Why Investors Shouldn’t Deify the Portfolio Manager

In the recent past, debt mutual funds have witnessed two significant events. Oddly, these seemingly unrelated events have evoked an identical response from investors.

In the first week of February 2017, RBI’s Monetary Policy Committee unanimously voted in favour of keeping policy rates unchanged. It was widely anticipated that the central bank would cut rates in keeping with the accommodative stance it has adopted over the last two-odd years.

Debt markets reacted negatively to the pause in rate cuts, with bond yields surging sharply.

Several portfolio managers running debt mutual funds had increased the maturity of their portfolios, to capitalise on the anticipated rate cut. Expectedly, their performance took a significant hit.

Last week, some debt funds from Taurus Mutual Fund were in the news on account of their poor showing; the funds posted losses ranging from 7% to 12% in a single day. The reason—they were invested in debt instruments from Ballarpur Industries. A credit rating agency downgraded the issuer’s long-term rating, on account of “delays in debt servicing by the company”, among others. The episode brought back memories of similar instances that have occurred in recent times.

In both the aforementioned instances—RBI keeping rates unchanged, and Taurus Mutual Fund’s credit bets—it is evident that portfolio managers were pursuing distinct investment strategies. In the former, managers were engaging in duration plays, while in the latter, taking credit risk was central to the strategy. However, both strategies came a cropper to the chagrin of investors.

Deifying the Portfolio Manager

Since then, I have had conversations with several investors. The most common refrain was that portfolio managers are to blame. But the grouse wasn’t along the lines of the justifiable “portfolio managers need to take responsibility for poor investment decisions”.

Rather it was akin to “how could the portfolio manager make a mistake?”

On digging deeper, I learnt that their rationale was: The portfolio manager is an investment expert. He gets paid a sizeable compensation for running the fund. Hence he shouldn’t be making a mistake, and as a result, exposing investors to a loss.

I was surprised to note that many investors view the portfolio manager like a superhero who cannot err. And therein lies a fundamentally flawed line of thought.

Selecting the Portfolio Manager

Admittedly, the portfolio manager plays a significant part in determining the fund’s fortune. Also, it must be stated that portfolio managers encompassing the entire spectrum—mediocre to supremely talented—exist in the mutual fund industry. Hence, the importance of selecting the right portfolio manager cannot be overstated.

One would expect the manager to be skilled, and have proven his mettle over the long haul. He must have successfully plied his craft across a market cycle. Furthermore, he needs to demonstrate confidence in his abilities by investing substantial monies in his funds alongside investors.

Simply put, the portfolio manager must indisputably earn his stripes before investors can entrust him with their monies.

Pragmatic Expectations and Evaluation

On their part, investors must be pragmatic while evaluating the portfolio manager. Investors would be justified in expecting the manager to get more calls right than wrong. For instance, a manager running an active strategy is expected to beat the benchmark index over the long haul.

However, expecting him to never err, or deliver a positive return consistently is unrealistic. Even the best of managers, can and will make a poor investment decision at some point. That is par for the course in market-linked investing.

Idolising the manager can also hurt investors by preventing them from making an accurate evaluation when the manager hits a purple patch. Consider the case of a manager who takes on unduly high risk to clock superior returns.

The Flipside of Deification

There’s a marked difference between holding the manager to high standards, and having unrealistic expectations. The latter can lead to disenchantment, and investors turning their back on mutual funds.

Sadly, investors whom I interacted with seemed to be leaning in that direction. They have jumped to the conclusion that since the portfolio manager cannot guarantee success, they are better off investing on their own. For most, that isn't the right course of action.

What Investors Must Do

Investors would do well to understand how portfolio managers operate, and then devise an evaluation system that works for them. A manager who fails to retain the investor's confidence should be penalized.

But deifying the portfolio manager and expecting him to deliver in a like manner is neither rational, nor in the investor's interest.

Investment Lessons From The JPMorgan Mutual Fund Episode

In the recent past, JPMorgan Mutual Fund has been in the news for all the wrong reasons. To begin with, it was reported that two of its debt funds i.e. JPMorgan India Treasury Fund and JPMorgan India Short Term Income Fund have suffered substantial losses on account of investments in an auto ancillary company—Amtek Auto. The latter is facing a financial crisis of sorts; in its communication with stock exchanges, it has mentioned a decline in operational performance, cash flow mismatch and steps being taken to counter the same. To further worsen matters, in Aug 2015, CARE (a rating agency) suspended its ratings of Amtek Auto stating that “the company has not furnished the information required by CARE for monitoring of the ratings”.

Expectedly such developments can hurt the price of the company’s debt issuance, and in turn the performance of mutual funds invested in these papers. Furthermore, the fund house decided to limit redemptions in the aforementioned funds “in the general interest of the unit holders”.

This entire episode has been curious to say the least. However, it offers some important investment lessons.

1. Evaluate the fund house’s character

Mutual fund investors are often guilty of not evaluating the fund house’s character before investing. This can prove to be a costly miss. The fund house’s character will go a long way in determining its policies, attitude towards investors and even the long-term performance of funds. While it would be unfair to draw conclusions on JPMorgan AMC based on a single incident, the asset manager’s decision to restrict redemptions does not portray it in a good light.

It must be clarified that the Scheme Information Documents of both funds explicitly state that the asset manager can restrict redemptions. Hence JPMorgan AMC’s actions are in line with stated policy. The trouble is that both funds are open-ended in nature wherein the implicit assumption is that investors are free to liquidate their investments at market price when they choose to do so. In the Indian mutual fund industry, this is the norm. On this count, the AMC has let its investors down. 

If investors in the fund are willing incur a loss, while liquidating their investments, that choice should be available to them. More importantly, if the AMC is truly concerned about investors’ best interests, it can compensate them for the losses incurred with their own monies. Conversely, limiting redemptions while they put their house in order amounts to penalizing investors for the AMC’s mistakes. A crisis will typically reveal true character, and in this case, JPMorgan AMC doesn’t come out smelling of roses. Hence it is pertinent that investors pay attention to the fund house’s character before investing. 

2. Debt funds are not risk-free investment avenues

A popular misconception suggests that debt funds are risk-free investment avenues. Admittedly, certain debt fund segments do expose investors to less risk versus say an equity fund. But treating them as risk-free investment avenues is plain erroneous. Being market-linked investments, debt funds are prone to risks such as interest rate risk and credit risk. Investors who wish to invest in risk-free instruments should stick to avenues such as small savings schemes (which are backed by a sovereign guarantee). 

Let’s focus on credit risk which is relevant to the case. Debt fund managers are known to take credit bets (invest in lower rated securities) to deliver outperformance. While the investment strategy is commonly deployed, as is often the case, some portfolio managers are more skilled than others, resulting in varying results. Clearly in the case of the two JPMorgan funds, the results were less than desirable.

It isn’t uncommon for some distributors and advisors to present debt funds as risk-free investment avenues. Irrespective of the reason – ignorance or mala fide intent – investors can and do end up being misled. Hence, they would do well to understand the true nature of debt funds before investing.

3. Participate in the investment process 

Yet again, this episode reinforces the need for investors to actively participate in the investment process. Admittedly, that is easier said than done. But investors should find motivation from the fact that their personal wealth is at stake. I’m not suggesting that investors become investment experts. Then again, being completely uninvolved is not prudent either.

For instance, while it helps to engage the services of an investment advisor, blindly acting on his advice isn’t recommended. Quiz him on his recommendations—enquire about the rationale, the risks involved, alternatives and how they stack up versus his recommendations. Additionally, it would help to read up about investing from independent and credible sources. The intention is to become informed investors. Apart from making better investment decisions, this will also help investors deal with testing periods in an assured manner.