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.

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.

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.

The Scourge Of Volatility

Last week, one of my frequent collaborators brought to my attention the case of an investor who had been sold a closed-end equity scheme by his relationship manager at a private sector bank.  On the face of it, the episode had all the key elements that I associate with the rash of mis-selling pursued by young, ignorant, callous, smooth-talking bankers, fuelled by excessive incentives from sales-hungry fund houses.  Among other things, the investor was given the impression that this scheme was the real deal, and that the client could exit anytime he liked (“all you have to do is sell it on a stock exchange”).  For their efforts, the bank charged the client 1.50% of the amount invested (this was over and above what they gained on account of getting the client into the regular plan). 

I am not aware of the risk profiling that was done by the bank, but soon afterwards, the client started getting jittery.  He was tracking the NAV movements of the scheme, and what he saw, perturbed him.  At one level, he was flustered by the fact that despite the current surge in stock prices, one month on, the scheme had not shown any positive returns.  More than that, though, it was the seemingly unending daily spikes in the NAV that left him aghast.  If that sounds hard to believe, consider this: on 6 of the 7 business days in this month so far, this domestic, diversified equity scheme rose or fell more than any other equity scheme (including sector specific schemes and international funds). For the investor, things came to a head last week when the scheme’s NAV fell by an astounding 4.3% on a single day: a day when the scheme’s benchmark index, the BSE 200, fell by just 0.8%, while the BSE Sensex fell by a mere 0.6%.

So how on earth did this scheme manage to be so volatile?  What was it holding that caused such a fall?

The November-end portfolio was officially uploaded just this weekend, so till then we could only speculate about what the portfolio might be.  My guess was that this scheme was holding concentrated positions in dubious mid-cap/ small-cap stocks.  I was wrong.  It turned out to be a well diversified portfolio, with no concentrated positions.  Moreover, the top stock holdings were all respectable names.  Even more baffling was the fact that only about two-thirds of the portfolio was in stocks.  As much as 35% of the portfolio was in money market instruments.  With such a portfolio, that kind of a fall was impossible to fathom.

But then my collaborator pointed out a tiny element of the portfolio that I had overlooked.  The scheme had some exposure to Nifty December 2020 Put Options.  It was this part of the portfolio that was a key contributor to the fluctuation.  For those who understand how prices of derivative contracts fluctuate, this should not be a surprise.  But for those who don’t, consider this: on the day of that huge fall in the scheme’s NAV, the prices of the two sets of contracts held by this scheme tumbled by 67% and 71% respectively.  It seemed ironical, given that this exposure was ostensibly meant to hedge the portfolio against a fall in equity prices.

If you think that this is an isolated case, I’d like to suggest otherwise.  This may be an extreme case, but when I did a quick check on the data available at Value Research, I found closed-end equity schemes to be, on an average, 17% more volatile than open end schemes.  Additionally, within the limitations of what I could analyze, I could link this to the exposure that many of these schemes took to long term derivatives contracts.  If you consider the added impact of this on an investor’s ability to get a fair price in the event that he/ she decides to exit before maturity, you may get a sense of how much of a scourge volatility can be to investors in closed-end schemes.  Take the aforementioned investor, for instance.  The day after the NAV fell by 4.3%, he tried to exit the scheme, but couldn’t find a buyer.  Even if there had been a buyer, would he have got a fair price?  As it is, trading a closed-end fund on an exchange is loaded in favour of the buyer: it can be expected to happen at a discount to the NAV.  If the scheme happens to be as volatile as this scheme was, I’d say that it would significantly increase the level of discount that a buyer would expect. 

When I shared my thoughts with some industry insiders, the argument that I was offered was that most investors in closed-end schemes do not seek to exit before maturity, and hence volatility would not matter to them.  I find it hard to agree with that.  In the imperfect but real world that we live in, I believe that many, if not most investors feel humanly compelled to periodically track the performance of the schemes that they have invested into, regardless of whether these are closed-ended or open-ended.  And if they see excessive volatility, they are likely to feel uncertain about the future, and to consider exiting.

But more than my own view, let me give the final word to Peter Stanyer, an authority on the subject of wealth management and more.  In his marvellous book, Guide To Investment Strategy, in the context of investing with a target date, he makes the point that it is reasonable for an investor’s confidence “to be shaken by disappointing developments along the way, even if those developments are not surprising to a quantitative analyst.”  He further goes on to say that “the perceived risk of a bad outcome will be increased by disappointments before the target date is reached, undermining confidence in the investment strategy.”  Now that‘s food for thought.

Special thanks to Robin Jehangir for his valuable inputs to this post.

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.

The Dubious Rise of Monthly Dividend Plans in Equity Schemes

The last two years have seen significant inflows into equity-oriented schemes.  Their AAUM over the period April to June 2016 stood at a level of 92% above the AAUM over the same period, two years earlier (I’ve excluded arbitrage schemes).  But one set of plans among these equity-oriented schemes recorded an extraordinary growth: the monthly/ quarterly dividend plans.  From an AAUM of 897 crore over April to June 2014, the AAUM under these plans over the period April to June 2016 stood at 8719 crore.  That’s an astonishing growth of 872%!

So what explains the phenomenal interest in monthly/ quarterly dividend plans of equity-oriented schemes?

When I asked people in the know, the most common answer I got was: “rampant mis-selling”.  One of them called it “an open dirty secret”, and nearly all of them had stories to tell of someone or the other who got conned by the ‘growth plus regular tax-free dividend’ pitch.  Indeed, I have personally met/ spoken with a number of people who were made this pitch.  Fortunately, some of them were wise or lucky enough to not be taken in, but I know a few who got suckered.

But these plans have existed for years.  So what triggered the recent rise in their sales? 

To get the complete picture, we must go back to November 2013.  At the time, there were, in all, 29 such plans from 8 fund houses with an AAUM of 572 crore over the period July to September 2013.  Very little of these assets could be attributed to any marketing effort.  The two largest plans were the regular monthly dividend plans of ICICI Prudential Balanced Fund and Tata Balanced Fund which together held around two-thirds of the industry AAUM across all such plans.

It was around this time that the people at ICICI Prudential decided to put their marketing muscle behind promoting their other “Balanced” scheme: Balanced Advantage Fund.  This equity-cum-derivatives scheme had recently undergone its third name change (till October 2013 it went under the name of Volatility Advantage Fund).  They were particularly keen to promote its monthly dividend plan.  They had seen some positive results over the preceding few months (when the scheme was known by its previous name): in the seven months since the launch of the monthly dividend plan, it had grown to account for around 12% of the scheme’s total AUM of 626 crore (as on 31 Oct 2013).  Now they wanted to put more efforts behind it. 

Eight months later, there was a lot to show for their efforts.  From November 2013 through June 2014, the BSE Sensex went up by around 20%.  That appreciation, and the positive sentiment, led to the overall AUM of equity-oriented schemes increasing by around 30% over the same period.  In comparison, the AUM of Balanced Advantage Fund zoomed up by over 300%.  Among all its plans, the monthly dividend plans grew the most.  By the quarter of April to June 2014, those monthly dividend plans accounted for 18% of the scheme’s AAUM, and 42% of the industry AAUM across all such plans.

The sales success of Balanced Advantage Fund made other fund houses sit up and take notice.  And just as a few of them started to consider reviving dormant monthly dividend plans and/ or launching new ones, an unexpected event happened that catalyzed them into action.  In July 2014, debt funds were dealt a body blow by changes in tax laws.  In the wake of this, distributors started looking around for options to pitch as an alternative to debt funds, for investment horizons of less than 3 years. One of those was, of course, arbitrage funds.  But a set of fund houses and distributors saw another, bigger opportunity in pitching monthly/ quarterly dividend plans of equity-oriented schemes as a substitute for debt funds.  One banker whom I spoke to, described it thus: “It became the hottest game in town”.

As a reflection of that, by the quarter of Oct to Dec 2014, the AAUM of these plans shot up by 148% compared to a rise of 40% for equity-oriented schemes overall.  But that was just the start.  By the quarter of April to June 2015 the AAUM of equity-oriented schemes overall had risen by 66% from a year ago.  In sharp contrast, the AAUM of these monthly/ quarterly dividend plans had catapulted by 350%. 

The trend was also reflected in the number of such plans, and the number of fund houses who jumped on the bandwagon.  In June 2014, there were 33 such plans from 8 fund houses.  A year later, there were 68 such plans from 13 fund houses.  Currently, by my estimate, there are 96 such plans from 15 fund houses.  I don’t know what the other fund houses are thinking or planning: I can only assume that they have their reservations about having such plans.  Thanks to its first mover advantage and marketing push, ICICI Prudential continues to be the leader in this dubious market with a share of over 46% of the AAUM, based on last quarter’s data.

As I spoke to people in the know, I got to hear and see what fund houses had done to promote these plans.  I heard stories of “over-the-top” and “under-the-table” incentives.  I was shown in confidence, privately circulated material, all but assuring monthly dividends.  I saw one equity scheme being described as an “All Seasons Fund”.  In a confidential presentation to advisors, a top fund house made the case for monthly dividends in an equity scheme by showing the daily returns and volatility of the scheme.  I saw a slide where the presenter noted that the fund had, on an average, “added an alpha of 0.03 on a daily basis with a Beta of only 0.49”.

In the public domain, the evidence was rather bland.  One of the more striking observations was that the names of some of these schemes appeared to contradict the idea of having a monthly/ quarterly dividend option e.g. Reliance Regular Savings Fund, Tata Regular Savings Fund. 

But for me, nothing stood out more than the contrast between ICICI Prudential’s Balanced Advantage Fund and its debt-oriented MIP schemes.  (Emphasis that follows is mine)

ICICI Prudential has two debt-oriented MIP schemes.  One is called ‘Monthly Income Plan’ while the other is called ‘MIP 25’.  Each of these schemes has multiple plans, including monthly dividend plans, and quarterly dividend plans.  There is a bizarre irony in a scheme called ‘Monthly Income Plan’ having a ‘quarterly dividend’ option, but I’ll leave that aside for now.

In its official fact sheet, ICICI Prudential says that its Monthly Income Plan is suitable for those investors who are seeking:

A hybrid fund that aims to generate regular income through investments in fixed income securities with an aim to make regular dividend payment and seek for long term capital appreciation by investing a portion in equity.

In contrast, ICICI Prudential says that Balanced Advantage Fund is suitable for those investors who are seeking:

An equity fund that aims for growth by investing in equity and derivatives.

In that backdrop, when I compared the data for the quarter April-June 2016, across these schemes, I noticed a couple of things:

• The monthly dividend plans of each of the MIP schemes accounted for about 15% of each scheme’s total AAUM.  In contrast, the monthly dividend plans of Balanced Advantage Fund accounted for 27% of its total AAUM. 
• The combined AAUM of all plans of both MIP schemes stood at 1502 crore whereas the AAUM of just the monthly dividend plans of Balanced Advantage Fund stood at over twice that number at 3069 crore.  This is despite the fact that one of the MIP schemes has been in existence since 2000 while the other has been in existence since 2004.

To me, these numbers suggest that somewhere between ICICI Prudential, its advisors, and its investors, that message of suitability seems to have got lost.  Maybe it is because having a monthly dividend plan in an equity scheme is deceptive product design.  Maybe it is something else.

To be fair, this is something that all fund houses who are promoting these plans need to think about.  Investing 101 tells us that a scheme can be suitable for one of three primary purposes:

(a) short-term parking
(b) regular income
(c) medium/ long-term growth

While equity-oriented schemes are clearly suitable for purpose (c), by virtue of having a monthly or quarterly dividend plan, they attempt to be suitable for (b) as well.  But that begs the questions: Can any scheme successfully serve both purposes (b) and (c)? Would someone really benefit from regular income if it was highly unpredictable?

Suitability analysis is an inviolate necessity regardless of whether one is an advisor or a fund house.  Lest we forget, as SEBI puts it very eloquently, “sale of units of a mutual fund scheme by any person, directly or indirectly,” by “not taking reasonable care to ensure suitability of the scheme to the buyer” constitutes mis-selling.

Now that’s food for thought.

Note: Scheme data has been mostly sourced from AMFI. All AAUM data related to equity-oriented schemes overall excludes arbitrage schemes to the extent that I could.  Since AMFI has not consistently classified these schemes separately, the segregation had to be done manually and there is the possibility of some error.

Special thanks to Robin Jehangir for his inputs.

How Short is ‘Short Term’?

What should one expect to be the average maturity of a debt fund that has the words ‘short term’ in its name?  And what if the fund has the words ‘ultra short term’ in its name?  Is it fair for a debt fund with the words ‘medium term’ in its name to have a shorter maturity than one that has the words ‘short term’ in its name, especially if both are managed by the same fund house?

These questions came to the forefront in the course of a conversation I had with an investor last week.  A couple of days earlier, he had made an investment in ICICI Prudential Ultra Short Term Plan, with the intention of withdrawing it in a few weeks’ time.  The day after making the investment, he discovered, much to his shock, that the said scheme had an average maturity in excess of 2 years.  No doubt, he didn’t do enough research before investing.  Nevertheless, in my opinion, for a fund house to maintain an average maturity of over 2 years in a scheme with the words ‘ultra short term’ in its name, is deceptive, to say the least. 

In a way, I had touched upon these questions in my post, Naming Schemes, over a year ago.  In that post, I had noted (without naming) how the maturity of JM Short Term Fund had swung between 1.5 years (in April 2014) and 8.5 years (in January 2015).  I had also noted (again, without naming) that the duration of Birla Sun Life MF’s Medium Term Plan, at the time, was shorter than the durations of its Short Term Fund and Short Term Opportunities Fund.  My conversation with that investor last week brought back some of those memories.  So after we had spoken, I took a look around to see what had changed.  I give below some facts that caught my attention.  All data is as on 31 Aug, and excludes Gilt schemes and ‘floating rate’ schemes.

• Schemes with the words ‘medium term’ in their names had average maturities that ranged from 10 months to 6.2 years.
• Schemes with the words ‘short term’ (and not ‘ultra short term’) in their names had average maturities that ranged from 1.5 months to 5.6 years.
• Schemes with the words ‘ultra short term’ in their names had average maturities that ranged from 1.5 months to 2.3 years.
• Reliance Short Term Fund had a maturity of 3.1 years whereas Reliance Medium Term Fund had a maturity of 1.4 years.
• Birla Sun Life MF’s Short Term Opportunities Fund had a maturity of 5.6 years, its Medium Term Plan had a maturity of 4.4 years, and its Short Term Fund had a maturity of 2.9 years.
• UTI Short Term Income Fund had a maturity that was nearly identical to the maturity of UTI Medium Term Fund at around 3 years.
• Invesco MF’s India Medium Term Bond Fund had a maturity of 10 months.  In contrast, its India Ultra Short Term Fund had a maturity of 1 year and its India Short Term Fund had a maturity of 5.2 years.

In my post, Naming Schemes, I had pointed out that in the US, a scheme whose name includes the words, ‘short-term,’ is required to have an average maturity of no more than 3 years.  In India, as far as I know, we still don’t have any such regulations.  But given the diversity and ingenuity that fund houses have shown in interpreting terms such as ‘short term’, ‘medium term’ and ‘ultra short term’, I’m not sure if merely having regulations will help investors.

NAV Observations

If you wanted to download the NAV history of a scheme, which website would you go to?  Would you go to the website of the fund house managing that scheme?  Or would you go to one of those websites where you can get the NAV history of schemes across fund houses?

As we know, there are a few different websites where one can get the NAV history of almost any scheme.  Each of us may have our own favorites: I certainly have mine.  Yet just over a week ago, when faced with a need to pull out the historical NAVs of half a dozen schemes, I went looking for this information on the respective fund house websites instead.  Maybe it was because it involved just three fund houses, or maybe I wasn’t thinking clearly: I don’t remember.  Fact is, on the very first fund house website that I checked, I couldn’t find the information that I wanted.  So without wasting any further time, I retraced my steps to one of my favorite websites and got all the information that I needed. 

Later on, I thought about my experience on the fund house website, and decided to take another look.  Maybe I had missed something.  But once again, I couldn’t find the information that I wanted.  Curious, I decided to check out a few other fund house websites.  On each website, I tried to obtain the complete NAV history for a few, somewhat randomly selected, schemes.  In all, I visited eight websites.  As it turned out, from only three of the eight websites was I able to get NAV data that was comprehensive and easy to use.  In this post, I give some details of what I observed.

The fund houses whose websites I visited were:

• Birla Sun Life (BSL)
• Franklin Templeton (FT)
• HDFC
• ICICI Prudential (I-Pru)
• IDFC
• Reliance
• SBI
• UTI

There was no strong reasoning that led me to these websites.  I was guided by a vague impression that given the assets and the number of schemes that these fund houses manage, these might be reasonably representative of the industry as a whole.

BSL, FT and IDFC were the three fund houses on whose websites I could get the complete information that I wanted, and in the way that I wanted it.  On their websites, I could download the entire NAV history of each of the schemes that I selected, in an easy-to-use Excel file.  Not only that, each of these fund houses, in different ways, made it easy to do so.  Consider this, for instance: on all of the other fund house websites, to get a scheme’s NAV history since inception, I was required to enter a “start date” and an “end date”.  That meant having to know the inception date in advance.  On the BSL website, once I selected my scheme, the “start date” and the “end date” were filled in by default with the launch date of the scheme, and the latest NAV date respectively.  On the FT website, there was an option to get the NAVs since inception, which I needed to select.  On the IDFC website, I didn’t even have to do that.  By design, selecting a scheme (whose NAV history I wanted to see) triggered the download of an Excel file which had the NAVs since the scheme’s inception.    

HDFC was the only other fund house that offered the complete NAV history of any scheme in an Excel-readable format.  But apart from having to know the inception date in advance, there were two obstacles.  Firstly, depending on the extent of history that I sought, it took a considerable amount of time for the data to be downloaded.  Secondly, the data in the Excel file was laid out in a manner that required a lot of work to make it usable. 

Reliance and UTI also offered me the option to download the NAVs into Excel but in the case of each scheme that I selected, only a limited history was available for download.  In contrast, SBI displayed the entire NAV history of the schemes that I selected, but it didn’t offer an option to download or export to Excel.  As far as I could make out, in the Beta version of its new website, one can download a limited NAV history into Excel.

I-Pru presented the NAV history of each scheme that I selected only as a chart, that too of dubious merit.  There was a link to export the data (or perhaps only the chart) to Excel but every time I clicked that link, I was led to an error page. 

But to be doubly sure that I had not missed something, I thought of rechecking with those fund houses where incomplete or no information was available.  So I reached out to them via email, mentioned what I had experienced, and requested them to email me the NAV history of a certain scheme or set of schemes. 

Reliance was quick to respond and they directed me to the AMFI website to get the NAV history.

I-Pru took 5 days to respond and gave me the same link that I had visited on their website.  When I pointed out that the Excel export option was a dead link, they promptly replied saying (somewhat cryptically) that the “Historical NAVs for the above mentioned scheme will be available as graphs.”

UTI has, thus far, neither acknowledged nor responded to my email.

It is not unreasonable to expect to get the complete NAV history of a scheme in a usable format.  And there is a good reason to visit a fund house’s website rather than anywhere else: the assurance that the data is authentic.  It is to the advantage of a fund house as well.  It is one more reason for someone to visit its website.  It is also in the fund house’s best interests that people draw inferences based on data that is authentic.  But it seems that some fund houses haven’t been able to figure out how best to facilitate such requests on their websites.  And if those email responses (or lack thereof) are anything to go by, some fund houses appear to be fine with driving visitors away from their websites.

JSPL paid up. So what?

Till about a week ago, the exposure of some debt funds to JSPL was a widely discussed topic among industry insiders.  Not anymore.  According to some people that I spoke to, after JSPL honored its repayment commitment to holders of its NCDs last week, this was being regarded as a closed chapter.  As one person put it, “Now that they’ve paid up, it’s business as usual.”

Well, for the sake of investors, and even the industry as a whole, I hope that SEBI is not treating this as such.  The events of the past couple of months or so, offer a useful window to understand the implications of how valuations, if not well thought through, can create price distortions. In this post, I propose to spotlight some of that.  But rather than state anything, I’d like to present a single piece of visual evidence.  Hopefully, it will also strengthen the case I sought to make in my last post, for SEBI to bring about greater uniformity in the valuation of junk bonds. 

The visual evidence is in the form of the relative NAV movements (from Feb 1 to Apr 5) of two schemes that had significant exposure to the JSPL NCD that matured last week.  The schemes are:

• ICICI Prudential Fixed Maturity Plan - Series 72 - 823 Days Plan H
• Reliance Fixed Horizon Fund - XXIII - Series 11

I have chosen these because of the comparative similarity in their returns and their exposure to JSPL, as shown in the table below.

	Exposure to JSPL as on Jan 31	Absolute Return from Feb 1 to Apr 5
ICICI Prudential Fixed Maturity Plan - Series 72 - 823 Days Plan H	13.57%	1.49%
Reliance Fixed Horizon Fund - XXIII - Series 11	11.85%	1.29%

 

This, then, is the chart showing their relative NAV movements from Feb 1 to Apr 5.

 

For anyone concerned with the fairness of scheme valuations, I believe this chart should set alarm bells ringing.  In fact, were it not for the prefatory remarks, I doubt if anyone would believe that the NAV swings of these two schemes were triggered by the valuation of near-identical holdings of the same security.

I’d like to close this post with one other observation: if the March-end portfolio disclosures are anything to go by, ICICI Prudential MF continues to hold JSPL NCDs (presently valued at over 157 crore) that have been downgraded by CRISIL to default status.  While the bulk of these are held in the portfolio of ICICI Prudential Regular Savings Fund, the exposure as a percent of this fund’s portfolio is just over 2%.  As far as I can make out, the scheme with the highest exposure (as a percent of its holdings) is ICICI Prudential Multiple Yield Fund - Series 10 - 1825 Days - Plan B, where these NCDs constitute over 6% of the portfolio.

All the holdings are due to mature in 2019, and as at the end of March, have been marked down to 67.5% of their face value. Despite CRISIL’s rating, as per SEBI regulations, these investments are not being treated as a NPA.  If my information is correct, the interest on these bonds is to be paid annually on 11 Aug.  If so, then that would mean that the treatment of this investment as a performing asset is based on interest received 8 months ago.  All may turn out well for those who are exposed to these NCDs but I wouldn’t consider the JSPL episode to be a closed chapter just as yet.

The Valuation of Junk Bonds

The recent, successive downgrades of securities issued by JSPL, have led me to ponder over the inconsistencies across fund houses in valuing junk bonds. Frankly, valuation of securities is not my forte.  But seeing the exposed fund houses take different approaches to valuing their holdings in JSPL, I felt the need to examine the choices that they made.  In that backdrop, and with some assistance, I have put my observations and thoughts here, as accurately as I could, in the hope that these encourage discussion around improving the fairness of valuations.

On Feb 15, CRISIL downgraded JSPL securities to junk status.  The next day, the schemes of Franklin Templeton MF (FT) and ICICI Prudential MF (I-Pru) holding JSPL securities reported a fall in their NAVs.  It appeared that both these fund houses had applied a discount of 25% to the face value of their holdings right after the downgrade, something that was subsequently confirmed by a reading of their month-end disclosures and FT’s additional disclosure.  However, the schemes of Reliance MF, which also held JSPL securities, did not report a decline in their NAVs after that downgrade. 

According to this news report, a spokesperson of Reliance MF said that the fund house had negligible exposure in the company and that the security that its schemes held had not been downgraded. He/she may have been referring to the exposure relative to the fund house’s total debt AUM because when looked at, relative to the AUM of the individual schemes which held JSPL securities, the exposure was, by no means, small.  In two of these schemes, the exposure to JSPL was in excess of 11% of the portfolio.  In a third, it was over 8%. As to the point about the security they held not having been downgraded, that was, in a way, accurate.  That security had been rated by CARE, and not CRISIL, and CARE had not, till then, downgraded the security.  Reliance MF’s stance, though, was at odds with that of I-Pru, which held the same security in a number of their schemes, and had chosen to mark it down right after CRISIL’s downgrade.  Eventually, on Feb 25, CARE downgraded that security.  The next day, the NAV of the schemes of Reliance MF fell marginally.  Going by the month-end portfolio disclosures, Reliance MF had applied a discount of 2.5% to the face value of its holdings, far less than what FT and I-Pru had applied. 

Then on March 9, CRISIL further downgraded JSPL securities to default status.  FT stated that it had sold off its entire holdings of JSPL, leaving nothing to be valued. This time around, Reliance MF reported a fall in the NAVs of all three debt schemes holding JSPL, ranging from –0.83% to –2.66%.  Unlike the last time, it seemed as if it had accepted CRISIL’s downgrade (CARE’s downgrade happened on March 11).  While the complete facts may take some time to be known, it seems that it marked down the value of the JSPL holdings to about 75% of their face value (i.e. to the level that FT and I-Pru had marked down their holdings in February).  In stark contrast, I-Pru did not report a fall in the NAVs of any of the FMPs that had significant exposure to JSPL.

So why did the NAVs of the schemes of I-Pru not dip?  After all, it would stand to reason that whenever a bond gets downgraded, its price would be expected to fall.  If anything, FT’s sale of JSPL securities (although different from the one held by the FMPs of I-Pru) on March 10, at a further discount to their February-end values, supported such reasoning.  And why did Reliance MF apply a discount in February that was only a fraction of the discount applied by FT and I-Pru?  Why did it refuse to acknowledge CRISIL’s downgrade in February, and then act upon it in March?  And why did it do an apparent volte face, and apply a more significant discount after the March downgrade?  What, indeed, were the reasons for all these inconsistencies in the valuation of this junk bond?

As far as I can make out, the valuation policies of most fund houses do not carry any specific instructions on valuing junk bonds.  These fund houses let the decision be taken by their respective valuation committees.  Even so, it seems that the norm is for junk bonds to be valued at 75% of their face value.  The decisions by FT and I-Pru appear to be in line with that.  Reliance MF, on the other hand, is one of the few fund houses to have explicit guidelines for valuing junk bonds.  According to its valuation policy that was in force in February, junk bonds (that were not NPAs) with more than 182 days to maturity were to be valued at 75% of their face value while those with less than 183 days to maturity were to be valued “after markdown by 2.5% to the Face Value every 2 weeks cumulatively starting from the day of the downgrade.”  In light of this, its valuation of JSPL holdings in February is very understandable: the security that it holds, is due for redemption next month.  However, there appears to be no explanation in their valuation policy for their subsequent decision to apply a cumulative discount of 25% at one go, right after the second downgrade.  There is also no explanation that I have been able to gather for I-Pru not marking down its holdings any further.

Regardless of fund houses sticking to their individual guidelines or the recommendations of their valuation committees, I believe that fund houses should disclose to their investors, in a transparent manner, the rationale behind decisions that may appear questionable.  At the same time, I also believe that SEBI needs to bring about greater uniformity and even conservatism in the valuation of junk bonds.  If you think about it, at the end of February, Reliance MF valued its JSPL holdings 30% higher than what I-Pru had valued its holdings.  By any yardstick, that is a vast difference.  Thankfully, if I may say so, Reliance MF’s holdings of JSPL were all in closed-end schemes.  If these were to have been in open-end schemes, the knowledge of the fund house’s relatively liberal valuation policy could well have triggered an exodus of its investors from those schemes.  Of course, it is entirely possible that someone may have actually exited those schemes based on that knowledge, irrespective of their closed-end structure.

Last but not the least, I would also make the case that SEBI should re-examine how NPAs are defined, and provisioned for.  Most fund houses classify NPAs based upon the definition in the SEBI guidelines.  But that definition ends up excluding securities such as the JSPL NCDs held by I-Pru and Reliance MF even though CRISIL has specifically stated that its downgrade reflected actual delays by JSPL in payment of interest on its term loans.  For a bond to qualify as an NPA under the current mutual fund valuation guidelines, a fund house has to have firsthand experience of the delay.  And it isn’t just the definition: even the provisioning guidelines, to my mind, are way too liberal.  As I see it, fund houses that strictly follow the guidelines, run the same risk that I referred to in the previous paragraph.

On a somewhat related note, an extract from the SID of one of the debt funds still holding JSPL NCDs was brought to my attention.  It reads thus:

“Credit evaluation is a continuous process.  It applies not only for issuers where investments are being evaluated for the first time but also for those where we already have credit exposures.”

I doubt if any fund manager would disagree with the truth in this statement.  Yet, a statement like this also begs these questions: Why would a scheme still be holding a security that has been downgraded to default status?  What does the fund manager of that scheme know that the rating agency does not know?  And as I think about it, there may be one other advantage to having more stricter and conservative guidelines for valuing junk bonds and for provisioning for NPAs: it may well act as an additional deterrent against fund managers buying and holding securities that are junk or borderline junk, without good reason.

Special thanks to Robin Jehangir for his inputs.

More on ‘Amazing Quant Fund’

A few readers responded to my last post and their observations and thoughts made the case for this post.  It would help to have read that post before reading this one.

One reader found it “highly unusual” that the fund house in question chose to replace its index fund with Amazing Quant Fund and then re-launch the index fund a couple of years later.  He also noted that because its objective allowed the fund manager to freely pick 15-20 stocks from within the NSE-50, its performance relative to their own NSE-50 index fund was an accurate reflection of the capabilities of the fund manager and perhaps, even the fund management team.  He suggested that any success that they may have had with other funds could well have been because of luck.

I, too, see immense merit in comparing the performance of Amazing Quant Fund with that of the NSE-50 index fund offered by the fund house.  The only challenge in this case is that it is not clear as to what extent is the portfolio construction attributable to their model versus the fund manager’s expertise.  As the fund house puts it, “final selection of stocks and weightage allocation is a composite effort of the Fund Manager and the quantitative model”.  Nevertheless, I feel it safe to presume that the fund management team would have had faith in that model for it to be used (they may even have had a hand in designing the model), and hence the credit or blame can be rightfully placed at their doorstep. 

Based on the evidence so far, it seems they have a lot to answer for.  As I mentioned in that post, in each of the last 5 calendar years, Amazing Quant Fund has given lesser returns than the index fund.  If we slice this further, it has given lesser returns over 11 of the last 16 quarters, and over 31 of the last 49 months, with no discernible edge in either up markets or down markets.  A track record such as that clearly questions the strength of the model and/or the fund manager’s expertise.

But why would such a fund continue to be in existence, and what would explain its massive AUM relative to the index fund?  Picking on this point, as I posed it at the end of that post, one other reader, a fund investor from Dehradun, offered some insights.  He was able to accurately identify which fund I was referring to, and he clarified that the vast difference in AUM between the two funds was because Amazing Quant Fund had offered a significant dividend-stripping opportunity last June (something I had overlooked).  He also took time to pen his thoughts on the ethics of fund houses.  I reproduce his email below:

Reference to what you wrote in the last line "Maybe they cannot see the facts for what they are." To me, in this case, it's the opposite and the distributors saw what others could not see and sold this scheme to investors who needed this when it was most beneficial to them. This fund helped investors in dividend stripping by announcing huge dividend which attracted around two thousand crores by investors who wanted to save taxes, just by creating notional loss. To my mind, every element of this – choice of an index linked scheme with very small AUM; best suited to manage a huge dividend declaration; being just 9 and half month before the end of financial year – is all very carefully planned and sold. The money, most likely if properly hedged, shall exit the fund around last week of March 2016; the investors shall use this notional loss to save tax by offsetting gains in this or coming many years. Now, one may ask why would someone take so much of risk to manage tax. The answer lies in the choice of this fund- quant (index). This loss can be hedged by using nifty futures.

This is also a way to show normal income to repatriate money beyond the RBI permissible limits from NRO account.

It is sad to see how mutual fund schemes, which are meant to be for the sole interest of investors, being used by the managers of these schemes (read, the AMC) to earn money for themselves. Earning money is no crime and I would have no worries if this earning money is done by ethical means. However, use of mutual fund scheme as a vehicle to help a section of investors (read, the HNI’s) save tax or to transfer wealth out of India? This raises the following questions in my mind:

• How can I trust a mutual fund with my money? Now, this is not about doubting the structure of mutual fund - trustees, custodian and auditors - which are present to safeguard my money. This is about something deeper- conflicting interests. The interest of AMC lies in more AUM resulting in more Fees. The investor interest lies in ethical practices which may not allow easy inflows in the short term, at-least for weaker AMCs. While, operation systems and checks can help safeguard my money from external threats, how effective can they possibly be if the AMC indulges in legally correct but unethical tendencies. If an AMC can launch a scheme for the benefit of some people to help them circumvent law and save taxes, what stops them from changing their fees after I invest my money in the scheme? What stops them from charging less fees when a big corporate enters in the scheme and from charging more after its exit?
• What am I supposed to think about the independent trustees who allowed the Index scheme to be changed and then again new index schemes to be launched?
• What faith should I have in a regulator who may have witnessed this all silently?
• What am I supposed to expect of the financial advisors? Investor interest matters the most or distribution fees matters the most? If indeed, investor interest matters the most, then is that interest safe with an AMC with highest returns or with an AMC with most ethical practices?
• As an investor, what should I give priority to while committing to an investment plan? The comfort of past performance of an AMC or the comfort of their ethical practices?

Now that should give SEBI, AMFI and the fund houses something to think about.  As for me, I put my thoughts on selecting a fund house here.  And I am glad to say that this fund house doesn’t make the cut for me.