About Target Maturity Debt Funds

This week will see the NFO of a target maturity debt fund, that has also been billed as India’s first debt index fund.  Open-end target maturity debt funds are a product category that merits serious consideration, and one that we should see a lot more of.  However, based on some of the commentary that I have seen in the media (mainstream and social), as well as what I’ve been hearing from advisors and investors, I feel that some of the wider understanding could be enhanced, and expectations tempered. In this post, I want to touch upon a couple of less-talked-about points.

It might be worth mentioning that open-end target maturity debt funds were first launched in India over two decades ago.  Back in the day, they used to be referred to as ‘serial plans’.  Unfortunately, this category (like some others) didn’t quite take off.  Perhaps it was an idea whose time had yet to come.

The first point that I want to bring up is that, conceptually speaking, such a fund doesn’t have to be an index fund or an ETF and even if it is structured as such, it may not be purely passively managed.  From what I have gathered, unlike equity index funds and ETFs, it is quite common for bond index funds and ETFs worldwide to not replicate the complete set of index constituents.  Instead, they follow what is referred to as a ‘sampling’ approach whereby the fund manager seeks to match the more fundamental characteristics of the index such as credit profile, duration, and yield.  To be fair, in India, SEBI has put in guidelines that limit the deviation from index constituents.  But it still leaves room for some degree of active bond selection. 

As a point of contrast, take the original ‘serial plans’. These were typically single-security gilt funds whose maturity coincided with the maturity of the underlying security.  Consequently, despite not being index funds, they were perfectly passively managed.  The same can also be said for any fund that follows a hard-coded list of issuers, and a pre-defined credit and maturity profile.  Thus, a part of me wonders if the index structure currently in vogue, might just be a way to work around the inflexibility of SEBI’s open-end scheme categorization.  Regardless, with the growing interest from investors, advisors, as well as fund houses, it may be worthwhile for SEBI to expand the existing scheme classification to include this category. 

The second point that I want to talk about is the predictability of return in these funds, as represented by the yields that are reported.  No doubt, this is a prominent reason to invest in these funds.  However, investors need to be careful in relying upon the disclosed yield.  For one, there is the question of how the yield might be impacted if there are large flows into or out of the fund.   For another, there is the extent of the gap between the maturity of the fund’s underlying securities and the actual maturity of the fund.  As an example, in the case of one existing fund, I noticed that around 10% of the portfolio is scheduled to mature 7 months or more, before the actual maturity of the fund.  As and when those bonds mature, it is a moot question as to whether the fund will be able to earn the same yield as what it is getting on those bonds today. 

In this context, it might be worth looking at the evidence shared by BlackRock in the US, with respect to its target maturity iBonds ETFs that have matured.  Among other things, it shows the difference between the initial net yield and the final return that investors got.  So far, the difference across all matured funds has ranged from +0.19% pa to -0.30% pa.  In absolute terms, that may or may not seem much but when seen relative to the yields (and the time horizon), that is certainly not a small difference.  For example, one of its ETFs started off in December 2014 with a net yield of 2.64% pa.  When it matured 6 years later, the total return to investors was 2.35% pa.

As a side note, I don’t know what to make of the fact that SEBI doesn’t allow fund houses to offer any indicative yield on FMPs yet it seemingly has no issue with the disclosure of yields on open-end target maturity funds.  All things equal, FMPs offer a more predictable return than these funds.

How Should Affected FT Investors Vote?

This has reference to the forthcoming vote by investors in the six schemes that Franklin Templeton (FT) has proposed to wind up.

There is a lot of publicly voiced advice on this, and almost all of what I have seen, is encouraging or urging a ‘Yes’ vote.  On its part, FT seems to also endorse that choice.   Presumably to make sure that the message is not lost, FT has framed the vote as being about an “orderly winding up”. 

In my limited understanding of the law, the vote is supposed to be for approving the winding up.  Period.  Adding the prefix “orderly” adds an element of bias to the process.  Is it legal?  I don’t know.  And what exactly does “orderly” mean?  It is certainly not an absolute term that can be defined unambiguously. 

Regardless, how “orderly” will the winding up be, is something that time will tell us.  There is certainly a fear amongst many of us, that a ‘No’ verdict may end up being not as “orderly” as a ‘Yes’ verdict.  Yet it is possible that a ‘No’ verdict could end up being very “orderly”.  If that sounds hard to believe, consider this comment made by someone on an online forum (lightly edited for clarity):

FT may say that a 'No' majority will lead to chaotic redemptions but that may not necessarily happen. Firstly, some of the funds have gained enough cash to ward off reasonable redemption pressure. And while this may sound bizarre, the schemes that are cash positive, also have the ability to borrow and pay off- and who knows, SEBI might become more generous about those limits. Secondly, FT has options to control redemptions. It can somewhat limit the amount redeemed per folio. It can also ward off redemptions by applying an illiquidity discount like they did in the case of the FoFs- which, by the way, seems to have worked. The one big problem with a 'No' majority is that there are too many ifs and buts.

Doubtless, the circumstances today are quite different from those in April, and which led to FT’s decision.  Is the change significant enough to merit re-opening one or more schemes?  As I said previously, only time can tell us.  Irrespective, the point about the Fund-of-Funds is especially interesting. 

For those who may not know or have forgotten, this is a reference to those schemes that are further invested in one or more of the affected six schemes.  Take for example, Franklin India Dynamic Asset Allocation Fund of Funds (FT DAAF).  This has exposure to Franklin India Short Term Income Plan (FT STIP), which is one of the six schemes. 

Right after the winding up was announced, the fund house applied, what I consider to be a high-handed, arbitrary “illiquidity discount” on that holding.  As on the date that happened, the AUM of FT DAAF was 768 crore.  As on 8 December, the AUM was 784 crore.  It would seem that there has been no rush for redemptions in the fund.  I am not saying that this is evidence that the discount was effective, but it is certainly worth thinking about.  I must confess, though, that the devil in me is tempted to hope for a ‘No’ verdict in any one scheme, just to see if the argument of extreme redemptions holds. 

So, what does this mean for investors, and should it affect the way they vote?

Permit me to go back to the person I quoted earlier, and offer something that he had to say on this.

As with any decision involving voting, we have to make our own individual choices and hope that the eventual outcome, even if different, doesn't impact us too badly. We can endlessly speculate about the best choice- but unfortunately, there is no single choice that will appeal to everybody. It depends on a person's circumstances and even which of the 6 schemes he/she is stuck with. For example, I personally know a few people who would genuinely benefit more from a 'No' majority.

Then there is the final result, and what happens after that. A 'Yes' majority will definitely bring far more certainty to what will happen after that than a 'No' majority. But that doesn't mean that a 'No' majority is necessarily a bad outcome. Equally so, it is not necessarily a good outcome. It all depends.

I concur with this view.  We ought to vote in a way that reflects the best possible balance between our conscience and our needs, and then find the strength to live with the outcome.

Observations On Recent Fund Returns

The last ten months or so have been an extraordinary period for those whose fortunes are linked to the stock markets.  It isn’t often that frontline indices fall by close to 40% and then completely recover from there, all within such a short span of time.  If I am not mistaken, it was way back in 1990-91 that we last saw something quite like this. 

But leave aside the rarity of that: there is a fair bit to take away from fund returns over these past ten months.  In this post I’d like to offer a few assorted observations that stood out for me.  Some are high-level observations while some are scheme-specific.

All calculations are for the period 14 January (Nifty 50 TRI: 17,349) to 6 November (Nifty 50 TRI: 17,392).  Unless mentioned otherwise, the calculations pertain to direct plans.  Data sources: Value Research and FundzBazar.

The inconsistencies of Index Funds
As one might expect from the dates that I mentioned, point-to-point, index funds and ETFs tracking the major domestic indices- Nifty 50, Sensex and Nifty 500-  gave little to no returns.  If you look beyond those indices, the returns across other non-sectoral index funds and ETFs are both much better, and much worse.  On the positive extreme, the lone ETF tracking the Nifty 50 Shariah index gained ~19%.  On the negative extreme, the CPSE ETF fell by ~28%, and Bharat 22 ETF fell by ~25%.  Dubious diversification, perhaps?

Luck, skill, or something else?
Over this period, actively managed Large-cap funds gave returns ranging from +8.3% to –10.9%.  However, Value Research and other websites, list one other open-end large-cap scheme that gave a return of –11.4%.  Strictly speaking, this is a Focused fund with a mandate to invest in stocks regardless of their market cap.  Be that as it may, going by this scheme’s month-end portfolios, through these ten months, on an average, 97% of its equity holdings were large-cap stocks.  If you think it is worth including in the list of large-cap funds, then consider this: it is managed by the fund house that also managed the large-cap scheme that gave the highest return.

Differences across Dynamic Asset Allocation Funds (DAAFs)
More than any other category, DAAFs have the freedom to adjust their allocation in a way that preserves value when markets crash, and cashes in on market recoveries and rises.  Leading from that, these funds have been frequently positioned as a sort of panacea.  Thus, these past ten months represent an excellent period to look at what DAAFs can accomplish.  It turns out that, over this period, the returns of these funds ranged from +17.8%  to –12.6%.  So, what explains this vast difference? To some extent it was on account of stock selection which, contrary to the spiel on the importance of asset allocation, isn’t an insignificant variable.  In addition, and quite obviously, it had to do with the differences in when and how much the funds shifted from equity to debt and vice versa.  To be fair, no one can perfectly time the market, so I personally didn’t expect any fund to shift its allocations perfectly.  However, the evidence suggests that some of the funds got that right a lot better than others.  

ICICI Prudential Equity & Debt Fund
Over this period, this scheme gave a return of -8.4% which made it one of the worst performing Aggressive Hybrid funds.  What’s more, its return was worse than that of any of the open-end, actively-managed, diversified pure equity funds from ICICI Prudential.  Its return looks even more disturbing when you dissect its asset allocation.

Going by this scheme’s month-end portfolios, over these ten months, its average allocation to cash and debt instruments was around 30%.  If we assume a return of 10% (that’s what the fund house’s short duration fund has delivered), that would imply that the equity holdings gave a return of –16.3%.  In contrast, the worst performing, open-end, actively managed, diversified pure equity scheme from the fund house, gave a return of -7.8%.  That raises the question: was this hybrid scheme pursuing a divergent and riskier equity strategy than all other pure equity schemes from this fund house?  If so, why?

SBI Dynamic Asset Allocation Fund
This is one of the most unique and well-meaning funds across the industry, and it breaks my heart to say that over these ten months, it utterly failed to live up to its promise.  For those who don’t know, its equity allocation seeks to mirror the Nifty 50/ Sensex while the debt allocation is exclusively held in the 10 year g-sec. As I stated earlier, point-to-point, over these ten months, the Nifty 50 and the Sensex delivered little or no return.  Thus, the contributors to this scheme’s return had to be the return from the cash and debt component (SBI MF’s 10 year g-sec ETF gained 8.8%), and whatever gains it could make by switching from equity to debt when the market peaked (and as it rose again), and from switching from debt to equity around the bottom of the market.  Unfortunately, all of this came to nought.  For reasons that only the fund house can really explain, this scheme’s return was –0.2%, which is just a tiny bit better than that of the Nifty 50 index fund managed by the fund house: –0.6%.  The only explanation that I can think of is that the algorithm used by the fund house, did a terrible job of deciding the switches between equity and debt.  Talk of good intentions going bad.

Correction: An earlier version incorrectly stated that the 10 year g-sec gained 10.8%. Actually, it was SBI MF’s 10 year Constant Maturity g-sec fund that gained 10.8%.  SBI MF’s 10 year g-sec ETF gained 8.8% over the period.

Will Someone Please Think About The Affected FT Investors?

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

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

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

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

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

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

Special thanks to Robin Jehangir for his invaluable inputs.