Debt Funds: Liquidity Matters, But Managing Liquidity Is The Key

Recently, I read an article written by an individual who is considered an expert on mutual funds. Weighing in on the ongoing debate of debt funds taking credit risk, he came up with an interesting solution--modify the structure of funds investing in illiquid securities, whereby redemption requests don’t have to be met immediately. The rationale being: the combination of investments in illiquid securities and an immediate redemption facility is at the root of the crisis. Hence the solution lies in permitting fund houses to make delayed redemptions. 

On the face of it, the recommendation seems reasonable. But scratch the surface, and the solution will appear simplistic. Here’s why:

To begin with, in a mutual fund, a portfolio manager’s role is not restricted to just identifying lucrative investment opportunities, and making timely investments. His ability to proficiently managing liquidity in the portfolio is no less important. Skilled portfolio construction can enable a manager to navigate unexpected market events (and handle redemption pressure) without unsettling the portfolio, or with minimum disruption to the portfolio. In other words, the presence of illiquid corporate debt in the portfolio need not make the portfolio illiquid. Indeed, liquidity management is one of the parameters on which the manager and his investment process must be evaluated. It is inexcusable for a manager to compromise the portfolio’s liquidity in a bid to clock higher returns. To my mind, such a scenario portrays the manager’s investment skills in poor light.

Furthermore, defining what constitutes a liquid investment is easier said than done. For instance, to suggest that only corporate bonds are illiquid wouldn’t be accurate. A cursory glance at data for trades in the benchmark 10-year GOI bond versus those for other GOI bonds reveals a telling picture. Market conditions and sentiment can significantly impact liquidity. In buoyant markets, the corporate debt segment can be more liquid than in a downturn. A parallel can be drawn for equity markets as well, wherein small/mid-caps typically tend to be more liquid during an upturn. Clearly, defining which funds invest in illiquid instruments (as has been suggested in the article) is more complicated than it has been made out to be.

Finally, there’s a need to discuss where the onus must lie: should investors be asked to tone down their expectations on the liquidity front, or should fund houses be responsible for performing better on the liquidity management front? 

In many ways, the financial crisis of 2008 proved seminal for the Indian mutual fund industry. Several debt funds (including close-ended products such as fixed maturity plans) witnessed extraordinary redemption pressure. Subsequently, SEBI put safeguards in place by prohibiting fund houses from providing premature redemption for close-ended funds and defining the investment profile for liquid funds, among others. Some fund houses and managers went back to the drawing board and re-evaluated their investment philosophy, especially for the debt funds segment. In turn, this equipped them to better manage liquidity in their portfolios. 

Present regulations governing redemptions are not only comprehensive, but reasonably indicative of how investments should be made. Hence, there is no valid reason for creating a third structure (a middle ground between open- and close-ended funds) to make up for a fund house/manager’s incompetence. As for fund houses which can’t make the grade, the ‘perform or perish’ maxim is apt. 

Should Fund Houses Fear Big-Ticket Investors?

Media reports suggest that a questionnaire from the country’s largest bank -- State Bank of India (SBI) has sent several fund houses running for cover. Apparently SBI invests substantial monies in debt mutual funds; last week, the bank sent a questionnaire to fund houses, seeking information about their investment practices and policies. Among others, SBI has asked for information on fund houses’ policy for compensating investors in the event of a loss incurred due to a default or downgrade. Clearly, the JPMorgan Mutual Fund episode continues to rankle investors.

Investors wanting to know more about a fund house’s investment practices is understandable. Indeed, one expects them to perform such due diligence before making an investment, rather than after investing. The curious part pertains to seeking compensation in the event of a loss. It doesn’t take a genius to figure out that mutual funds are market-linked instruments; hence the possibility of incurring a loss cannot be ruled out. Given that fund houses operate as pass-through structures, expecting them to compensate investors for a loss incurred in the normal course of investing seems farfetched. So why would a behemoth like SBI seek such information? For the answer, let’s step back in time.

Hail big-ticket investors!

The mutual fund industry’s fondness for big-ticket investors (institutions and high net-worth individuals) is no secret. Over the years, this liking has manifested itself in various forms: institutional plans with liberal expense and load structures (versus retail plans), launch of fixed maturity plans that enabled a handful of big-ticket investors to make quasi-PMS investments. In the 2008 meltdown, several fund houses did their best to protect large investors in debt funds, by transferring illiquid securities to equity funds. In effect, liquidity was provided to large investors at the cost of retail investors (who largely invest in equity funds). Over time, it took intervention from the market regulator SEBI (in the form of abolishing differential expense and load structures, and instituting the 20-25 rule, among others) to create a level playing field. 

But then old habits die hard. Perhaps some big-ticket investors have a sense of entitlement which leads them to believe that mutual funds should be structured as  risk-free (at least in part) investments for them.           

The counterview 

Data from AMFI reveals that as of Sep 2015, debt and liquid funds accounted for roughly 67% of mutual fund assets. In both the segments, a lion’s share (62% in debt funds and 92% in liquid funds) was held by institutional investors. Simply put, a bulk of mutual fund assets come from institutional investors. Fund houses can claim that they are obligated to offer these big-ticket investors preferential treatment. But such thinking is flawed.

Any serious fund house knows that long-term assets are the key to survival and growth. Yet again, data reveals that fund categories wherein retail investors dominate tend to display longer investment horizons versus categories wherein institutional investors dominate. Hence, it is in the interest of fund houses to offer retail investors a fair deal.

If fund houses find themselves in a vulnerable position, they must shoulder at least part of the blame for having failed to democratize investments. Several fund houses have been guilty of chasing short-term institutional monies and failing to develop a strong retail investor base.

It will be naïve to believe that any fund house will offer to compensate SBI for losses incurred in its schemes. It’s high time self-respecting fund houses send an unambiguous message: The era of offering preferential treatment to big-ticket investors (and treating retail investors as second-class citizens) is over. It is in the best interest of fund houses to come to terms with this realisation and act on it at the earliest.

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.

Don’t let the tax bogey affect your mutual fund investments

It’s official. The Finance Ministry has clarified its stance on taxation for non-equity mutual funds regarding the ‘retrospective’ aspect. Also, it is evident that there will be no rollback in other proposals; Finance Bill 2014 has been passed by the Lok Sabha and is now awaiting a nod from the Rajya Sabha. For all intents and purposes, fixed maturity plans (FMPs) have lost the tax advantage they enjoyed over fixed deposits (FDs), and now debt fund investors must have an investment horizon of at least 36 months if they wish to reap tax benefits on long-term capital gains.   

An interesting outcome of this development has been in the form of investment advice. Experts are falling over each other trying to determine which investment avenue is best suited for individuals in specific tax brackets. For instance, statements such as “if you are in the lowest tax bracket then FDs make sense, however for those in the highest tax bracket, long-term debt funds will be the best bet” have become commonplace. Fund houses seem to have been caught up in the frenzy as well. Media reports suggest that some of them are trying to extend/roll over one-year FMPs for a further 24-month period so that investments therein will become eligible for long-term capital gains.

The trouble with this tax-focused muddle is that it contravenes the basic principles of investing. Don’t get me wrong—I’m not suggesting that tax implications should be ignored; however, they certainly shouldn't be the primary basis for making an investment. For instance, a fundamental difference between FDs and debt funds (including FMPs) is that the former offer safety of capital and assured returns, while the latter are market-linked investments i.e. the capital invested is at risk, and there are no assured returns. It is imperative that investors first get a fix on what their risk profile is, and accordingly pick an investment avenue, rather than start off by evaluating which avenue is more tax-efficient.

Likewise, the investment horizon is no less important. Consider a scenario wherein an investor in the highest tax bracket has surplus monies to put away for 18 months. It would not be prudent to invest in a 3-year FMP only because the taxation thereon is more liberal versus that on an 18-month FD. Simply put, investors must focus on aspects such as risk profile and investment horizon, before considering the investment’s tax-efficiency. Failing to do so could result in investors deploying monies in avenues unsuitable for them, and for inapt tenures as well.   

Arbitrage funds to the rescue…

If the aforementioned experts are to be believed, debt funds have lost their appeal for good, and now investors should focus on a new silver bullet—arbitrage funds. Sadly that argument is both preposterous and flawed.

Arbitrage funds operate on the premise of exploiting mispricing opportunities between the cash and derivatives markets. They thrive on market volatility. At its core, it is a straitjacketed approach since it will only deliver in certain market conditions. Furthermore, unlike debt funds which invest in fixed income securities, arbitrage funds operate in the domain of equities—so much for their likeness. If you are wondering why arbitrage funds exist in the first place—the answer is herd mentality. In the NFO-driven era of 2005-06 when a couple of fund houses launched arbitrage funds, others followed suit lest they be left behind. Like most NFOs, the launch of arbitrage funds had little to do with conviction in investment merit.  

So why have arbitrage emerged as the season’s flavour? Because they are treated as equity funds for taxation (read liberal tax rates and provisions) while plying a market-neutral strategy. On their part, investors would do well to steer clear of experts who profess that arbitrage funds make apt replacements for debt funds. 

Admittedly, a higher tax liability on debt fund investments is taxing both literally and figuratively. But trying to circumvent it by investing in unsuitable avenues will only make matters worse. The solution lies in coming to terms with the new scenario and staying the course.