Lessons from the Franklin Templeton Episode

Recently, Franklin Templeton Mutual Fund announced that it would wind up six open-ended debt funds. Among others, the fund company’s communication stated:

“There has been a dramatic and sustained fall in liquidity in certain segments of the corporate bonds market on account of the Covid-19 crisis and the resultant lock-down of the Indian economy which was necessary to address the same. At the same time, mutual funds, especially in the fixed income segment, are facing continuous and heightened redemptions”.

“…in close consultation with the investment team, are of the considered opinion that an event has occurred, which requires these schemes to be wound up and that this is the only viable option to preserve value for unitholders and to enable an orderly and equitable exit for all investors in these unprecedented circumstances”.

Simply put, the fund company has stated that running the earmarked debt funds has become untenable, in present market conditions. That’s a rather candid admission for an asset manager to make. Of course, there’s no mention of the investment strategy deployed which also contributed to the present state of affairs; but we will discuss that a bit later. Needless to say, in the Indian context, such a step is unprecedented.     

The Rise

Over the years, Franklin Templeton Mutual Fund made a name for itself by deploying a credit risk (or high-yield investing) strategy in the debt funds segment. On that count, it can be safely stated that not only was it among the pioneers, but also first among equals in the mutual fund industry. The fund company emerged relatively unscathed from the financial crisis of 2008. In particular, its investment team steered clear of real estate securities, many of which defaulted.

Subsequently while most fund companies decided that investing in lower-rated securities was not for them, the team at Franklin Templeton stuck to their guns. It would only be fair to mention Santosh Kamath - CIO-Fixed Income, at this stage. A skilled investment professional, he played a key role in setting up the research infrastructure and building a robust investment team. A driving force of the fixed income team, he yielded considerable influence on investment decisions.

For the next 10 years or so, fixed income funds from Franklin Templeton delivered a strong showing in their respective categories. The performance prompted some of the largest fund companies to emulate Franklin Templeton’s fixed income template, and build dedicated ‘credit investing’ teams.

And the Fall…   

Over the last 18-24 months, credit risk as an investment strategy has been out of favour. A slowing economy, followed by several borrowers defaulting took the sheen off the strategy. When investors turn risk-averse, there is a flight to safety--preference for highest (AAA) rated papers. This in turn meant loss of liquidity in lower rated papers, wherein Franklin Templeton largely operated. It certainly didn’t help that a number of papers held by its funds defaulted as well.

The fund company has been in the news for writing down securities it was invested in (simply put: investments went bad, and the funds suffered losses). Industry sources claim that there has been a run on several of Franklin Templeton’s debt funds, with investors queuing up to redeem their investments.

With no liquidity for its investments, the fund company would have had no choice but to sell its holdings at throwaway prices. This in turn would lead to shrinking net asset value (NAV), prompting more investors to liquidate their investments. A classic vicious cycle. Perhaps that led to the decision to wind up the chosen debt funds.    

If You Are an Investor in Funds Earmarked for Closure

For those invested in funds earmarked for closure, this is an undesirable situation to be in. The only option is to be patient, and hope that the fund company can liquidate its holdings at a reasonable price, thereby minimising your losses. In other words--wait and watch.

What Investors Must Learn

1.    Understanding Risk

Some believe that Franklin Templeton erred by pursuing a credit risk strategy, while others claim that debt funds should simply avoid taking on risk. That line of thought is both flawed and naive. The funds in question didn’t turn risky overnight; they were as risky even when they were delivering returns at a blistering pace, for years. No one seemed to complain then. The only change now is that that the underlying risk has come to the fore.

Market-investing is not without risk—that’s the plain and simple truth. The key lies in the risk being clearly communicated (by fund companies, advisers and distributors) and understood (by investors).

2.    Patience is the Key

While investing in markets, one must have adequate time on hand. While this principle is often mentioned in the context of equity investing, it is as relevant in the case of debt funds. Unforeseen events can and will occur. When that happens, time on hand can provide much-needed leeway to sail through. 

This principle holds good even in the Franklin Templeton episode. For instance, investors in the six funds due for winding up, who aren’t faced with investment goals in the immediate future can patiently wait for maturity proceeds of their investments. They won’t be forced to prematurely liquidate other investments from their portfolios.

3.    No One Is Infallible

Even robust investment strategies will falter at some point; the most skilled portfolio manager will make poor investments. Sadly, that is the true nature of investing. Investors must do their bit to evaluate both portfolio managers and investment strategies. That done, they must also accept the fact that even the best will experience failure and under-performance.

4.    Expect the Unexpected

Perhaps, in the final analysis, Franklin Templeton’s move will be in investors’ best interests. But nobody could have seen it coming. In the mutual fund setup, apart from the portfolio manager and the investment strategy, there’s also the fund company, which is run by individuals. One can’t always predict how they will react to a particular scenario. Hence the need to factor in an additional layer of uncertainty.

5.    Diversify

An investor with 15% of his portfolio held in one of the affected funds will be relatively better off, as opposed to someone who invested 30% of his portfolio. Likewise, an investor invested in debt funds from three different fund companies is likely to fare better than someone who invested his entire debt portfolio with Franklin Templeton.

The principle of diversification is relevant not only in terms of asset classes (read: asset allocation), but also while allocating monies to individual funds.