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.” 

Will Someone Please Think About The Affected FT Investors?

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

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

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

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

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

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

Special thanks to Robin Jehangir for his invaluable inputs.

The Lament Of A Mutual Fund Specialist

Guest Post

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Perfect Timing

A short post on something that caught my eye. 

On 6 July, there was a unusually sharp jump in the NAVs of a few debt funds.  Topping the list was JM Low Duration Fund whose NAV rose by an astounding 19.9%.  Next was a cluster of three funds from Principal MF and two funds from HSBC MF whose NAVs went up in the range of 5.6% to 8.6%.

As far as I can make out, the jump in the NAVs can largely be attributed to the sale of defaulted DHFL NCDs that had matured last year.  Until recently, defaulted debt securities couldn’t be traded after their maturity.  However, last month, in a landmark move, SEBI came out with an operational framework for enabling transactions in such securities.  This decision paved the way for these NCDs to be traded (assuming one could find a buyer). 

From what I’ve been able to gather, following that, on 6 July, these funds were able to sell their NCDs at around 22% of their face value.  Since these securities carried a ‘nil’ value in the books (on account of being completely marked down), the entire sale value qualified as gains for the fund.  Hence, the huge jumps in NAVs.  In fact, in the case of some funds, thanks to the fall in their AUMs, this rise has taken their NAVs above where they were at the time that DHFL defaulted last year.

As interesting as I found this, there was something else that held my attention that bit more, and which will explain the title of this post.

I mentioned earlier that there were two funds from HSBC MF that saw their NAVs shoot up on 6 July.  These were  HSBC Short Duration Fund (up by 8.3%) and HSBC Low Duration Fund (up by 7.7%). 

On 23 June, which was the date that SEBI announced the operational framework, HSBC Low Duration Fund had an AUM of 76.5 cr.  Its AUM had consistently remained in the range of 75-78 cr since the start of the month and continued to remain so till 25 June.  Then, on 26 June, there was a huge inflow (estimated at ~16 cr) as a result of which the AUM spiked up to 92.5 cr.  From then onwards (up to the 6 July NAV jump), the AUM remained in the range of 93-95 cr.  That leads me to believe that the increase in AUM on 26 June was driven by a single large investor (or a group of investors acting collectively) who was/ were betting big on this scheme.  Sure enough, they’ve made a killing.

This throws up a few questions.

What made the investor(s) choose this particular scheme?  Was the timing just a coincidence?  Or was it shrewd thinking on the part of the investor(s)?

As it happens, just about two months ago, I had seen a somewhat similar example of impeccable timing.

Two months ago, on 8 May to be specific, HSBC MF had completely marked down its aforesaid DHFL holdings.  That day, the NAV of HSBC Low Duration Fund fell by 9.7% while that of HSBC Short Duration Fund fell by 9.0%.  In the case of the latter scheme, this was preceded by a very notable change in the AUM.

Over the two business days before the day of the fall, there was a ~19% drop in the AUM of HSBC Short Duration Fund.  On 4 May, the AUM was 271.3 cr.  On 5 May, it fell to 245.2 cr.  On 6 May, it was down to 219.9 cr.  7 May was a non-business day.

Once again, were those large redemptions merely a coincidence? 

I wouldn’t want to insinuate anything but I must confess that in both instances, the timing looks unbelievably perfect to me. 

The Vodafone Valuation Controversy

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

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

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

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

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

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

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

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

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

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

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

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

Dead Weight In Debt Fund Portfolios

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

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

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

Now think about what that means.

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

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

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

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

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

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

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

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

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

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.

Stock Caps In Index Funds

Last week, SEBI made a groundbreaking announcement, defining the criteria for an equity index to be eligible for being tracked by an index fund or an ETF.  Among other things, it capped the weight of a single stock in such an index at 25% (35% in the case of a sectoral/ thematic index). It also capped the combined weight of the top three constituents in such an index at 65%.  I may be wrong but I don’t think that there is any precedent worldwide for such a regulatory intervention.  In this post, I share my initial thoughts on this.

2018 was a very good year for those rooting for index funds and ETFs in India.  For the first time since 2013, a comparable ETF (actually, 3 ETFs) gave a higher return than any actively managed, diversified, domestic equity fund.  And almost all actively managed, large cap funds underperformed the BSE Sensex and Nifty 50 (in terms of returns).  However, there were some uncomfortable questions that lurked beneath the surface.  For instance, were it not for the superlative returns of a handful of stocks, would such outperformance by index funds and ETFs been possible?  And how was one to look at the fact that there was a difference of over 2.5% in the returns of the best performing and worst performing Nifty 50 index funds?

There were also questions about the construction and maintenance of indices.  For example, what was one to make of the massive churn that some indices went through?  By my count, in April last year, the Nifty Midcap 100 had 46 of its constituents changed at one go while the Nifty Smallcap 100 had 55 of its constituents changed at one go.  Then, there was the question about the suitability of Vakrangee to be part of the (erstwhile?) Nifty Quality 30 Index and what that said about strategy indices per se.  But it would seem that the thing that caught SEBI’s attention the most was the absence of caps on individual stock weightings in most indices, and how that might impact investors in funds that tracked these indices.

Having caps on exposure to individual stocks is a key part of prudent portfolio management.  Some indices have such caps, most do not.  Since index funds are intended to replicate indices, the absence of such caps exposes investors in index funds to concentration risk.  While this risk has always been known, it is only in recent years, with the rise of the FAANG stocks, that the global conversations around this have begun somewhat seriously.  But there are some parts of the world where this has already become a hot button issue.  For instance, in South Africa, media giant Naspers currently makes up 22% of the JSE Top 40 Index and 18% of the JSE All-Share Index.  What’s more, its weighting in the former index is greater than all of the super sectors that make up that index; in the latter it is greater than all but one.

In India, while the broad based indices are not under immediate threat of such a domination, some thematic/ sectoral indices are already being questionably influenced by their top constituents.  For example, in the Nifty Infrastructure Index, L&T alone has a weight of 36%.  Similarly, in the Nifty Bank Index, HDFC Bank alone has a weight of 36%.  If you add the weights of ICICI Bank and Kotak Mahindra Bank, these 3 banks make up 68% of the index.  Then there is the Nifty PSU Bank Index in which SBI alone has a weight of 72%.  More importantly, each of these indices has one or more index funds / ETFs tracking it.  In this backdrop, SEBI’s decision would appear to be necessary or, at the very least, justified.  Personally speaking, I have would have preferred the caps to be lower.  Still, it’s much better than not having any caps.

One of the arguments that I heard against SEBI’s decision was that the construction and maintenance of indices is the domain and prerogative of stock exchanges and index companies, and that the regulator has no business or authority to decide the rules that govern an index. It isn’t an argument that is altogether without merit but, strictly speaking, SEBI hasn’t directly asked stock exchanges or index companies to make such changes.  What it seems to have done is to indirectly put pressure on them by placing the onus of compliance on fund houses.  As I read it, if an index doesn’t meet the criteria set by SEBI, it can’t be the basis of an index fund or an ETF (at least, one that is managed by an Indian fund house).  In other words, if an index company values the business that comes from licensing its indices to Indian fund houses, it will have to comply with SEBI’s requirements.  Of course, the index companies are free to keep their current indices as they are, and create separate indices exclusively for Indian fund houses.  But if they do, well, we might be in for interesting times.

There is also the question of how this might impact the performance of indices.  I don’t have the means to do back testing but I am sure, sooner or later, someone will tell us how such changes, had they happened in the past, could have impacted historical returns.  For now, my guess is that after SEBI’s announcement, active equity fund managers are feeling a little bit relieved.

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.

How Fund Houses Are Trying To Sabotage SEBI’s Expense Ratio Reforms

Seeing the things that some fund houses do, frequently gives me the feeling of watching cheap crooks in action.  The type that get a thrill from travelling without a ticket.  The type that like to steal from the weak and elderly.  The type that give a stupid grin when caught with their hands in the cookie jar.  Except that there’s nothing cheap about the scale on which fund houses operate.

It’s been a month since SEBI’s disclosure norms for expense ratios came into effect.  They were among the most significant set of reforms undertaken by SEBI in recent times.  They were intended to boost transparency, and bring down costs.  Yet the fact is that some fund houses have lacked the ability to appreciate the spirit of those moves, while others have plain ignored it. Worse still, some fund houses have shown no respect for investors or for SEBI and have, in effect, mocked the process of reforms (see here, for example).  In this post, I want to give a sense of how widespread this is.  I will talk specifically on one key issue i.e. the expense ratio files that fund houses have put up on their websites.  I hope to spotlight the questionable approach of multiple fund houses, and the message that they appear to be giving to their investors. It is based on what I have seen across the websites of select fund houses: it is not an exhaustive analysis. 

“Don’t visit our website!”
On many fund house websites, locating the expense ratio file can be a tall order.  It might be under disclosures, or under downloads, or somewhere else.  Probably no fund house has made it tougher to locate the file than Kotak Mahindra MF.  Leave aside the fact that its website is a sprawling mess, or that it does not seem to have even the option for a search.  When I tried looking for the file, I just couldn’t find the link.  It wasn’t even on the sitemap.  Finally, I had to do a search on Google to get to the file.  Just so that you know, when it comes to other fund houses, doing a search on Google isn’t going to necessarily help.

“We’re going to make it really difficult for you!”
What if you want to compare expense ratios across all schemes of a fund house?  Many fund houses have presented their data in such a manner that it is not easy to do so.  Some, such as IDFC MF and Kotak Mahindra MF have given the data for each scheme in a separate sheet, making it a gruelling task to do such comparisons.  Others like  ICICI Prudential MF and SBI MF have made the task even more laborious because they have opted to have separate files for each scheme.  Thus, instead of a single download, they expect you to make multiple downloads, each time you want to see the data.  And given the number of schemes that they have, that, by itself, could take a really long time. 

“We’re going to make it really, really difficult for you, and we don’t care what SEBI thinks!”
Getting expense ratio information from the HDFC MF website poses a different level of difficulty.   The fund house first wants you to decide whether you want current data or historical data.  If it is historical data, then you are expected to put in a date range.  Thereafter, just like ICICI Prudential MF and SBI MF, you have to download the data for each scheme separately.  Last, but not the least, the information in the files is presented in a format that is different from what SEBI has stipulated.  As a result, if you simply want to compare expenses across direct and regular plans of a single scheme, doing so is an uphill task.

“We’re going to drive you nuts, and SEBI can’t do a thing about it!”
In what I would describe as a drastic departure from SEBI’s format, DSP BlackRock MF and IDBI MF (and possibly others) have opted to give the expense ratios for each date in a separate file.  Consequently, if you want to examine the date-wise expense ratios in any single scheme, be prepared for a nightmarish experience.  In the case of IDBI MF, if you want to compare expense ratios across schemes on any single date, that task will also prove to be arduous because the information for each scheme is in a separate sheet.  In my opinion, of all the fund houses, the approach taken by IDBI MF is either the most harebrained or the most sadistic.

“We’re the most investor-friendly!”
I have to admit that, going into this exercise, I did not expect UTI MF to emerge as the best example of a fund house conforming to SEBI’s disclosure.  Fact is, it was a delight to see what the fund house has done: I just hope that they keep it up.  All you need to do is to select a date range.  You can then download the daily expense ratios across all schemes, exactly the way SEBI has specified, and all in a single sheet.  What’s more, the scheme names are entered in such a way that using the feature of filters in Excel, you can easily make comparisons across schemes.  I am not sure if what they have done can be improved but as things stand, every fund house should at least follow their lead.

Last-Minute Expense Ratio Chicanery

In an earlier post, where I praised SEBI’s recent directives related to scheme expense ratios, I had suggested that these could result in expense ratios being reduced.  I had consciously used the word ‘could’ because I was not sure if all fund houses would whole-heartedly adopt SEBI’s directives in their intended spirit.  I haven’t actively tracked what fund houses have done since then, but based on information that came my way, at least one fund house has given enough reason to doubt its sincerity.

Last week, an investor reached out to me with something that was bothering him.  Towards the end of February, he had invested in ABSL Cash Manager.  At the time of investing, thanks to Value Research, he got the impression that the expense ratio of the direct plan was 0.09%.  A couple of weeks later, someone told him “on good authority” that the expense ratio of the plan had been sharply increased.  However, on the Value Research website, the expense ratio was being shown as 0.08%.  He then double-checked on the Morningstar website which also reflected the same number.  In that backdrop, he had these questions for me:

• Had the expense ratio actually gone up or had that person misinformed him?
• If it had gone up, then why hadn’t the fund house intimated him, as it was supposed to, in line with the new SEBI directives?
• If it had gone up, why was it not being correctly reported on the Value Research and Morningstar websites?

Here, then, is what I could gather.

From 30 Dec 2017 till 27 Feb 2018, the expense ratio of the direct plan of ABSL Cash Manager remained almost unchanged at ~0.09%.  W.e.f. 28 Feb, the fund house did, in fact, jack up its expense ratio to 0.29%.  In absolute terms, that may appear to be a small increase but in relative terms, it was roughly a three-fold increase.  More than that, though, there were some other aspects about this increase that made it appear very fishy. 

The first was related to the timing of the change.  The change happened just one day before some of SEBI’s new directives were to come into force.  Any change on or after 1 March would require a fund house to intimate investors via email or SMS, at least three working days prior to effecting the change.  Thus, by making the change on 28 Feb, ABSL MF managed to sidestep that requirement.  Also, since the change happened on the last day of the month, it would have a negligible impact on the average expense ratio for the month, which is the number that the fund house reports in the monthly fact sheet.  So, if someone tracked expense ratio changes via the fact sheet, the change would not be detected/ suspected until the first week of April, when the next month’s fact sheet would be released.

The second dubious aspect of this change was that it was not made in isolation.  By my count, on 28 Feb, at one go, ABSL MF increased the expense ratios across as many as 38 schemes, some of which had not seen any change in their expense ratios in over a year.  Furthermore, of these, 21 were closed-end schemes.  Why is that relevant?  Those who are familiar with SEBI’s new directives will know that one of the circulars issued by it stipulated that schemes where exit load was not levied, or was not applicable, and where an additional 0.20% was being charged, would not be allowed to do so any longer.  This was especially directed at closed-end schemes, where such expenses were widely being charged.  In other words, it would seem that the increases by ABSL MF in the base expense ratios of these 21 schemes were made to negate the cuts imposed by SEBI. 

There was one last thing that I found particularly disturbing, and that was that some of the open-end schemes in which expense ratios were increased, are among the largest in their respective categories, by AUM.  Take ABSL Cash Plus, for example.  As on 28 Feb, this scheme had AUM of 43,997 crore which makes it, by far, the largest liquid scheme in the industry, by AUM.  A scheme of that size would be expected to have significant economies of scale and would be expected to have among the lowest expense ratio in its category.  Going by the average expense ratio for Feb 2018, which was 0.03% for the direct plan, and 0.12% for the regular plan, that would appear to be true.   But in the case of this scheme, too, the expense ratios of both plans saw a steep increase on 28 Feb, to ~0.19% for the direct plan, and ~0.28% for the regular plan.  Could there be a reasonable justification for such a hike?  I can’t think of any, other than to make money for the AMC.  If my maths is correct, going by the Feb-end AUM, the increase in the expense ratios of this scheme alone, would have resulted in additional income to the AMC of ~19 lakhs per day.

And what about the information given on the Value Research and Morningstar websites? 

It would appear that both these entities have been content to take data on expense ratios from the fund house monthly fact sheets, and not bother with any intra-month changes.  Well, the times are changing, and given the present requirement of daily reporting of expense ratios by fund houses, they’ll have to consider updating data more frequently.  For now, I’d be careful about relying on what they report.  If you want authentic information related to expense ratios, the only place I would recommend is each fund house’s website.

Update (27 March 2018): Some evidence has come to light that suggests that the file with the expense ratio changes on 28 Feb 2018 was actually uploaded on the ABSL MF website only on the evening of 1 March 2018.  If correct, it makes the actions of ABSL MF even more troubling.

Three Cheers For SEBI!

Over the past few days, SEBI has released a series of directives to fund houses that are aimed at rationalizing the expense ratios of mutual fund schemes, and enforcing greater transparency in their disclosure. This is a short post to applaud SEBI’s recent moves, and to talk a bit about what these mean for investors.

First, some background to explain the magnitude of the problem that SEBI was trying to solve.  Over the years, a number of fund houses have been pushing the limits on what they can charge investors in their schemes, without arousing any suspicion.  On this blog itself, I have spotlighted multiple instances of fund houses ripping off their investors (see here, here and here).  A lot of this was possible because these fund houses made it difficult for investors to figure out what they were being charged, let alone if they were being fleeced or not.  In a study of fund house websites and monthly fact sheets that I had done around three years ago, I noted that nearly all the large fund houses had questionable disclosure standards related to expense ratios (see here).  Little has improved since then.

While entities such as Morningstar and Value Research have also been reporting numbers across schemes, and across fund houses, the accuracy of their numbers is often in question.  As a result, the most reliable sources for expense ratios, thus far, have been the scheme annual reports.  But even these have their limitations.  Firstly extracting and comparing information from the annual reports is a challenge.  Secondly, annual reports do not reflect the expense ratio changes that happen during the year (in many instances, the changes are very frequent, and significant).  Thirdly, the annual reports are too dense to be easily scrutinised.  At least, that’s the only reason I can think of, for a fund house like Kotak Mahindra MF to get away without separately disclosing the expense ratios of its direct and regular plans in its annual reports.  Long story short, it was a mess.  With SEBI’s latest directives, hopefully, all of this will be a thing of the past.  Here’s how I see its moves benefitting investors.

You’ll be able to make clearer comparisons across schemes
SEBI has stipulated a format that all mutual funds have to adhere to.  The well-thought-out format requires fund houses to separately mention the base expense ratio for each scheme plan, the additional expenses, and the taxes.  Moreover, the information is required to be put on a spreadsheet that can be downloaded from the fund house’s website.  This will make it easier to extract this information, and to compare information across schemes. 

Expense ratios will be available daily
That’s right: not annually, not monthly- SEBI’s directive requires the information to be disclosed daily.  This would be particularly useful for prospective investors in liquid and ultra short term funds.

You’ll be able to clearly see changes in expense ratios
SEBI’s format requires that, going forward, the daily historical expense ratios across all schemes be available in a single spreadsheet.  Thus, you will be able to quickly and easily examine the historical changes in the expense ratio of any scheme.  Such a disclosure can also be expected to act as a deterrent against fund houses frequently tinkering with the expense ratios.

You’ll be alerted about changes in expense ratios
In yet another path-breaking move, SEBI has directed fund houses to intimate investors via email or SMS of any change in the base expense ratio of any scheme that they have invested into.  This intimation has to happen at least three working days prior to affecting the change.

Your expense ratios could come down
Apart from the indirect impact of competition that the abovementioned transparency measures might bring about, SEBI has forced fund houses to cut down on some dubious charges.  If my calculations are correct, the expenses could come down by up to 0.59% p.a. (the exact number would vary from scheme to scheme).

Call me biased or naïve if you like, but I am delighted by the way in which the current leadership and team at SEBI are tackling some of the key issues related to mutual funds.   I look forward to even better days for mutual fund investors.

In Praise Of SEBI’s Scheme Rationalization Directive

In the three weeks since SEBI released its circular on categorization and rationalization of mutual fund schemes, there have been at least two dozen opinion pieces written on it, across newspapers, blogs, and online portals.  With a number like that, it is usually pointless to try and add anything new to the conversation.  But after going through what has been written, and speaking with advisors and investors, I feel that SEBI’s circular hasn’t been appreciated as much as it should have.  I think it is one of the most important directives from the regulator in recent times, and deserves a standing ovation.  If nothing else, I’d like to add my voice to that of those who have applauded it.

Here are some of the ways in which I expect it to benefit investors:

You’ll know what you’re buying: A number of fund houses have made it difficult for investors to comprehend the true nature of the schemes that they buy into.  In some cases, the scheme names are misleading while in others, the investment objectives are way too ambiguous.  While the issues with the names may still persist, SEBI’s elaborate description of most categories leaves little wriggle room for fund houses to creatively expand a scheme’s investment objective.  So once this directive comes into effect, if you buy an equity scheme categorized as ‘large cap’, you’ll know exactly what to expect.

You’ll have clearer choices: Currently, choosing between scheme categories can be tricky.  There are at least two issues that investors face.  The first is that there is a lack of uniformity in the way that scheme categories are defined by various entities.  For example, one prominent online portal divides domestic, diversified, non-ELSS equity funds into five categories whereas another splits these into just three categories.  Hopefully, SEBI’s intervention into the classification process will result in all these entities adopting a uniform approach. 

The second problem is that among the prevailing classifications, some categories are so loosely defined that certain schemes could fit into any of two or three different categories.  As a result, there are differences in the way that these schemes are categorized by different entities.  While SEBI’s classification does not completely eliminate overlap, the important difference is that there will now be little ground for an entity to categorize a scheme any differently from the way a fund house does.

As a foot note, I’d like to say that I disagree with those who contend that the SEBI circular keeps far too many categories, particularly among debt funds.  I believe that the number of categories is a less consequential issue than it is being made out to be.  As for debt funds, their structural complexity as well as the widely segmented audience that they cater to, necessitates far many more categories than equity funds.  I think that the categories put forth by SEBI meet that requirement quite well.

Underperformance will be difficult to mask: At present, some fund houses have multiple schemes with similar objectives but with subtly different strategies/ portfolios.  This enables them to hedge their bets on which strategy/ portfolio will do better.  But more than that, this helps in effecting a psychological deception upon prospective investors.  Put differently, if you are a prospective investor who is comparing fund performances in a category in which there are, say, two somewhat similar schemes from the same fund house, you are more likely to notice the better performing scheme (and miss seeing the underperforming scheme).  Thanks to SEBI’s stipulation that a fund house can have only one scheme in most categories, fund houses will now have to necessarily go with their highest-conviction strategies. Hopefully, then, a clearer picture of the true performance of a fund manager should emerge.

Style drift will be curbed: Style drift is far more widespread than most people realize, and is thus a bigger risk than most people realize. Going by the latest SPIVA India scorecard, as many as 53% of the funds that were classified by Morningstar as large-cap 3 years ago (and which continue to exist today), no longer have a large-cap orientation.  In fact, in just the last 1 year, 25% of equity funds that were classified as large-cap, have ceased to have a large-cap orientation.  In case you’re wondering, it isn’t just large-cap funds, or even equity funds.  11% of equity funds that were classified as mid/small-cap a year ago, are no longer classified as such, while 32% of debt funds across Morningstar’s ‘Intermediate Bond’ and ‘Short-Term Bond’ categories no longer fit those categories.  SEBI’s circular is short on the details of how it will monitor style drift.  But the painstaking detail in which it has defined most categories, gives one the confidence that that, in itself, should be useful in curbing style drift, without constraining a fund manager’s flexibility.

You’ll be able to make fair comparisons:  Making fair and accurate performance comparisons between schemes is integral to good investing.  Unfortunately, on account of the issues mentioned earlier (ambiguous investment objectives, style drift etc.), investors are rarely able to do so.  Once SEBI’s classification comes into effect, this should become a thing of the past, and you should be able to make genuine apples-to-apples comparisons of fund performance.  Doubtless, it will take time for the benefits to materialize but from the point of view of investors, this could well be the biggest benefit from SEBI’s directive.

Watch Out For Clandestine Portfolio Changes

In May this year, Birla MF (now, Aditya Birla MF) announced changes in the names of three of its ‘MIP schemes’: BSL Monthly Income, BSL MIP, and BSL MIP II- Savings 5 Plan.  What is noteworthy about these changes is that these were intended to mask some of the most brazen portfolio changes that I can remember seeing in any scheme in recent times.  Thankfully, two months later, SEBI shot down the name change decisions, forcing the fund house to “reinstate” the original names.  Unfortunately, despite SEBI’s intervention, the portfolio changes continue to remain, largely unnoticed.

In this post, I’d like to spotlight some of those changes and make the case for stricter regulation of scheme portfolio changes.  Equally importantly, what I share here, should serve as a cautionary tale for investors on the need to closely monitor the portfolios of the schemes that they invest into.  Note: This post has been pieced together from publicly available information and conversations with people supposedly in the know.  I reached out to the spokesperson of the fund house for its side of the story but for reasons best known to him, there was no response from his side.

The roots of the name changes of the abovementioned schemes can be traced back to January this year, when someone on the investments team at Birla MF initiated the idea to launch three debt schemes that would have significant exposure to instruments rated lower than AA.  As the idea was bounced around, it was felt that launching new schemes would be time consuming and expensive and, as an alternative, it was proposed that three of the existing MIP schemes be converted into pure debt schemes.  The fund house had four MIP schemes that had been around for several years but only one of those schemes had seen its AUM grow somewhat consistently.  The other three schemes, despite being in existence for an average of 16 years, had a combined AUM of just under 650 crore (as on December 31 2016).  More to the point, in their existing form, these three schemes did not seem to have much of a future.  Thus, it made sense for the fund house to explore the possibility of converting these schemes.  On the flip side, though, there was at least one key obstacle that would have to be overcome.  Converting a MIP scheme into a pure debt scheme would mean, as some would say, a change in the asset class of the scheme, and ran the risk of being rejected by SEBI.  Apparently, a few months earlier, SEBI had turned down a similar proposal by another fund house.

In order to manoeuvre this idea past SEBI, the fund house hit upon a plan to present it, not as a series of scheme conversions, but as a set of scheme name changes.  But to make a credible case, some groundwork needed to be done.  This was to be in the shape of two sets of changes that would be made to the portfolios of these schemes.  The first involved removing the equity exposure of these schemes.   The second involved reworking the portfolios so that there was a greater allocation to debt instruments that were rated lower than AA.  Thus, in March 2017, the work on restructuring the portfolios of these schemes began.  By the end of the month, the portfolios looked very different from those at the end of the previous month (or any earlier month).  The changed portfolios continued through April 2017, and the groundwork for the name changes was in place.

It is in the magnitude of changes made to the scheme portfolios that one can truly understand the lengths to which the fund house was prepared to go to accomplish its questionable objective.  To help you get a sense of that, I have given below a table which shows the extent to which each scheme’s portfolio was invested in equities, and in debt instruments rated lower than AA, before and after the change.  To present a fair picture, for the investments before the change, I have taken the average portfolio holdings for the 12 months from March 2016 to February 2017 while for the investments after the change, I have taken the average portfolio holdings for the months of March 2017 and April 2017.

	BSL Monthly Income	BSL MIP	BSL MIP II- Savings 5
Average % of Portfolio in Equities
March 2016 – February 2017	16%	17%	11%
March 2017 – April 2017	0%	0%	0%
Average % of Portfolio in Securities Rated A+/ A/A-
March 2016 – February 2017	9%	9%	9%
March 2017 – April 2017	41%	43%	43%

Based on month-end portfolio disclosures.  All percentages are calculated on invested portfolios to avoid impact of cash holdings.  Data source: Prudent Corporate Advisory Services Ltd.

By any measure, this would seem to be a radical transformation in the portfolios of these schemes.  If I were an investor in these schemes, seeing such a sudden and drastic shift would make me seriously consider exiting these schemes.  At the very least, I would expect an explanation from the fund house.  Yet, as far as I can make out, no communication was sent to investors intimating them about these changes.  It makes me wonder about the adequacy of the regulations that govern mutual funds that a fund house can get away with making such sweeping changes to the portfolio.  I would argue that making changes of such a magnitude should be subject to the same requirement as is changing the fundamental attributes of a scheme i.e. investors must be given the option to exit without any penalties. 

As for the fund house, I am sure that it would contend that it was acting within the law, and it would be right about that.  I question its sincerity to the spirit of the law, and its morality.  I look at its actions as trampling upon the trust of its investors.