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?
An open ended equity scheme predominately investing in mid cap stocks
…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?
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 houses are required by SEBI to classify the risk of each scheme as one of five levels: low, moderately low, moderate, moderately high, or high. But what exactly should we make of a scheme whose risk level is defined by the fund house as, say, ‘moderately low’? On the other hand, what should we make of Value Research or Morningstar telling us that the risk grade or risk rating of that scheme (relative to its peers) is, say, ‘average’?
It isn’t just their ambiguity: I would not rely on any of these labels as they largely stem from a narrow view of risk. I believe that if we are not careful, these can lead us to make flawed assumptions about the riskiness of a scheme and, worse, act upon them.
To illustrate the perils of relying upon these risk ratings, I’d like to take the case of a specific scheme whose risk ratings are currently poles apart from my assessment of its risk. To be clear, this scheme is an extreme outlier: it would be hard to find a scheme quite like this. However, the extremity of this example is what makes it useful to show the arbitrary nature of fund house risk ratings, and the limitations of the methodology followed by entities such as Value Research and Morningstar.
The scheme in question is a debt fund that has been around for over ten years. From what I can see, for most of its existence, there has been a noticeable consistency in the way that its maturity/ duration and its credit profile have been managed.
As regards its performance, in each of the last 10 quarters, its return was above average (compared to its peers). In 3 of the last 6 quarters, its return was exceptional. In the month of June, this scheme gave a higher return than almost every non-gilt fund. Its return in June was also higher than its return in any of the preceding 12 months.
The fund house has classified its risk as ‘moderately low’. On the other hand, both Value Research and Morningstar have currently given it a risk grade/ rating of ‘average’ and an overall rating of 5 stars (based on the performance of its direct plan, growth option).
So, what’s the problem?
Just as with some other schemes, over the past several months, this scheme saw a significant fall in its AUM. Consequently, there is a certain illiquid NCD in its portfolio, which it hasn’t been able to sell off, whose proportion to the portfolio has zoomed up as the AUM has fallen. As on May-end, this NCD made up 71% of the scheme’s portfolio. As on June-end, this NCD made up 87% of the portfolio.
Take a minute to digest that, if you will, because there’s more.
That single NCD is currently rated BBB (CE) and is under “credit watch with negative implications”. In other words, that NCD is just about making the cut for being ‘investment grade’ and is precariously close to slipping below that. If it does, well, there’s no saying how much an investor could be impacted. If industry practices are anything to go by, for starters, the fund house would have to mark down the value of that investment by at least 25%. And for those who have forgotten, here’s a bit of a flashback. Last month, when DHFL was downgraded from BBB- to D, one scheme which had 67% of its portfolio in DHFL NCDs saw its NAV fall by 53% on that single day.
So how does a scheme with a portfolio like this get a risk rating of ‘average’ or a risk level of ‘moderately low’?
From what I have gathered, in the Value Research/ Morningstar risk ratings, factors such as portfolio concentration, even credit quality are not considered. In contrast, consider the approach that CRISIL takes for its fund ranking. In the case of debt funds, for example, apart from return, the ranking gives weightage to elements such as asset quality, interest rate sensitivity, liquidity and company concentration, among other things. As it happens, moneycontrol.com, which apparently uses CRISIL’s ranking, has given the abovementioned fund an overall rating of 2 stars. While I am not suggesting that CRISIL’s process is perfect, it is certainly a lot better than anything else that I have seen.
On the other hand, in the case of the fund house classification, the issues may be more complicated. For one, fund houses are currently bound by the way in which SEBI has defined the risk levels. For another, product labelling is practically a one-time exercise. Personally, I don’t see much utility to having such a risk classification, certainly not in its present form. Regardless, I would prefer that fund houses gave investors a list of things to check before investing and also highlight issues that warrant caution.
In any case, investors would do well to not blindly go by star ratings or risk ratings. If we choose to use them, at the very least, we should understand their limitations.
To say that the month gone by was extraordinary, would be an understatement. It shone a whole new light on the riskiness of debt funds. And for some debt fund investors, it was catastrophic. While there has been ample media coverage on most of what happened, in this post, I’d like to talk about some of the less-reported stuff that stood out for me.
Let me start with the downgrades. We all know about DHFL. We probably know about Sintex as well. But there were two other companies whose downgrades threw up a few questions for me- Wadhawan Global Capital (WGC) and Cox & Kings. There were only a handful of schemes holding debt of these companies, and in all but one of those schemes, investors were not impacted. Still, these questions are pertinent given how much credit rating agencies influence debt fund returns.
WGC is the parent company of DHFL, and I talked a bit about it in an earlier post. I had mentioned that its rating was linked to that of DHFL and that it was downgraded along with it between February and May (although with an inconsistent time lag). I had pointed out that when DHFL was downgraded to ‘default’ on 4 June, WGC wasn’t. After a questionable delay, on 21 June, the new rating for WGC was released. But guess what? Its rating wasn’t downgraded to ‘default’. Instead, in what I consider a sleight of hand, its rating was delinked from DHFL and was independently assessed as BB. But why the long delay? This wasn’t a complex company that needed deep evaluation. Did the delay have anything to do with some stake sales that were to came through (and eventually came through)? Would the rating have been the same if it had been done right after the DHFL downgrade? Was such a delay justified? Was the delinking from DHFL justified?
There’s more: one fund house held around 300 cr of NCDs issued by WGC that were due to mature in 2020 and 2022. Since WGC was untouched by the DHFL downgrade, its schemes holding these NCDs weren’t impacted either. Not only that, if reports are to be believed, this fund house managed to sell back its entire WGC holding (or at least a large part of that) to the DHFL promoters, before it eventually got downgraded to BB. In some quarters, the move was hailed as a masterstroke by the fund manager. Frankly, I don’t know if it would qualify as skill, luck, or something else. Regardless, assuming this information to be correct, I’d be curious to know what made the promoters of DHFL fast track this repayment and prioritize it over repayments to other creditors, especially in light of their inability to honour DHFL maturity payments later in the month.
As for Cox & Kings, for those who may not know, the company defaulted on repayment of commercial paper due on 26 June, to the extent of 150 cr. Fortunately for mutual fund investors, only one scheme was impacted. However, what I found intriguing is that just two days before the default, one of the credit rating agencies had reaffirmed the rating of the company’s 2000+ cr CP program as A1+, the highest rating that can be given. As someone said, it’s getting hard to know what to make of ratings any longer.
On account of the downgrades (mostly DHFL), June was a month of widespread negative returns across debt funds. By my count, 159 schemes ended up with negative returns. 14 of these fell by 10% or more, of which 4 schemes fell by 40% or more. If my numbers are correct, the simple average return of all debt funds (including gilt and liquid funds) put together was –0.24%. To my mind, this hits home the need for quality in diversification across debt funds. Blindly diversifying oneself wouldn’t have been enough.
If I drill down into individual categories, unsurprisingly, the worst affected category was that of credit risk funds. Again, if my numbers are correct, this category had an asset-weighted return of -0.71%. But this was by no means the only category with a negative asset-weighted return. There were 3 other categories: low duration (-0.58%), medium duration (-0.58%), and short duration (-0.29%).
Among the schemes that gave negative returns, there were two schemes that particularly grabbed my attention. The first was BOI Axa Credit Risk Fund which fell by over 44% in June. It was the subject of a post that I wrote a couple of years ago, where I had called it out for the level of risk it was taking. Sadly, some of my fears about this scheme have come true. Investors who are in the scheme since its inception (over 4 years ago) are now sitting on a loss of over 30%. If I am not mistaken, it has been impacted by more downgrades than any single scheme. What worries me is that the worst may not be over for this scheme.
The other scheme is a somewhat obscure FMP managed by ABSL MF: Series OW (1245 days). It fell by ~6.7% in June. It was hit by both the DHFL downgrade as well as the IL&FS downgrade. From what I can see, it also appears to be holding NCDs of one of the Essel group promoter companies. What caught my eye is that according to Value Research, it has now given negative returns in 5 of the first 6 months of this year. I haven’t yet investigated this in detail but it certainly adds a new angle to the riskiness of debt funds.
When bond prices fall, yields go up. So is there an opportunity in this crisis, to capture the accrual from high yields? That’s a question I’m hearing in some circles. The June-end portfolio yields are yet to be disclosed. If the May-end yields and back-of-the-envelope calculations are anything to go by, I will not be surprised if there are a dozen schemes or more with yields in excess of 13%. Some of the likely high-yield schemes are closed for subscription. A few others have exit loads. But the opportunity, wherever it exists, comes with the risk of further downgrades and write-offs. And if there are too many people seizing the opportunity, there could be a dilution. Still, it’s something worth thinking about. In any case, for those of us who are already invested, the yields offer a glimmer of a silver lining in the gloomy cloud of June. But we also need those side pocket changes, real fast.
“Investors should beware of lies, half-truths and dangerous nonsense.” This was a piece of advice from someone who represents an institutional investor, that came in the course of an exchange we had, earlier this week. As it happened, a day or so before, I had seen a cautionary tweet by a well known investor on similar lines. However, the context of our conversation was somewhat different. While we talked a bit about general opinions aired in the media, our exchange was largely about pronouncements made by fund houses.
There is nothing new about fund houses making inaccurate statements. But there are some who feel that the manner in which certain fund houses are increasingly trying to mess with our perceptions, is a cause for concern. Sadly, there is very little that is done by way of fact-checking, and such assertions are rarely called out. That means it’s pretty much up to each of us to be on our guard.
Here are three instances from recent memory that came up in our conversation. I would suggest that you look at them as illustrative of a larger problem more than an indictment of the individual fund houses.
The specific context of the statement is not clear- it may have been about their debt funds in general or it may have been about their credit risk fund. Also, it is not clear as to what point in time is being referred to. Regardless, I think it needs at least one piece of additional context- that ICICI Prudential, in fact, held paper of IL&FS Financial Services in two of their FMPs that matured a couple of weeks before the downgrade happened, last year. As per the last disclosed portfolios of these FMPs, in each of these FMPs, the exposure to IL&FS Financial Services was in excess of 13%. I’ll leave it to your imagination to think about what might have happened if the FMPs and NCDs were to have matured just two weeks later.
Mirae Asset MF
A few months ago, Mirae Asset courted controversy over the decision to reclassify its multi-cap fund as a large-cap fund. There is nothing that can be accomplished by a large-cap fund that cannot be accomplished by a multi-cap fund, and there was no basis for such a step to be initiated in the interest of investors. Still, the fund house persisted in defending the indefensible. In many quarters, it was felt that this move was connected to the forthcoming launch of its focused fund, which would have a multi-cap orientation. The fund house denied this. In a piece that appeared in The Economic Times, its spokesperson was quoted as saying:
We are coming up with a focused fund which should not be confused with a multi cap scheme.
It is a true-blue multi cap with no sector or segment bias.
For whatever it is worth, it seems that as per the last portfolio disclosure, 19 of the 28 stocks in the new fund are also part of the erstwhile multi-cap fund (now large-cap fund), with a portfolio overlap of 45%.
Kotak Mahindra MF
Kotak Mahindra was recently in the spotlight for withholding part of the maturity payments to some of its FMP investors. This had been triggered by its questionable exposure to Essel group companies and complexities arising out of collecting on that debt (I call it a default). As I had written in an earlier post, one of its spokespersons was quoted as making a series of bizarre statements, most notably this:
I tend to disagree that it is a call gone wrong…
But more than any single statement, the entire argument made by the fund house, of acting in the interest of investors, was dubious, and circumvented key facts. The fact that the decision to invest into debt instruments secured by shares was something they foisted upon investors. The fact that they went beyond accepted norms of prudence in having concentrated exposures with up to 20% of some portfolios in Essel group companies. The fact that they increased that risk by opting for zero coupon bonds. The fact that the mess they eventually faced, could very well have been anticipated and avoided. I can go on. Thankfully, someone on Twitter called them out with a blistering tweetstorm. Here’s the link.
For those who need a quick recap, on 4 June, DHFL fell behind on its interest payment to NCD holders to the extent of 900 odd crore. They cited the trust deed to say that they had 7 days to make good on that (for it to not be considered as a ‘default’), and they assured investors (and everyone else) that they would do so. Apparently, the credit rating agencies had a difference of opinion. With what I think was an uncharacteristic swiftness, they downgraded the company to ‘default’ status. Taking a cue from that, all fund houses holding any NCDs of DHFL marked down their holdings by 75-100%.
Fast forward to 11 June. In an exchange filing, DHFL confirmed making good on all interest payments. In itself, that should have made all the NCD holders happy, and to look forward to the next interest payment (or maturity payment). For the investors in the debt funds that held DHFL NCDs, there was little to cheer about. Over this period, their total wealth was eroded by an estimated 3000 crore, and there is no clear picture as to when this will be recovered. For some investors, there will be no recovery.
So how did this come about?
Let me start with the credit rating agencies. For many years, DHFL was rated AAA by all of them. Not just that, until a few months ago, its NCDs were also a part of the CRISIL AAA Medium Term Bond Index. With such credentials, I find the manner in which DHFL was rapidly downgraded to be rather odd. And as I hinted above, I also wonder about the promptness with which they downgraded DHFL to default status. It’s not a decision that can be reversed right away. Couldn’t they have waited for the 7 day period to expire, before taking that decision? I am no expert and when I spoke to those who are, they told me that the credit rating agencies were simply acting by the letter of the law. Still, none of them could give me a satisfying explanation for the apparent flexibility shown in other recent instances or even in the rating of the parent company of DHFL, Wadhawan Global Capital Ltd (WGC).
Without getting too technical, WGC had issued NCDs whose rating was inextricably linked to that of DHFL. Thus, when DHFL enjoyed a AAA rating, WGC had a AAA (SO) rating. When DHFL was downgraded from AAA to AA, then to A, and then to BBB, so was WGC. However, there was a noticeable inconsistency in the time lag between the downgrades of the two companies. On one occasion, the downgrade happened on the same day whereas on others there was a lag of 3-10 days. And for whatever it is worth, as at the time of writing, unlike DHFL, WGC has not been downgraded to ‘default’ (nor is there any other update to the rating). In that backdrop, it is hard for me to believe that rating agencies cannot exercise flexibility.
Let me then move on to the role of AMFI. It recently came out with “standard” guidelines for how sub-investment grade securities should be valued by mutual fund schemes. Prior to this, it was up to each fund house’s valuation committee to decide and there wasn’t much by way of industry-wide consistency. From that perspective, AMFI’s guidelines should have been a welcome move. Unfortunately, not enough thought went into the details. The result was a blunt tool about which, the less said the better. Among other things, it recommended that securities be marked down uniformly, regardless of their maturity. It is a mystery to me as to why AMFI didn’t simply opt for scrip level valuation for these securities, something which has been talked about for a long time. In any case, in the present instance, I expected fund houses to apply some discretion rather than blindly follow the guidelines.
I have a bigger issue with the fund houses, though, on a different count. It had been a long standing demand of fund houses that they have the ability to create ‘side pockets’ (or segregated portfolios, as they are formally called) of securities that are significantly downgraded. In the event of a default, a side pocket protects the interest of investors who exit after the default but before the money is recovered. It also helps investors who stay put by protecting them from the impact of ongoing sales and redemptions. Yet, despite the fact that SEBI approved the use of side pockets over 5 months ago, barring one exception, fund houses have not yet initiated the process.
But the biggest peeve I have with fund houses isn’t specific to DHFL- it is about understanding and communicating the real nature of debt funds and their risks. Fund houses will not admit it, but most of their salespeople and advisors don’t understand this fact: debt funds are an incredibly complicated investment option.
On the face of it, a mutual fund is a means to invest into an asset class, without some of the attendant risks. Thus, an equity fund is a means to invest in equity shares, and a debt fund is a means to invest into debt instruments. In reality, though, things are much more twisted. While the characteristics of equity funds roughly mirror those of their underlying investments, debt funds have attributes that are markedly different from their underlying investments. Unlike debt instruments, debt funds don’t assure any return and, other than FMPs, don’t have a fixed tenure. One could argue that debt funds distort the very trait of debt instruments that makes them regarded as safe, and appealing to investors. It’s worth asking why should they even be called ‘fixed income’ funds. Furthermore, compared to equity funds, debt funds carry a larger variety of significant risks. The scariest part, though, is that, as we have seen, there are some risks that are hard to fathom or even give a name to.
A few weeks ago, on an online investment forum, an individual reported receiving a notice from the Income Tax authorities, issued under sections 147/148 of the IT Act. Without getting too technical, such a notice is supposed to be served when the Income Tax officer “has reason to believe” that you haven’t disclosed your income fully. This is how that person described what he felt after receiving the notice (warning: contains expletives):
…when I did a quick read about the section under which the letter was sent (147/148)- I started shitting bricks. It's really scary stuff. What got me also worried was that this pertained to FY 2011-12 which was like 7-8 years ago. I started going nuts over whether I had missed out something and if I still had the records from back then.
There’s more. The ITO required him to submit copies of bank accounts, credit card statements, investments etc. for 2011-12 within a period of 5 working days and to meet him in person. By law, there are stiff penalties for not complying with this.
So what has this got to do with investing in mutual funds?
The primary reason for this notice was a dubious interpretation of half-baked information supplied by mutual fund companies to the Income Tax authorities about this person’s investments. If that statement surprises you, here’s a bit of background.
Mutual fund companies (and some other entities) are required by law, to report to Income Tax authorities, specific high value transactions made by their customers each year. For each person, this information forms a part of what is known as his/ her Annual Information Report (AIR). Notably, the type of information that is required to be reported, hasn’t been well thought through. For instance, fund houses are expected to report only purchases (excluding switches) but not redemptions. Consequently, Income Tax officers have been known to use this incomplete information to confront mutual fund investors with allegations of evasion of income, something that happened in the case of the abovementioned person as well.
Net of redemptions, this person had made negligible purchases of mutual funds during the year in question. Unfortunately, his gross purchases were close to twice his salary income for that year. It seems that the ITO pounced upon this fact to allege that this person had not fully disclosed his income. Rather than cross-check this information with the person’s return (which was on record), the ITO preferred to issue him the notice. The way I see it, the ITO was either incompetent and/ or had questionable motives. Be that as it may, I can’t help thinking that had the AIR shown the complete details of purchases and redemptions, this notice might never have been issued.
That’s not the only aspect about the AIR that bothers me. Fund houses are expected to report purchases for each individual, regardless of whether they are the first holder or the second holder, and without mentioning if a person is the first holder or the second holder. To understand how this can cause its own problems, let me share with you the case of a lady whom I personally know.
She is a housewife and has no independent income of her own. Until now, she had never filed a return: in fact she never needed to. In March this year, she received a similar notice from her ITO for undisclosed income because according to her AIR, she made significant mutual investments in a certain year. As it happens, those are all investments made by her husband, where she is the second holder. She tried to explain this fact but the ITO insisted that she first file her return and then submit copies of her bank accounts and mutual fund statements. As in the earlier mentioned case, she was given 5 working days to do so.
While the purpose of the AIR may be to track those who shortchange on taxes, there is little doubt in my mind that honest tax payers as well as honest non-tax payers can end up being troubled, for no fault of theirs. In the course of preparing this piece, I spoke to a few tax consultants. All of them were of the view that such notices could come to anyone whose gross mutual fund purchases (reported in the AIR) are disproportionate to their other disclosed income, irrespective of the actual amount of investment. What’s more, each of them confirmed first-hand experiences of clients being inconvenienced.
My overarching takeaway from this is that being honest, in itself, is not enough: there is a need to be smart. It’s a broken system, so to speak, and there is little regard for your honesty or any general principle of fairness. Being smart is about knowing how they might do so and minimizing the chances of that happening.
While it is up to each one of us to decide what we’d like to do, here are some things that I would include as part of being smart.
Know what kind of information about your investments is required to be reported by mutual fund companies (and other entities). Currently, each fund house is required to report purchase transactions (excluding switches) that add up to more than 10 lakh in a financial year. Here is a link to the relevant section of the Income Tax Rules.
In light of the previous point, decide how you would want to go about making investments (including mutual fund investments). As an example, I have come across investors who go to great lengths to avoid the chance of their mutual fund investment information appearing in the AIR. In the context of the current laws, they prefer to invest just enough in any single fund house to not trigger the reporting requirement.
Be aware of what is actually reported in your AIR. The list of transactions reported by fund houses for each year are available as part of Form 26AS which can be accessed via the Income Tax e-filing website. It could help to check out this form diligently each year. For one, I have seen instances of information being wrongly reported by fund houses. For another, you will be better prepared for the possibility of a notice.
Keep copies of every document that can shed light on your income, including bank statements and investment statements. In the event of receiving a notice, you may have to quickly produce documents pertaining to several years before. In addition, consider keeping copies of credit card statements (including for corporate credit cards, if they are tagged to your PAN). ITOs have been known to ask for these as well.
If you don’t already have a tax consultant, consider identifying one whom you can retain for help. As indicated above, receiving a notice can be a harrowing experience as well as one that calls for swift action. Additionally, it can necessitate several face-to-face interactions with the ITO. Having a resourceful tax consultant can make things simpler. He/ she will typically know what to do, and can take on the responsibility of tackling the ITO. A truly resourceful (and genuine) tax consultant should be able to save a honest client much grief.
Before I close, here’s some food for thought for fund houses. I am not aware of the lobbying efforts undertaken by the fund industry but I find it striking that while mutual fund investments are expected to be reported, ULIPs are not. In any case, as mentioned earlier, in its current form, there is ample room for the information shared with the Income Tax authorities to be misused against the interest of mutual fund investors. While the instances of such cases may currently not be much, it may be best not to underestimate the potential magnitude of the problem. Any investor who has to go through what the aforementioned individuals have gone through, could well decide to stay away from mutual funds for life. Anyone who fears the possibility of something like that happening may well think likewise.
This is only my second post in the last nine months, and while I’d like to believe that there hasn’t been much to write about all this while, the truth is that ongoing priorities have kept me away, not just from writing, but from closely tracking the fund industry as well. Still, thanks to the evolving FMP crisis (which I couldn’t ignore) and the incessant cajoling of my collaborators, for whatever it is worth, here it is.
Anyone who has been following the coverage of the crisis in the media (mainstream and social), would have noted that much of the attention has been on Kotak MF, and on the so-called “safety” of FMPs. In this post, I’d like to move that spotlight a bit. The way I see it, firstly, the risks in investing in FMPs are, more or less, the same as they have been over the last several years. It’s just that many investors, advisors, and fund houses, have been in denial over the fact that portfolio concentration is a much bigger risk than credit quality in itself. While I’ve talked at length about this previously, in this post, I want to talk about the questionable choices made by fund houses this time around, once this risk became a likely reality. Secondly, I feel that looking at the FMP fiasco from the lens of the decisions of HDFC MF (rather than Kotak MF) offers a better picture of what has happened. Investors in Kotak FMPs may have been the first to be visibly impacted, but it was HDFC MF that was the first to make the choices that brought us to where we are.
Let me start by flipping back to a month ago. By my count, there were 6 NCDs issued by three Essel group companies that were due to mature in March. HDFC MF had investments in two of these companies (across 5 NCDs). Most of these investments were held in FMP portfolios. These are the details of those NCDs:
Name of company
Date of Maturity
Edisons Utility Works Pvt. Ltd.^
22 March 2019
22 March 2019
20 March 2019
Sprit Textiles Pvt. Ltd.#
22 March 2019
20 March 2019
^ Since renamed as Edisons Infrapower & Multiventures Pvt. Ltd. # Since renamed as Sprit Infrapower & Multiventures Pvt. Ltd. NCDs whose ISIN is shaded are zero coupon bonds
As you will note from the table, all of these NCDs were slated to mature between 20-22 March 2019. The reason I mention this is because, in the portfolio disclosure made by HDFC MF, all of these investments were shown to be held in the portfolios of its schemes as on 31 March 2019, more than a week after they were supposed to have matured. It begs the question- what happened? If the fund house got back its money on the date of maturity, then why were these investments shown in the scheme books as on 31 March? And if the fund house didn’t get back its money, shouldn’t these investments have been written off?
When I first saw the portfolios, I couldn’t figure out what exactly had happened. Since then, it has come to light that the maturity date of these investments was “revised” to 30 September 2019. But how did something like that come about? Surely, an issuer can’t unilaterally revise the date of maturity. Was this the outcome of the much talked about agreement between the lenders and the Essel group back in January?
Regardless, in my opinion, there can be no excuse for treating non-payment on the original due date as anything but a default. What I find especially remarkable is that three of the NCDs above were zero coupon bonds and accounted for over 61% of the value of these NCDs. To put it differently, these are investments on which the fund house would not have received a single rupee of interest or principal over the last 3 years or so.
It appears that Kotak MF took a similar stance as HDFC MF in respect of the NCDs it held (which matured on 8 April). In its case, it appears that all the NCDs that matured were zero coupon bonds. Personally, I believe that all these investments should have been written off completely.
But coming back to the revision of maturity date, there are two other aspects about this that bother me. The first relates to investment norms for FMPs. As per SEBI regulations, a FMP can invest only into securities which mature before the date of maturity of the scheme. Of the 8 HDFC FMPs that held the aforesaid NCDs, one is maturing on 30 September (i.e. on the revised maturity date). All the other FMPs (including one that has been decided to be rolled over) were/ are maturing not later than 1 July 2019. Going by that, revising the maturity date would appear to be in violation of the SEBI MF regulations.
The second issue that bothers me is the role of the rating agency. In December, last year, the rating agency had put the abovementioned companies/ NCDs on “credit rating watch”. On 31 January, soon after the debacle related to the sale of shares of ZEEL, the rating agency put out a note, stating that the rating remained unchanged. What puzzled me about that note was that the rating agency seemed to base its view more on the stated intent of the lenders and the borrowers, than anything else. Importantly, there was no mention of any change in the date of maturity of the NCDs.
Then on 18 February, it downgraded the ratings by one notch to A, while maintaining the “credit rating watch”. But there was still no mention of the maturity of the NCDs being revised. Its next communication was only on 10 April i.e. three weeks after the original maturity date of these NCDs had passed. It was here that it noted the revised maturity date of the NCDs. From what I could gather, and strangely to me, the rating agency didn’t seem to see this as an issue of any significance. Personally, I think there was a good case for the rating to be downgraded to D.
Looking at this all together, throws up a number of questions. Why did the fund houses not mark down these investments? Was it a coincidence that both Kotak MF and HDFC MF decided the same course of action? Was it a coincidence that the rating agency took a similar view? Or that the rating agency put out its note only after the NCDs held by Kotak MF had matured?
One industry insider, whom I spoke to, offered this explanation for the action of the fund houses: “It’s all about the NAV. They can’t risk showing a low NAV.” That may well be, and there may be other reasons as well. One thing appears certain to me: both these fund houses (and perhaps others as well) appear to be desperate to project an illusion of safety around FMPs. What is worse is that these fund houses are attempting to manipulate investors by playing on their behavioural biases.
Take for instance, the decision by HDFC MF to roll over one of its FMPs. Like some others, I hold the view that the officially stated purpose behind doing so, is a preposterous and sanctimonious assertion meant to camouflage the fact that the scheme has ~20% of its portfolio in Essel group companies. But in terms of their relationship with investors, the roll over strikes me as a way to delude the investors into believing that they never risked losing money.
Similarly, I noted a very careful choice of words by one of the spokespersons of Kotak MF, which also struck me as intended to delude investors. To paraphrase the comment: “The impact is primarily on the returns, not on principal”. To which I am tempted to retort: “Have you ever heard of time value of money?” Even more bizarre was another statement by that person: “I tend to disagree that it is a call gone wrong”.
For anyone still wondering about what the fund houses were thinking, I present this last (hopefully accurate) observation from the latest HDFC MF and Kotak MF portfolio disclosures. While most of the NCDs of Essel group companies were held in FMP portfolios, there were only two open-end debt funds that also held these NCDs. These were HDFC Credit Risk Debt Fund and Kotak Credit Risk Fund. Need I say anything more?
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.
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.