Time for a rethink on MF regulations

The Indian debt market witnessed a series of major set-backs over the last 18 months or so, triggered by the IL&FS default towards the end of 2018, followed by a spate of collapses  - most notably of DHFL and Yes Bank – and culminating in the present phase of gloom and doom occasioned by the Covid-19 outbreak in March, 2020. Among other consequences of the convulsions caused by these events, there has been an unprecedented outflow of funds from the open-ended, closed-ended debt/fixed income schemes and hybrid schemes of mutual funds (MF) in India. In 2019-20, the net outflow from open-ended and close-ended debt/fixed income schemes were Rs. 4778 crores and Rs. 33810 crores respectively. Some reports put the gross outflow in March, 2020 at a whopping Rs. 1.94 lakh crores.          

Woes of few MFs

Amid the debt market turmoil, Franklin Templeton (FT) segregated its investments in certain debt securities of Yes Bank and Vodafone Idea from six open-ended debt/fixed income schemes and one hybrid scheme, taking advantage of a dispensation permitted by the SEBI for this purpose in December, 2018. Around the same time, two more MFs have announced delay in redemption of several of their close-ended debt/fixed income schemes, on account of their large exposures to the struggling Essel group.

Some reports put the gross outflow in March, 2020 at a whopping Rs. 1.94 lakh crores.

These developments attracted attention of the authorities, resulting in the announcement of a Rs. 50, 000 crores liquidity support measure for MFs by the RBI on April 27, which, however, proved to be a non-starter as its actual utilisation was a paltry Rs. 2000 crore. A bit of comical relief in this otherwise dire situation was provided by a high-profile politician with his desperate but laughable attempt to politicise the events by stating that the government should have rescued the FT schemes in question.

Deeper causes

It is easy and tempting to attribute the segregations by FT and the redemption difficulties in two other MFs as being caused solely by the present severe liquidity difficulties in the debt market. But a deeper look would soon reveal that the liquidity stress has only brought to the fore the underlying shortcomings in the portfolio management of the schemes that went unnoticed for a long time – too much credit risk for comfort. This, in turn, was caused by a significant departure from the tenets of professional portfolio management relative to a benchmark, taking advantage of the inadequacies of the regulatory prescriptions in this regard. 

Significance of benchmarks        

In general, a portfolio benchmark serves the following purposes: One, it embodies the risks the portfolio manager is expected to take to achieve the strategic return objectives of the investors. Two, the total rate of return on the benchmark provides a measuring gauge for the actual portfolio return. Three, the deviations in terms of risks (credit, interest rate and liquidity risks in the case of debt/fixed income schemes of MFs) of the portfolio vis-à-vis its benchmark can only be tactical and not strategic. Four, from the point of view of the investors, the expected risks of the portfolios (schemes of MFs) are those underlying their benchmark.

The brutal truth about taking too much credit and liquidity risks vis-à-vis benchmark, as a matter of strategy, is that the impressive extra returns that this may generate in few years, even in a row, get more than wiped out in a bad year.

Hence, in all professional arrangements for portfolio management of funds, the permitted risk deviations from the benchmark are defined and disclosed upfront. An upshot of the foregoing is that if the actual risk exposures of a portfolio usually differ too much from those of its benchmark, then the benchmark is a faulty one. If such faulty benchmarks are permitted, then they create wrong incentives for the portfolio managers to take excessive risks at the cost of the investors.  A comparison of the risk profiles of the seven schemes (post-segregation) of FT as on March 31, 2020 and their benchmarks will drive home this point (Table 1).        

Table - 1

 

FT Scheme’s Risk Profile

Benchmark

Benchmark Risk Profile

Risk Divergence

Credit Risk

Modified# Duration

 

Credit Risk

Modified Duration

Credit Risk Fund

No AAA-rated debt, 50% in A-rated or below

2.11

NIFTY Credit Risk Bond Index

Aggregate of 15 sub-indices of which 4 are AAA-rated, 9 AA-rated and 2 A-rated

1.64

Very high

Debt Hybrid Fund

45% in gilt and AAA-rated

3.53

CRISIL Hybrid 85+15

Aggregate of 8 sub-indices, of which 4 are Gilt and AAA-rated, whose combined weight is over 70%  

4.99

Very high

Dynamic Accrual Fund

 

No gilt, only 0.95% in AAA-rated

1.81

CRISIL Composite Bond Fund Index

 

Aggregate of 7 sub-indices, of which 4 are Gilt and AAA-rated, whose combined weight is over 70%  

4.99

Extremely high

Income Opportunities Fund

 

No gilt, almost entirely in AA-rated or below

3.0

NIFTY Medium Duration Debt Index

Aggregate of 5 sub- indices, of which two AAA-rated and one Gilt

3.11

Very high

Low Duration Fund

 

Almost entirely in AA-rated or below

1.12

NIFTY Low Duration Debt Index

 

Aggregate of six sub-indices, of which one AAA-rated, one AA-rated and 4 CP/CD (A+ rated)

0.54

Very high

Short-term Income Plan

 

Almost entirely in AA-rated or below

2.06

CRISIL Short Term Bond Fund Index

Aggregate of 9 sub-indices, of which 3 are AAA-rated and one Gilt, whose combined weight is 67%

1.64

Extremely high

Ultra-short bond Fund

 

Almost entirely AA-rated or below

0.61

NIFTY Ultra Short Duration Debt Index

Aggregate of 6 sub-indices of which one is AAA-rated and 4 CP/CD (A+ rated) 

0.24

Very high

# A measure of interest rate risk

(Source: www.franklintempletonindia.com)

 

Excessive risk-taking destroys value

The excessive risk-taking never benefitted the investors, as the schemes underperformed their benchmarks, most notably in 2019-20. Both the 1-year and 5-year return performances of the all the seven schemes of FT were way below their respective benchmarks.  The brutal truth about taking too much credit and liquidity risks vis-à-vis benchmark, as a matter of strategy, is that the impressive extra returns that this may generate in few years, even in a row, get more than wiped out in a bad year. This is most vividly illustrated in the case of Dynamic Accrual Fund and also in the case of Ultra-short Duration Fund, where the risk as well as return divergences vis-à-vis their benchmarks were a kind of extreme.

Fund management in a fiduciary capacity is not a fun-filled way to earn high bonuses by garnering smart ‘accruals’ – a desi term for extra yield coming from debt instruments with higher credit and liquidity risks.

In fact, the high credit risk taken in both of them defies any logic. However, to be fair to portfolio managers, another truth must also be told: credit ratings of debt issuances in India have little use left from a risk management point of view. Inevitably, the managers are guided by their own assessments in taking risk decisions in a flexible manner. This explains the preference for aggregate benchmarks and not any of their sub-indices that would better reflect the portfolios’ risk exposures.       

Regulatory inadequacy

SEBI’s regulations on the choice of benchmarks by MFs are imprecise and are, therefore, prone to misuse. For debt schemes there is a requirement that the benchmarks should be a ‘suitable index that is a representative of the fund’s portfolio’, which has been interpreted by different MFs in their own ways that suited them. And, of course, any excess portfolio return vis-à-vis the benchmark has routinely been publicised as ‘alpha’, even when there were significant risk differences between the two.   

Fund management in a fiduciary capacity is not a fun-filled way to earn high bonuses by garnering smart ‘accruals’ – a desi term for extra yield coming from debt instruments with higher credit and liquidity risks. The regulators owe it to the investors to undertake meaningful reforms in the MF industry and credit rating businesses in India.      

(Himadri Bhattacharya is a former central banker and a consultant to the IMF)