC that were due to mature in 2020 and 2022.  Since WGC was untouched by the DHFL downgrade, its schemes holding these NCDs weren’t impacted either.  Not only that, if reports are to be believed, this fund house managed to sell back its entire WGC holding (or at least a large part of that) to the DHFL promoters, before it eventually got downgraded to BB.  In some quarters, the move was hailed as a masterstroke by the fund manager.  Frankly, I don’t know if it would qualify as skill, luck, or something else.  Regardless, assuming this information to be correct, I’d be curious to know what made the promoters of DHFL fast track this repayment and prioritize it over repayments to other creditors, especially in light of their inability to honour DHFL maturity payments later in the month.

As for Cox & Kings, for those who may not know, the company defaulted on repayment of commercial paper due on 26​ June, to the extent of 150 cr.  Fortunately for mutual fund investors, only one scheme was impacted.  However, what I found intriguing is that just two days before the default, one of the credit rating agencies had reaffirmed the rating of the company’s 2000+ cr CP program as A1+, the highest rating that can be given.  As someone said, it’s getting hard to know what to make of ratings any longer.

On account of the downgrades (mostly DHFL), June was a month of widespread negative returns across debt funds.  By my count, 159 schemes ended up with negative returns.  14 of these fell by 10% or more, of which 4 schemes fell by 40% or more.  If my numbers are correct, the simple average return of all debt funds (including gilt and liquid funds) put together was –0.24%.  To my mind, this hits home the need for quality in diversification across debt funds.  Blindly diversifying oneself wouldn’t have been enough.

If I drill down into individual categories, unsurprisingly, the worst affected category was that of credit risk funds.  Again, if my numbers are correct, this category had an asset-weighted return of  -0.71%.   But this was by no means the only category with a negative asset-weighted return.  There were 3 other categories: low duration (-0.58%), medium duration (-0.58%), and short duration (-0.29%).

Among the schemes that gave negative returns, there were two schemes that particularly grabbed my attention.  The first was BOI Axa Credit Risk Fund which fell by over 44% in June.  It was the subject of a post that I wrote a couple of years ago, where I had called it out for the level of risk it was taking. Sadly, some of my fears about this scheme have come true.  Investors who are in the scheme since its inception (over 4 years ago) are now sitting on a loss of over 30%.  If I am not mistaken, it has been impacted by more downgrades than any single scheme.  What worries me is that the worst may not be over for this scheme.

The other scheme is a somewhat obscure FMP managed by ABSL MF: Series OW (1245 days). It fell by ~6.7% in June.  It was hit by both the DHFL downgrade as well as the IL&FS downgrade.  From what I can see, it also appears to be holding NCDs of one of the Essel group promoter companies.  What caught my eye is that according to Value Research, it has now given negative returns in 5 of the first 6 months of this year.  I haven’t yet investigated this in detail but it certainly adds a new angle to the riskiness of debt funds.

When bond prices fall, yields go up.  So is there an opportunity in this crisis, to capture the accrual from high yields?  That’s a question I’m hearing in some circles.  The June-end portfolio yields are yet to be disclosed.  If the May-end yields and back-of-the-envelope calculations are anything to go by, I will not be surprised if there are a dozen schemes or more with yields in excess of 13%.  Some of the likely high-yield schemes are closed for subscription.  A few others have exit loads.  But the opportunity, wherever it exists, comes with the risk of further downgrades and write-offs.  And if there are too many people seizing the opportunity, there could be a dilution.  Still, it’s something worth thinking about.  In any case, for those of us who are already invested, the yields offer a glimmer of a silver lining in the gloomy cloud of June.  But we also need those side pocket changes, real fast.

10 Years After The 2008 Peak

On Jan 8 2008, the BSE Sensex closed at a then all-time high level of 20,873.  This week, as it hit new all-time highs, I have been poring through performance numbers of equity funds over these last 10 years.  In this post, I’d like to share some of my observations and thoughts.

Is this what we expected?
“How much return would you expect the Sensex to give over a 10 year period?”  Back in the day, I would pose this question to advisors and investors, as part of a long-running series of exercises that I conducted.  Throughout 2007-08, the most common answer I got was “at least 15% p.a.”.  It was an understandable response.  The growth in the Sensex from its base date in 1979 to its value at the end of December 2007, stood at just over 20% p.a. (without reinvesting dividends).  Some would consider the estimate of 15% p.a. to be too high.  The most conservative estimates that I heard were of a growth of no less than 10% p.a.  Yet, the fact is that over the last 10 years, the BSE Sensex TRI grew by just 6.6% p.a.  The BSE MidCap TRI did a bit better, growing by 7.9% p.a.  And for whatever you may find it worth, the BSE SmallCap TRI grew by just 5.3% p.a.  All these numbers pale in comparison to the fact that a 10 year deposit with SBI over the same period would have given an assured compounded annualized rate of 8.78%.

So, going forward, could such long-term underperformance by equity indices be a more frequent occurrence, or is this just a blip?  When I discussed these numbers with a prominent industry observer, he responded with a quote that is frequently attributed to Keynes: “Markets can remain irrational far longer than we can remain solvent.”

How much value did actively managed funds really add?
Of the 140 actively managed, domestic, diversified equity funds that survived these 10 years, only 2 schemes gave an annualized return in excess of 15% p.a.  While the median return of this group was 9.2% p.a., 61 schemes (i.e. 44% of all schemes) gave less returns than the SBI deposit would have.  Of these, 28 schemes (20%) gave less returns than the BSE Sensex.  All these numbers exclude entry loads, which were prevalent at the time.

How did the largest schemes perform?
The table below gives the list of the largest equity funds (by AUM) at the end of December 2007 along with their returns over these 10 years.  Some of the names on this list may surprise those who weren’t investors at the time.  I can’t say how many investors were committed to being invested in these schemes for 10 years or more.  For those who were, it is a moot question as to whether their faith in these schemes was justified.  For better context, I have also given the ranking of these schemes based on their return.

	AUM Rank Dec 2007	Return p.a. 2008-2018	Return Rank 2008-2018
Reliance Growth Fund	1	9.9%	72
Reliance Diversified Power Sector Fund	2	4.1%	181
HDFC Equity Fund	3	11.4%	37
ICICI Prudential Infrastructure Fund	4	4.8%	173
DSP BlackRock India T.I.G.E.R. Fund	5	5.6%	155
Reliance Vision Fund	6	7.8%	116
Fidelity Equity Fund*	7	10.2%	65
Franklin India Flexi Cap Fund	8	10.2%	66
SBI Magnum Taxgain Scheme	9	8.2%	105
Reliance Focused Large Cap Fund	10	5.6%	156

Returns are for the period 8 Jan 2008 to 8 Jan 2018 and exclude loads.  AUM and Return ranking is among all open-end equity funds that survived these 10 years.  Total no of funds: 202.
* This scheme has seen a change in fund house management from 2008 to 2018.
Data/ Information sources: AMFI, NJ India Invest, Value Research

How many of us could predict the top performers?
The table below gives the list of domestic, diversified equity funds which gave the highest return over these 10 years.  Alongside I have given their ranking among equity schemes based on their current AUM, as well as their AUM ten years ago.  Going by their AUM ranking ten years ago, it would seem that most investors weren’t betting big on most of these schemes.

	Return p.a. 2008-2018	AUM Rank Dec 2007	AUM Rank Current
HDFC Mid-Cap Opportunities Fund	16.5%	36	4
DSP BlackRock Micro Cap Fund	16.0%	108	26
ICICI Prudential Value Discovery Fund	14.7%	97	5
Canara Robeco Emerging Equities Fund	14.5%	257	59
Franklin India Smaller Companies Fund	14.2%	49	23
Sundaram Select Midcap Fund	14.0%	19	29
DSP BlackRock Small and Mid Cap Fund	13.8%	44	35
IDFC Premier Equity Fund*	13.6%	77	30
UTI Mid Cap Fund	13.5%	114	44
L&T Midcap Fund*	13.4%	239	86

Returns are for the period 8 Jan 2008 to 8 Jan 2018 and exclude loads.  AUM ranking is among all open-end equity funds.  Current AUM ranking is based on AUM  at end of Nov 2017 which is the latest date for which data was available across all fund houses.  Total no of funds- Dec 2007: 287; Current: 385. 
* These schemes have seen a change in fund house management from 2008 to 2018.
Data/ Information sources: AMFI, NJ India Invest, Value Research

How important is the long-term performance of a scheme to investors?
This is the question that bothers me the most.  It is widely recognized that a scheme’s long-term, multi-cycle performance is a good indicator of a fund management team’s competence.  However, if the current AUM of equity schemes is anything to go by, it would seem that long-term performance of a scheme doesn’t really matter to many investors.  As evidence, consider this: three of the ten largest actively managed, diversified equity funds today, did not exist 10 years ago.  These three schemes currently have a combined AUM of ~47,000 crore.  In other words, investors have poured significant money into schemes that were not tested in the brutal bear phase of 2008-09.  I find it all the more astonishing given that two of the fund houses behind those schemes had a patchy record with their other schemes during 2008-09 while the third fund house itself did not exist at the time (nor did its sponsor have any known track record of fund management). 

That’s not all.  There is one more statistic that quantifies the lack of consideration for long-term performance.  It is that the actively managed, domestic diversified schemes that actually underperformed the BSE Sensex over the past 10 years currently have a combined AUM of ~19,000 crore.  If you include thematic/ sector funds, that number goes up to ~32,000 crore.

Warren Buffett famously stated that risk comes from not knowing what you are doing.  While past underperformance (or absence of performance) is no guarantee of future underperformance, I hope investors in all these schemes know what they are doing.

A Nightmare Of Flawed Processes

At the start of this year, I wrote a post: Will You Get Your Money Back, On Time?  In that, I spotlighted the case of an investor who was unable to execute a redemption transaction on the website of a prominent fund house.  His experience was all the more harrowing because, despite his best efforts, he couldn’t reach the customer service team at the fund house.  As an investor, there were two aspects of that episode that I found particularly scary. The first was that the entire incident was the result of poorly designed processes on the part of the fund house.  By my count, there were at least five questionable actions that were triggered through no fault of the investor.  The second was the attitude of the people at the fund house who took no responsibility for what happened.  That made me wonder if they would even bother to examine the flaws of their processes, let alone take any corrective action.

That was not an isolated case: it was just one that warranted a detailed post.  Fact is, I have seen evidence of such flawed processes, across multiple fund houses.  In this post, I would like to present another case, that transpired last week, and which should be of relevance to all investors.  Here, too, the events described could have happened to almost anyone.

This case relates to a Mumbai-based DIY investor who attempted to redeem his investments in a certain ultra short term fund managed by another prominent fund house.  This is a fund house that prides itself on the quality of its processes, and its customer service team.  The investor planned to execute the transaction via the fund house’s website on Monday last week.  But a day before that, on Sunday, when he went on the website to check the exact value of his investments, he was shocked by what he saw.

The summary showed the value of his investments as 35.92 lakhs, which was in line with what he estimated.  However, when he opened the account statement, he was stunned to see that the number of units available for redemption were zero.  As he wondered why that was the case, he spotted an entry made just a few days earlier, with a cryptic description: “pledging”.  It seemed as if all his units had been pledged, something he was absolutely sure, that he had not requested.

Being a Sunday, he had no way of contacting the fund house.  So frantically, he called up people who might have an answer, but it got him nowhere.  He spent a restless day, and night, and first thing on Monday, called up the fund house.  He didn’t get an immediate explanation but someone assured him that they would get back.  They did, but with a baffling reply.  Apparently, in the course of the last switch that he had made (from an equity fund into this scheme), the fund house had deducted a lesser exit load than what was applicable.  When they realized their mistake, they marked a lien against his units with the intention of recovering that amount.

Right away, that threw up several questions, none of which the customer service person could answer.  Why hadn’t they simply written to the investor, or called him up?  If for any reason, they had to mark a lien, why did they do it on the entire units, given that the amount to be recovered was merely 4,000 or so?  Why couldn’t they explain it better on the account statement, instead of using an ominous word such as “pledging”?  Why were they hassling him in this manner when it was the fund house which was at fault?  What sort of processes did the fund house have in place if it couldn’t calculate the exit loads correctly?   Wasn’t the investor entitled to compensation from the fund house for the mental anguish caused by its actions?

From what I could gather, the investor conveyed his intention to immediately withdraw his entire investments.  The customer service person told him that he could do so, and that the amount would be deducted from the redemption proceeds.  Unfortunately, even after that assurance, things didn’t go smoothly.  As per the fund house’s service standards, the redeemed amount should have been automatically credited to the investor’s bank account, early morning on Tuesday.  That didn’t happen.  Once again, he was forced to call up the fund house and enquire what was going on.  Eventually, a few hours later, the amount was credited to his account. 

Many years ago, someone asked me what was the worst thing that could happen to a mutual fund investor.  To that person’s surprise, my answer then, as it would be today, was that in my opinion, there could be nothing worse for an investor than to not be able to rightfully access his/her money at will.  Just like the investor mentioned here, and the one in my earlier post, I have lived such a nightmare once: I hope that I don’t have to, ever again.  I hope that you don’t have to, either.

Special thanks to Robin Jehangir for bringing this case to my attention.

Excessively Expensive Income Funds

For some time now, I have been trying to maintain a watch list of the most expensive plans among income funds.  While expenses matter regardless of fund category, in the case of income funds they have a more consistent and harder impact (than, say, in the case of equity or balanced funds). Much more often than not, higher expenses lead to low returns or higher risk or both. 

While pursuing this objective, one of my most striking observations has been that the plans that I consider to be excessively expensive, account for a large chunk of the AUM in the category.  If I go by last quarter’s AAUM data, then 69% of the money invested in regular plans (i.e. other than direct) of income funds (other than liquid funds and pure debt fixed maturity plans) was allocated to plans that I consider to be excessively expensive.  This could mean one of two things: either my threshold for expensiveness is too low or most investors in regular plans have been sold plans that are way too expensive.  For those who want to explore the truth of the matter, in this post I present a small selection of the income funds on my list.  But before we get into the specifics, there are a few things to bear in mind. 

Firstly, evaluating and explaining a plan’s expensiveness can be a far more complex exercise than most people realize.  In presenting the data in this post, I have opted to keep things simple (some may regard it as an oversimplification).  I have limited the scope of my presentation to non-direct plans, and have primarily focussed on each plan’s expense ratio relative to that of peer group schemes. For the purpose, I have grouped schemes into five categories.  While I have tried to keep things as objective as possible, in any discussion on expensiveness, some degree of subjectivity/ personal bias is unavoidable.

Secondly, against each scheme that I have listed, I have given the current AUM of its non-direct plans.  This is intended to serve two purposes.  For one, it tells you how much money stands invested in these expensive plans.  Additionally, it can help you better understand a plan’s expensiveness.  As a rule of thumb, schemes with larger AUM are expected to have lower expense ratios than schemes with lesser AUM.  Similarly, schemes with larger AUM than most of their peer group should ideally have expense ratios that are below the category average. 

Thirdly, bear in mind that this is a small selection of schemes from my list.  My complete list of excessively expensive plans is too long and complex to be meaningfully presented here.  The plans presented below are not necessarily the most expensive ones: they are some of the most expensive ones.  They have been handpicked to show how widespread the problem of high expenses is.

Lastly, what you see below is not the ideal way that I would like to present this information.  I am compelled to do so because of the constraining ways in which fund houses report expense ratios and AUM data, and because many fund houses frequently change their expense ratios.

Ultra Short Term Schemes
Average Current Expense Ratio: ~0.75%

	Expense Ratio Regular Plan FY 17	Current AUM Non-Direct
IDBI Ultra Short Term Fund	1.40%	410 cr
ICICI Prudential Savings Fund	1.38%	7,057 cr
SBI Savings Fund	1.36%	3,546 cr
DHFL Pramerica Low Duration Fund *	1.24%	686 cr
HDFC Cash Management Fund - Treasury Advantage Plan	1.13%	10,768 cr

With one exception, this category covers all schemes currently classified by Value Research as ‘Ultra Short Term’.  Data for expense ratios has been sourced from scheme annual reports, monthly factsheets and third party sources.  Data for AUM has been sourced from latest available AAUM disclosures and includes AUM for plans that have been suspended for fresh investments. Schemes whose expense ratios are shaded in yellow have above-average AUM in the category.

* One plan in which fresh sales have been suspended since 2012 but in which there continues to be AUM had an expense ratio of 2.51% in FY 17.

Short Term Schemes
Average Current Expense Ratio: ~0.94%

	Expense Ratio Regular Plan FY 17	Current AUM Non-Direct
HDFC Regular Saving Fund *	1.79%	4,517 cr
Franklin India Short Term Income Plan	1.57%	7,000 cr
Sundaram Select Debt Short Term Asset Plan	1.48%	307 cr
Aditya Birla Sun Life Short Term Opportunities Fund	1.40%	4,605 cr
IDFC Super Saver Income Fund - Medium Term Plan	1.31%	2,057 cr
ICICI Prudential Short Term Fund	1.24%	6,329 cr

This category covers all schemes currently classified by Value Research as ‘Short Term’.  Data for expense ratios has been sourced from scheme annual reports, monthly factsheets and third party sources.  Data for AUM has been sourced from latest available AAUM disclosures and includes AUM for plans that have been suspended for fresh investments.  Schemes whose expense ratios are shaded in yellow have above-average AUM in the category.

* (1) The expense ratio of the regular plan of HDFC Regular Savings Fund saw one of the steepest jumps in the category from 1.07% in FY 16 to 1.79% in FY 17.  (2) The expense ratio of the direct plan in FY 17 was 1.19% which was higher than the expense ratios of the regular plans of most schemes in the category.

Medium Term/ Long Term/ Dynamic Schemes
Average Current Expense Ratio: ~1.43%

In my opinion, this category as a whole, is somewhat more expensively priced than it should be.  By my reckoning, if it were to have been fairly priced, then at this point in time, the average current expense ratio for this category should have been ~1.07% (disclaimer: based on complex calculations, subjective assumptions, and personal bias).

	Expense Ratio Regular Plan FY 17	Current AUM Non-Direct
Sundaram Bond Saver	2.61%	120 cr
Sundaram Income Plus *	2.23%	117 cr
Franklin India Income Builder Fund	2.08%	872 cr
Reliance  Income Fund	2.00%	499 cr
Aditya Birla Sun Life Corporate Bond Fund	1.97%	2,947 cr
HDFC Income Fund	1.96%	1,086 cr
HDFC Corporate Debt Opportunities Fund	1.84%	10,724 cr
Franklin India Corporate Bond Opportunities Fund	1.83%	6,237 cr

With one inclusion, this category covers all schemes currently classified by Value Research as ‘Credit Opportunities’, ‘Income’ and ‘Dynamic Bond’.  The inclusion is Sundaram Income Plus which is currently classified by Value Research and Morningstar as ‘Ultra Short Term’.  Since its stated benchmark is CRISIL Composite Bond Fund Index, I feel it appropriate to include it in the present category.  Data for expense ratios has been sourced from scheme annual reports, monthly factsheets and third party sources.  Data for AUM has been sourced from latest available AAUM disclosures and includes AUM for plans that have been suspended for fresh investments. Schemes whose expense ratios are shaded in yellow have above-average AUM in the category. 

* (1) Over the last 3 financial years, the expense ratio of the regular plan of Sundaram Income Plus has seen a remarkable level of fluctuation, changing from 2.17% in FY 15 to 0.38% in FY 16 to 2.23% in FY 17.  (2) The expense ratio of the direct plan of Sundaram Income Plus in FY 17 was 0.22%.  As far as I can make out, the difference between the expense ratios of the regular plan and the direct plan of the scheme was the highest for any pure-debt scheme.

MIP Schemes
Average Current Expense Ratio: ~2.15%

In my opinion, this category as a whole, is way too expensive.  Consider this: in the case of many fund houses, if you were to create an MIP-type allocation on your own by investing in their most expensive equity scheme, and their most expensive debt scheme, that would be cheaper than investing in their MIP schemes.  By my reckoning, if it were to have been fairly priced, then at this point in time, the average current expense ratio for this category should have been ~1.26% (previous disclaimer applies).

	Expense Ratio Regular Plan FY 17	Current AUM Non-Direct
DSP BlackRock Monthly Income Plan	2.60%	447 cr
HDFC Monthly Income Plan - Short Term Plan	2.60%	322 cr
BNP Paribas Monthly Income Plan	2.59%	327 cr

This category covers open end income schemes that allow for marginal equity allocation, and which are targeted at investors seeking regular income.  Data for expense ratios has been sourced from scheme annual reports, monthly factsheets and third party sources.  Data for AUM has been sourced from latest available AAUM disclosures and includes AUM for plans that have been suspended for fresh investments.

Closed End Income Schemes With Marginal Equity 
Average Current Expense Ratio: ~2.31%

In my opinion, this is, by far, the most expensive category of income funds.  In terms of asset allocation and return potential, it is similar to the category of MIP schemes.  However, the essential running costs of these schemes are less (lesser servicing costs, lower portfolio turnover etc.).  As a result, there is a case to say that the average expense ratio in this category should be less than that of MIP schemes.  There is also a case to say that the expense ratios of many plans in this category reflect fund house-distributor collusion with the intent of milking investors, at its ugliest.  By my reckoning, if this category were to have been fairly priced, then at this point in time, the average current expense ratio should have been no more than 1.26% (previous disclaimer applies).

	Average Expense Ratio Regular Plans FY 17	Current AUM Non-Direct
HDFC Capital Protection Oriented Fund - Series III	2.69%	322 cr
DHFL Pramerica Hybrid Fixed Term Fund (Multiple Series)	2.65%	634 cr
Sundaram Hybrid Fund (Multiple Series)	2.65%	520 cr
Axis Hybrid Fund (Multiple Series) *	2.53%	6,474 cr
ICICI Prudential Multiple Yield Fund (Multiple Series)	2.51%	1,364 cr
Kotak Capital Protection Oriented Scheme (Multiple Series) ^^	2.44%	426 cr
ICICI Prudential Capital Protection Oriented Fund (Multiple Series)	2.34%	3,277 cr

Data for expense ratios has been sourced from scheme annual reports and third party sources.  Data for AUM has been sourced from latest available AAUM disclosures.  While compiling the data, only plans that were in existence on the date of compilation i.e. 21 Sep 2017 have been considered.

* 93% of  the current AUM of Axis Hybrid Fund has come via associate distributors such as Axis Bank.

^^ As far as I can make out, Kotak Mahindra MF does not follow SEBI directions/ industry practices in reporting plan-wise expense ratios in its annual reports. The expense ratio number given here includes both direct and regular plans.  The actual expense ratio for regular plans alone can be assumed to be higher than what is mentioned.

Two More Audacious Debt Funds

In response to my last post about the fund that I referred to as ‘Rainbow Fund’, a reader wrote in to say that there were two other debt funds that carried higher risk than that fund.  In his words, these were “the ultimate high risk debt funds”. 

Frankly, such a claim, even if correct, may not have been enough for me to consider doing a post. I might have simply responded to him by email, offering my thoughts.  But there were three things about the funds that he made reference to, that stood out for me.  Firstly, these funds are managed by a fund house that I have believed to have one of the best risk management processes in the industry.  While I was aware that these particular funds were pushing the limits of prudent credit risk, I had not imagined that anyone would compare them with Rainbow Fund.  Secondly, these funds are much, much larger than Rainbow Fund, and hence, there is a lot more investors’ money at stake.  Thirdly, and you can laugh at me, I do not believe in coincidences, and this was the second person to write to me, asking me to do a post about these funds.

Just over a year ago, I received a painstakingly detailed email from a gentleman who wanted me to caution readers against investing in these very funds.  According to him, he had personally invested in these funds but had inadvertently not seen their portfolios at the time of doing so.  Later on, when he did look at the portfolios, he was shocked by what he saw.  He then withdrew his money even though doing so attracted an exit load.  In his email to me, he presented a lot of evidence to support his view on these funds’ riskiness.  While I found a lot to appreciate in it, I also sensed that it was beyond my ability to transform his research into a post that would do justice to his efforts.  For that reason, I suggested that he approach a capable financial journalist instead.  Looking back, I feel that I should have perhaps invited him to do a guest post.

In that backdrop, the intent of this post is to offer my quick take on these funds through the same window which I used to examine Rainbow Fund.  This is, by no means, a comprehensive assessment.  For the purpose of this post, I will refer to these funds as ‘Strip Fund’ and ‘Scorpio Fund’.  Here are some of the facts, based on the disclosed portfolios as on 31 March 2017:

	Rainbow Fund	Strip Fund	Scorpio Fund
% of Portfolio in Securities Rated A+/ A/A-	41%	68%	74%
% of Portfolio in Securities Rated BBB-	2%	3%	3%
% of Portfolio in Unrated/ Privately Rated Securities	25%	7%	1%
Yield Range of Unrated/ Privately Rated Securities (% pa)	12% – 16%	13%	13%
% of Portfolio in ZCBs Rated A+ or below	6%	24%	24%
% of Portfolio in Unrated/ Privately Rated ZCBs	25%	6%	0%

ZCB: Zero Coupon Bonds

Though the table focuses mostly on credit risk, it gives a glimpse of some of the challenges in trying to assess the relative riskiness of funds.  For instance, if one only considers unrated/ privately rated securities, then Rainbow Fund appears to be taking more risks.  Yet, if you combine these with securities rated A+ or lower, it would appear that Rainbow Fund is taking less risks than the other two funds.  One way to get a clearer picture is to look at the yields of the underlying instruments, particularly those which are unrated/ privately rated.  In that respect, Strip Fund and Scorpio Fund score marginally over Rainbow Fund.

There are other data points, too, which favour these funds but in my opinion, these are all small differences.  The credit quality of the portfolios of all three funds crosses the limits of what I consider to be prudent levels, by a significant margin.  And I find the extent of their exposure to low-grade ZCBs to be disturbing.  I don’t know what the investors in these funds think about all of this but for their sake, I hope that they are at least aware of these facts.

In all fairness, I must point out that both Strip Fund and Scorpio Fund enjoy a high Analyst Rating from Morningstar.  I am not sure if that will continue though, given the dip in the credit quality of their portfolios since the last assessment.

Correction: The exposure of Scorpio Fund to ZCBs Rated A+ or below was originally incorrectly mentioned as 29%.