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.” 

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.

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.

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.

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.

You Can’t Always Believe What Fund Houses Tell You

“Investors should beware of lies, half-truths and dangerous nonsense.”  This was a piece of advice from someone who represents an institutional investor, that came in the course of an exchange we had, earlier this week.  As it happened, a day or so before, I had seen a cautionary tweet by a well known investor on similar lines.  However, the context of our conversation was somewhat different.  While we talked a bit about general opinions aired in the media, our exchange was largely about pronouncements made by fund houses. 

There is nothing new about fund houses making inaccurate statements.  But there are some who feel that the manner in which certain fund houses are increasingly trying to mess with our perceptions, is a cause for concern.  Sadly, there is very little that is done by way of fact-checking, and such assertions are rarely called out.  That means it’s pretty much up to each of us to be on our guard. 

Here are three instances from recent memory that came up in our conversation.  I would suggest that you look at them as illustrative of a larger problem more than an indictment of the individual fund houses.

ICICI Prudential MF

In a recent piece published in The Economic Times, its spokesperson was quoted as saying:

We had nil exposure to debt papers of IL&FS…

The specific context of the statement is not clear- it may have been about their debt funds in general or it may have been about their credit risk fund.  Also, it is not clear as to what point in time is being referred to.  Regardless, I think it needs at least one piece of additional context- that ICICI Prudential, in fact, held paper of IL&FS Financial Services in two of their FMPs that matured a couple of weeks before the downgrade happened, last year.  As per the last disclosed portfolios of these FMPs, in each of these FMPs, the exposure to IL&FS Financial Services was in excess of 13%. I’ll leave it to your imagination to think about what might have happened if the FMPs and NCDs were to have matured just two weeks later.

Mirae Asset MF

A few months ago, Mirae Asset courted controversy over the decision to reclassify its multi-cap fund as a large-cap fund.  There is nothing that can be accomplished by a large-cap fund that cannot be accomplished by a multi-cap fund, and there was no basis for such a step to be initiated in the interest of investors.  Still, the fund house persisted in defending the indefensible.  In many quarters, it was felt that this move was connected to the forthcoming launch of its focused fund, which would have a multi-cap orientation.  The fund house denied this.  In a piece that appeared in The Economic Times, its spokesperson was quoted as saying:

We are coming up with a focused fund which should not be confused with a multi cap scheme.

Barely three weeks later, in a piece that appeared in Mint, this was how he was quoted describing the focused fund:

It is a true-blue multi cap with no sector or segment bias.

For whatever it is worth, it seems that as per the last portfolio disclosure, 19 of the 28 stocks in the new fund are also part of the erstwhile multi-cap fund (now large-cap fund), with a portfolio overlap of 45%.

Kotak Mahindra MF

Kotak Mahindra was recently in the spotlight for withholding part of the maturity payments to some of its FMP investors.  This had been triggered by its questionable exposure to Essel group companies and complexities arising out of collecting on that debt (I call it a default).  As I had written in an earlier post, one of its spokespersons was quoted as making a series of bizarre statements, most notably this:

I tend to disagree that it is a call gone wrong…

But more than any single statement, the entire argument made by the fund house, of acting in the interest of investors, was dubious, and circumvented key facts.  The fact that the decision to invest into debt instruments secured by shares was something they foisted upon investors.  The fact that they went beyond accepted norms of prudence in having concentrated exposures with up to 20% of some portfolios in Essel group companies.  The fact that they increased that risk by opting for zero coupon bonds.  The fact that the mess they eventually faced, could very well have been anticipated and avoided.  I can go on.  Thankfully, someone on Twitter called them out with a blistering tweetstorm.  Here’s the link.

Unravelling The DHFL Mess

For those who need a quick recap, on 4 June, DHFL fell behind on its interest payment to NCD holders to the extent of 900 odd crore.  They cited the trust deed to say that they had 7 days to make good on that (for it to not be considered as a ‘default’), and they assured investors (and everyone else) that they would do so.  Apparently, the credit rating agencies had a difference of opinion.  With what I think was an uncharacteristic swiftness, they downgraded the company to ‘default’ status.  Taking a cue from that, all fund houses holding any NCDs of DHFL marked down their holdings by 75-100%. 

Fast forward to 11 June.  In an exchange filing, DHFL confirmed making good on all interest payments.  In itself, that should have made all the NCD holders happy, and to look forward to the next interest payment (or maturity payment).  For the investors in the debt funds that held DHFL NCDs, there was little to cheer about.  Over this period, their total wealth was eroded by an estimated 3000 crore, and there is no clear picture as to when this will be recovered.  For some investors, there will be no recovery. 

So how did this come about?

Let me start with the credit rating agencies.  For many years, DHFL was rated AAA by all of them.  Not just that, until a few months ago, its NCDs were also a part of the CRISIL AAA Medium Term Bond Index.  With such credentials, I find the manner in which DHFL was rapidly downgraded to be rather odd.  And as I hinted above, I also wonder about the promptness with which they downgraded DHFL to default status.  It’s not a decision that can be reversed right away.  Couldn’t they have waited for the 7 day period to expire, before taking that decision?  I am no expert and when I spoke to those who are, they told me that the credit rating agencies were simply acting by the letter of the law.  Still, none of them could give me a satisfying explanation for the apparent flexibility shown in other recent instances or even in the rating of the parent company of DHFL, Wadhawan Global Capital Ltd (WGC).

Without getting too technical, WGC had issued NCDs whose rating was inextricably linked to that of DHFL.  Thus, when DHFL enjoyed a AAA rating, WGC had a AAA (SO) rating.  When DHFL was downgraded from AAA to AA, then to A, and then to BBB, so was WGC.  However, there was a noticeable inconsistency in the time lag between the downgrades of the two companies.  On one occasion, the downgrade happened on the same day whereas on others there was a lag of 3-10 days.  And for whatever it is worth, as at the time of writing, unlike DHFL, WGC has not been downgraded to ‘default’ (nor is there any other update to the rating).  In that backdrop, it is hard for me to believe that rating agencies cannot exercise flexibility.

Let me then move on to the role of AMFI.  It recently came out with “standard” guidelines for how sub-investment grade securities should be valued by mutual fund schemes.  Prior to this, it was up to each fund house’s valuation committee to decide and there wasn’t much by way of industry-wide consistency.  From that perspective, AMFI’s guidelines should have been a welcome move.  Unfortunately, not enough thought went into the details.  The result was a blunt tool about which, the less said the better.  Among other things, it recommended that securities be marked down uniformly, regardless of their maturity.  It is a mystery to me as to why AMFI didn’t simply opt for scrip level valuation for these securities, something which has been talked about for a long time.  In any case, in the present instance, I expected fund houses to apply some discretion rather than blindly follow the guidelines.

I have a bigger issue with the fund houses, though, on a different count.  It had been a long standing demand of fund houses that they have the ability to create ‘side pockets’ (or segregated portfolios, as they are formally called) of securities that are significantly downgraded.  In the event of a default, a side pocket protects the interest of investors who exit after the default but before the money is recovered. It also helps investors who stay put by protecting them from the impact of ongoing sales and redemptions.  Yet, despite the fact that SEBI approved the use of side pockets over 5 months ago, barring one exception, fund houses have not yet initiated the process. 

But the biggest peeve I have with fund houses isn’t specific to DHFL- it is about understanding and communicating the real nature of debt funds and their risks.  Fund houses will not admit it, but most of their salespeople and advisors don’t understand this fact: debt funds are an incredibly complicated investment option.

On the face of it, a mutual fund is a means to invest into an asset class, without some of the attendant risks.  Thus, an equity fund is a means to invest in equity shares, and a debt fund is a means to invest into debt instruments.  In reality, though, things are much more twisted.  While the characteristics of equity funds roughly mirror those of their underlying investments, debt funds have attributes that are markedly different from their underlying investments.  Unlike debt instruments, debt funds don’t assure any return and, other than FMPs, don’t have a fixed tenure.  One could argue that debt funds distort the very trait of debt instruments that makes them regarded as safe, and appealing to investors.  It’s worth asking why should they even be called ‘fixed income’ funds.  Furthermore, compared to equity funds, debt funds carry a larger variety of significant risks.  The scariest part, though, is that, as we have seen, there are some risks that are hard to fathom or even give a name to. 

Thoughts On The FMP Fiasco

This is only my second post in the last nine months, and while I’d like to believe that there hasn’t been much to write about all this while, the truth is that ongoing priorities have kept me away, not just from writing, but from closely tracking the fund industry as well.  Still, thanks to the evolving FMP crisis (which I couldn’t ignore) and the incessant cajoling of my collaborators, for whatever it is worth, here it is. 

Anyone who has been following the coverage of the crisis in the media (mainstream and social), would have noted that much of the attention has been on Kotak MF, and on the so-called “safety” of FMPs.  In this post, I’d like to move that spotlight a bit.  The way I see it, firstly, the risks in investing in FMPs are, more or less, the same as they have been over the last several years.  It’s just that many investors, advisors, and fund houses, have been in denial over the fact that portfolio concentration is a bigger risk than credit quality in itself.  While I’ve talked at length about this previously, in this post, I want to talk about the questionable choices made by fund houses this time around, once this risk became a likely reality.  Secondly, I feel that looking at the FMP fiasco from the lens of the decisions of HDFC MF (rather than Kotak MF) offers a better picture of what has happened.  Investors in Kotak FMPs may have been the first to be visibly impacted, but it was HDFC MF that was the first to make the choices that brought us to where we are.

Let me start by flipping back to a month ago.  By my count, there were 6 NCDs issued by three Essel group companies that were due to mature in March.   HDFC MF had investments in two of these companies (across 5 NCDs).  Most of these investments were held in FMP portfolios.  These are the details of those NCDs:

Name of company	ISIN	Date of Maturity
Edisons Utility Works Pvt. Ltd.^	INE097P07047	22 March 2019
	INE097P07062	22 March 2019
	INE097P07096	20 March 2019
Sprit Textiles Pvt. Ltd.#	INE069R07091	22 March 2019
	INE069R07109	20 March 2019

^ Since renamed as Edisons Infrapower & Multiventures Pvt. Ltd.
# Since renamed as Sprit Infrapower & Multiventures Pvt. Ltd.
NCDs whose ISIN is shaded are zero coupon bonds

As you will note from the table, all of these NCDs were slated to mature between 20-22 March 2019.  The reason I mention this is because, in the portfolio disclosure made by HDFC MF, all of these investments were shown to be held in the portfolios of its schemes as on 31 March 2019, more than a week after they were supposed to have matured.  It begs the question- what happened?  If the fund house got back its money on the date of maturity, then why were these investments shown in the scheme books as on 31 March?  And if the fund house didn’t get back its money, shouldn’t these investments have been written off? 

When I first saw the portfolios, I couldn’t figure out what exactly had happened.  Since then, it has come to light that the maturity date of these investments was “revised” to 30 September 2019.  But how did something like that come about?  Surely, an issuer can’t unilaterally revise the date of maturity.  Was this the outcome of the much talked about agreement between the lenders and the Essel group back in January? 

Regardless, in my opinion, there can be no excuse for treating non-payment on the original due date as anything but a default.  What I find especially remarkable is that three of the NCDs above were zero coupon bonds and accounted for over 61% of the value of these NCDs.  To put it differently, these are investments on which the fund house would not have received a single rupee of interest or principal over the last 3 years or so. 

It appears that Kotak MF took a similar stance as HDFC MF in respect of the NCDs it held (which matured on 8 April).  In its case, it appears that all the NCDs that matured were zero coupon bonds.  Personally, I believe that all these investments should have been written off completely.

But coming back to the revision of maturity date, there are two other aspects about this that bother me.  The first relates to investment norms for FMPs.  As per SEBI regulations, a FMP can invest only into securities which mature before the date of maturity of the scheme.  Of the 8 HDFC FMPs that held the aforesaid NCDs, one is maturing on 30 September (i.e. on the revised maturity date).  All the other FMPs (including one that has been decided to be rolled over) were/ are maturing not later than 1 July 2019.  Going by that, revising the maturity date would appear to be in violation of the SEBI MF regulations.

The second issue that bothers me is the role of the rating agency.  In December, last year, the rating agency had put the abovementioned companies/ NCDs on “credit rating watch”.  On 31 January, soon after the debacle related to the sale of shares of ZEEL, the rating agency put out a note, stating that the rating remained unchanged.  What puzzled me about that note was that the rating agency seemed to base its view more on the stated intent of the lenders and the borrowers, than anything else.  Importantly, there was no mention of any change in the date of maturity of the NCDs.

Then on 18 February, it downgraded the ratings by one notch to A, while maintaining the “credit rating watch”.  But there was still no mention of the maturity of the NCDs being revised.  Its next communication was only on 10 April i.e. three weeks after the original maturity date of these NCDs had passed.  It was here that it noted the revised maturity date of the NCDs.  From what I could gather, and strangely to me, the rating agency didn’t seem to see this as an issue of any significance.  Personally, I think there was a good case for the rating to be downgraded to D.

Looking at this all together, throws up a number of questions.  Why did the fund houses not mark down these investments?   Was it a coincidence that both Kotak MF and HDFC MF decided the same course of action?  Was it a coincidence that the rating agency took a similar view?  Or that the rating agency put out its note only after the NCDs held by Kotak MF had matured? 

One industry insider, whom I spoke to, offered this explanation for the action of the fund houses: “It’s all about the NAV.  They can’t risk showing a low NAV.”  That may well be, and there may be other reasons as well.  One thing appears certain to me: both these fund houses (and perhaps others as well) appear to be desperate to project an illusion of safety around FMPs.  What is worse is that these fund houses are attempting to manipulate investors by playing on their behavioural biases. 

Take for instance, the decision by HDFC MF to roll over one of its FMPs.  Like some others, I hold the view that the officially stated purpose behind doing so, is a preposterous and sanctimonious assertion meant to camouflage the fact that the scheme has ~20% of its portfolio in Essel group companies.  But in terms of their relationship with investors, the roll over strikes me as a way to delude the investors into believing that they never risked losing money. 

Similarly, I noted a very careful choice of words by one of the spokespersons of Kotak MF, which also struck me as intended to delude investors.  To paraphrase the comment: “The impact is primarily on the returns, not on principal”.  To which I am tempted to retort: “Have you ever heard of time value of money?”  Even more bizarre was another statement by that person: “I tend to disagree that it is a call gone wrong”.

For anyone still wondering about what the fund houses were thinking, I present this (hopefully accurate) observation from the latest HDFC MF and Kotak MF portfolio disclosures.  While most of the NCDs of Essel group companies were held in FMP portfolios, there were only two open-end debt funds that also held these NCDs.  These were HDFC Credit Risk Debt Fund and Kotak Credit Risk Fund.  Need I say anything more?

The IL&FS Debacle

It began around a week ago with the steep downgrade of IL&FS and some of its subsidiaries by three credit rating agencies.  That, in varying degree, impacted investors in an estimated 32 schemes across 11 fund houses.  Then late last week, IL&FS failed to honour a mere 50 crore maturity of its commercial paper (CP).  From what I can make out, within the next 10 days, 175 crore of the IL&FS group’s CPs held by mutual funds are due to mature.  It is anybody’s guess if they will honour those obligations. Regardless of what happens, and whether a fund house invested in the group’s securities or not, this debacle should give all fund houses, as well as SEBI, a lot to mull over.  There is also plenty of food for thought for investors.

Can credit rating agencies be trusted?
From A1+ to A4: I can’t remember the last time that a company was downgraded overnight this sharply.  One day, it had the highest rating possible, and the next, it was rated as being on the brink of default.  The rating agencies may claim that they had given indications in August that a downgrade could be on the cards.  But it seems to me that there were grounds for multiple, smaller downgrades, much before that.

The biggest fallout of this could be a loss of trust in credit ratings.  Will we ever be able to look at a AAA/ A1+ rated company and believe with confidence that our money is safe?  How is an investor to then trust the credit quality of a debt fund?  While the rating agencies may have tarnished their own credibility, their actions could impact the growth of debt mutual funds.  

Didn’t fund managers know what was going on?
While there is good reason to blame the rating agencies, I find it hard to believe any fund manager who pleads ignorance about how bad things were.  If nothing else, the yields on the instruments certainly suggested that something wasn’t right.  Here’s one example. 

On 28 August, a certain fund house bought a CP of IL&FS with a residual maturity of 62 days at a yield of 9.25%.  On the same day, that fund house also bought a A1+ rated CP of Indiabulls Commercial Credit with a maturity of 59 days.  The yield: 7.85%. 

Looking at those specific transactions also made me wonder if it was a coincidence that the Indiabulls investment was bought by that fund house in its liquid fund while the IL&FS investment was bought in its credit risk fund.

Let’s talk about concentration risk
About three weeks ago, on a certain online investment forum, someone asked investors on the forum about the things that they considered in selecting a liquid fund.  Most responses dwelled on the credit quality of the portfolio and expense ratio as the key factors.  But there was one reply that was markedly different.  According to that person, the thing that mattered to him most was “concentration risk of non-sovereign holdings”.

It was the mix of credit risk and concentrated holdings that was at the heart of the JPMorgan-Amtek Auto and Taurus-Ballarpur fiascos.   Despite that, the risk of having large positions in individual companies is still not widely well-understood- by investors, or even by fund managers.  I’d say that the IL&FS debacle makes the case that having a concentrated position in a single company can be a bigger risk than credit risk.  Based on August-end data, at least 4 schemes (including one liquid fund and one ultra short term fund) had near double-digit percentage exposures to IL&FS and its worst-hit subsidiaries, with several more close behind.  If I go back a month, I can add more schemes to that list.

For investors, monitoring the exposure of a scheme to a single company, particularly in debt funds, is not easy.  Unlike equity funds, debt funds often have multiple instruments of a single company.  I think it would help if SEBI made it mandatory for schemes to disclose the maximum percentage holding of any single company/ group of companies whose ratings are interlinked.  Personally, I would like SEBI to go one step further and bring down the single-company exposure limits for debt funds, perhaps more so for liquid and ultra short term funds.  The way I see it, investors in debt funds are generally less prepared for the risks of funds holding concentrated positions than, say, investors in equity funds. 

How should junk bonds be valued?
The IL&FS downgrade has once again brought to the forefront the challenges associated with valuing junk bonds.  As I have written in the past (see here and here), this is a contentious issue on which there is no industry-wide consensus.  By and large, fund houses mark down junk bonds by 25%, but not necessarily so.  It can become especially problematic if the instruments have a very short residual maturity, as was the case this time around.  Let me explain with an example.

As on 31 August, Principal Cash Management Fund (a liquid fund) had 9.8% of its portfolio in CPs issued by IL&FS Financial Services.  4.4% was in a CP that matured on 10 September while 5.4% was in a CP that will mature on 24 September.  On Saturday, 8 September, ICRA downgraded these instruments to junk status.  Being a liquid fund, the next NAV to be declared was for Sunday, 9 September.  The question before the fund house now was of how to value its IL&FS investments for the purpose of that NAV.

From what I have gathered, notwithstanding the downgrade, the fund house was confident of getting back its money, some of which was due just one day later.  So from that point of view, some might argue that there was no need to mark down the investments.  Yet SEBI regulations stipulate that each day’s NAV has to reflect the realizable value of the underlying investments.  In that light, a mark down was unavoidable.

Eventually, the fund house decided to mark down its IL&FS investments by 25%.  As a result, the NAV on 9 September fell by 2.3%.  The very next day, on 10 September, when they got back the first tranche of their money as expected, the NAV jumped up by 1.2%.  Unfortunately, those gains were not available to anyone who had exited based on the NAV of 9 September. 

Before you jump to any conclusion, here are a couple of points worth noting.  One is that the fall in the NAV of  Principal Cash Management Fund was in no small measure linked to the percentage exposure taken by the scheme to the IL&FS securities.  If its percentage exposure had been less, the fall would have been less.  The second relates to a scheme managed by another fund house which held a CP of IL&FS that matured last week.  After the downgrade, this fund house decided to mark down its holding to a lesser degree, compared to what Principal MF did.  As it turned out, it did not receive its money back from IL&FS on the due date and had to mark down its holding further.  In effect, the brunt of the fall was borne by investors who stayed invested in the scheme. The saving grace, if I may call it that, was that its exposure to that CP was less than 3%.

I can’t see a perfect solution to this problem.  But I think it would help if SEBI enforces more consistency in the process of valuing junk bonds.  If I understand correctly, currently CRISIL and ICRA provide scrip level valuation for investment grade securities with residual maturity of over 60 days.  There is a case to extend this to all debt securities, including junk bonds.

Can Distributor Commissions Impact Direct Plan Expense Ratios?

When it comes to distributor commissions, there are two sets of guidelines/ rules in particular, that fund houses are expected to follow.  The first defines the limits of how much can be paid from a mutual fund scheme to any distributor.  The second stipulates that the cost of commissions paid to distributors not be charged to investors in direct plans.  So, on the face of it, it would appear to be legally impossible for expense ratios of direct plans to be impacted by these commissions.  However, despite being sandwiched between these limitations, fund houses have a way around this. 

While most of the commissions to distributors are paid from the respective mutual fund schemes (and are clearly reflected in the expense ratios), in the case of many fund houses, there are also significant amounts paid that these fund houses cannot (or do not want to) show in the accounts of the respective schemes.  These commission payments are then made from the books of the AMCs.  If you take the top 3 AMCs (by AUM), it would appear that in 2017-18, such commission payments accounted for almost 60% of the overall expenses of these AMCs and made up over 28% of the fee that they charged for managing their schemes (a.k.a. management fee). 

The way I see it, one would have to be pretty naïve to believe that these payments to distributors did not influence the management fees charged by the AMC to the mutual fund schemes (including direct plans).  Based on what I saw of the financials of the top 3 fund houses, if these commission payments were not to have been made, as a rough estimate, the expense ratios of the direct plans of their equity funds, on an average, could have been lower by around 0.35%.

But even when one considers commission payments made from the mutual fund schemes, not everything may be above-board.  Here’s an example of something that I saw recently, and which I found questionable.

Over the past month or so, it appears that a number of AMCs, across several schemes, reduced the commissions that they were paying to distributors from these schemes.  In itself, this reduction in distributor commissions should have brought down the expense ratios of the regular plans of the concerned schemes.  But rather than pass the benefit of that reduction to investors,  the AMCs decided to correspondingly increase their management fees.  Obviously then, there was no reduction in expense ratios of the regular plans where this happened.  What’s worse is that this action resulted in an increase in the expense ratios of direct plans. 

To illustrate how this played out, let me put before you the break-up of the expense ratios of a certain hybrid fund, up until a few days ago, before these were changed.

Expense Ratios: Before Changes

		Regular Plan	Direct Plan
Management Fee	0.67%
Commissions	1.10%
Base TER		1.77%	0.67%
Other Expenses		0.33%	0.05%
GST		0.12%	0.12%
Total TER		2.22%	0.84%

TER: Total Expense Ratio.  Management fee is charged by the AMC while commissions are paid to distributors.  GST is calculated @18% on the management fee.  Information for Base TER, Other Expenses and GST has been taken from AMC disclosures.  Management Fee and Commission have been inferred from the available information.

Then, a few days ago, it appears that the fund house decided to reduce the element of commissions in the base TER from 1.10% to 0.90%.  But, as I said above, rather than give the benefit of this reduction to investors, the AMC chose to increase its management fees.  After the change, this was the break-up of the scheme’s expense ratios:

Expense Ratios: After Changes

		Regular Plan	Direct Plan
Management Fee	0.87%
Commissions	0.90%
Base TER		1.77%	0.87%
Other Expenses		0.33%	0.05%
GST		0.16%	0.16%
Total TER		2.26%	1.08%

TER: Total Expense Ratio.  Management fee is charged by the AMC while commissions are paid to distributors.  GST is calculated @18% on the management fee.  Information for Base TER, Other Expenses and GST has been taken from AMC disclosures.  Management Fee and Commission have been inferred from the available information.

If you compare the two tables, you will notice that as a direct consequence of the  AMC’s decision to pocket the entire reduction in commissions, the expense ratio of the direct plan jumped up. 

As I mentioned earlier, this is not an isolated case.  Over the past month or so, I noticed several schemes across multiple fund houses where, in varying degrees, something similar had happened.

The expense ratio is typically described as an indicator of what a fund house charges.  Call me cynical if you like, but I look at the expense ratio as a means to know if a fund house is fleecing me.  Thanks to SEBI’s disclosure requirements, more than ever before, it has become easy to access and analyze expense ratios, and to understand how some fund houses adjust/ manipulate expense ratios to shaft investors.  It’s in our own interest to take advantage of the availability of this information.

Baffling Trades In ICICI Securities

Why would a fund manager buy shares of ICICI Securities in the IPO and then sell them off at a loss, two months later? 

As many of us would know, since its IPO in March, the stock price of ICICI securities has seen a sustained fall.  At no point, thus far, has the price come back to its IPO price of 520.  If I take the month of May in particular, the price ranged between a high of 421 and a low of 352.  Yet in that same month, fund managers across 10 9 schemes that acquired the stock in the IPO, brought down those holdings or exited them completely.  All put together, these fund managers sold off shares worth 96 91 crore at the time of the IPO, at a loss of somewhere between 19% to 32%.

The table below lists the schemes that took this hit.

Schemes that sold shares of ICICI Securities in May 2018

	No of shares bought in IPO Price: 520	No of shares sold in May   Price: 352-421
HDFC TaxSaver	981,120	508,500
Axis Long Term Equity Fund	480,788	480,788
Reliance Growth Fund	288,456	288,456
Reliance Banking Fund	192,304	192,304
Edelweiss Maiden Opportunities Fund-1	96,180	96,180
UTI Multi Cap Fund	96,152	96,152
Edelweiss Long Term Equity Fund	96,152	86,183
Kotak Bluechip Fund	63,448	63,448
Kotak Equity Savings Fund	30,744	30,744
UTI Banking and Financial Services Fund	288,484	3,957

Data Sources: BSE, NSE, RupeeVest.

The way I see it, a couple of months is just too short a period for a long term investor to have drastically changed one’s view on this stock.  So what else could explain the actions of these fund managers? 

One view is that the fund managers may have been forced to do this on account of scheme reclassification.  That doesn’t make sense to me because the stock fitted comfortably into the portfolios of all of the schemes on the list above.  Another view is that this might have been done to meet redemptions.  But the extent to which most of these fund managers reduced their positions makes me doubt that.  As it happens, one of the schemes on the list is a closed-end scheme while three others are ELSS.  A third view is that the fund managers may have decided to cut their losses.  While that’s not implausible, it strikes me as an approach that a trader would take and not something that a fund manager would do. 

As I took a closer look at the numbers, something else emerged.  This pertains to three two fund houses whose schemes are listed above: Kotak Mahindra MF, Reliance MF and  UTI MF.  It turns out that in the same month, while their schemes listed above reduced or exited their holdings, there were other schemes managed by these fund houses where the exposure to ICICI Securities was increased.  In the case of the latter two fund houses, the shares sold in one scheme were identical to the shares bought in another scheme, suggesting the possibility that these might be inter-scheme transfers.

Fund houses that took contradictory action on ICICI Securities in May 2018

	Action taken	No of shares
Kotak Mahindra MF
Kotak Bluechip Fund	Sale	63,448
Kotak Equity Savings Fund	Sale	30,744
Kotak Emerging Equity Scheme	Purchase	154,828
Reliance MF
Reliance Growth Fund	Sale	288,456
Reliance Banking Fund	Sale	192,304
Reliance Focused Equity Fund	Purchase	192,304
UTI MF
UTI Banking and Financial Services Fund	Sale	3,957
UTI Multi Cap Fund	Sale	96,152
UTI Value Opportunities Fund	Purchase	96,152

Data Source: RupeeVest.

Frankly, I can’t think of any good reason why a fund house would have sold its loss-making investments in one scheme only to buy those shares in another scheme. 

In fact, looking at all of this, makes me question the credentials of the concerned fund houses and fund managers to manage long-term investments.  I came upon all of this information, quite by accident.  But now I wonder that beyond ICICI Securities, where else may something like this have happened, and how often it might have happened.  I guess that unless these fund houses/ fund managers decide to open up about this, we may not know.  Personally, I think that investors in these schemes should press hard for answers.

Correction: The original version of the post incorrectly identified UTI Multi Cap as a fund that had sold shares of ICICI Securities.  That scheme was merged into UTI Value Opportunities Fund.  I apologize for the inaccuracy.