Should Investors Fear Debt Funds Taking Credit Risk?

In October 2008, fixed maturity plans (FMPs) were in the news for all the wrong reasons. The financial crisis had set in, and equity markets had crashed.

Debt markets weren’t spared either: it was feared that papers issued by some real estate and broking firms, among others would default. Several debt funds, including FMPs were heavily invested in such instruments. Amidst tight liquidity, there was a run on fund companies, which in turn led to distress sales, and net asset values (NAVs) crashing. The latter fuelled more panic, and further distress sales.

Roughly nine years hence, I see a similar narrative playing out in the context of debt funds taking credit risk. Admittedly, the level of fear isn’t even remotely comparable as yet, but make no mistake, the narrative is similar.

Every time a credit rating agency downgrades the rating on an instrument, it makes headlines. Media lists which mutual fund portfolios hold the downgraded paper, alongside the allocation. Words such as default and loss are liberally tossed around, leading to fund investors hitting the panic button.

So should investors fear debt funds that take credit risk? Let’s find out.

The strategy of taking credit risk (or high-yield investing) entails investing in securities with a lower credit rating. Such instruments offer a higher coupon rate (versus securities with a higher credit rating). Furthermore, there is a possibility of the price appreciating if the credit rating is upgraded.

Does this investment strategy involve risk—indeed, it does. There is risk of the issuer defaulting on the payment of interest and/or the principal. Often such bonds can be illiquid which further accentuates their risk profile.

Given the risk, should investors shun funds using a credit risk-based strategy? No, and here’s why: The strategy of taking credit risk is as legitimate as any other. Several portfolio managers (both in India and globally) have plied it successfully and delivered pleasing long-term results. A strategy doesn’t become faulty simply because it entails risk.

Some experts argue that investors should only invest in debt funds deploying the duration strategy. That’s a weak argument because failing to read the direction in which interest rates will move, can also lead to losses. A case in point is the performance of debt funds in February 2017, when contrary to expectations, RBI kept policy rates unchanged.

Also, this is a case example of missing the woods for the trees—mutual fund investing is not without risk. Sure, some strategies are riskier than others, but risk is omnipresent.

Investors will do themselves a huge disservice by treating debt funds with a credit strategy like pariahs, and hitting the panic button in reaction to every news story. Instead, a prudent approach will be to acquire an unambiguous understanding of the risk involved, and then decide if they are comfortable taking on the same.

It's worth noting that when investment decisions are based on a combination of fear and ignorance, the results can be rather unpleasant.

Do Fund Companies Dislike Direct Plans?

Recently, I had a rather curious interaction with a fund company. Promoted by a public sector bank, the fund company ranks among the larger ones in the industry.

I invested in an equity fund opting for Direct Plan; as per norm, the payee on the cheque was: XXXX Fund – Direct Plan – Growth; the same was explicitly mentioned on the transaction slip as well. Oddly, the statement of account revealed that I had been allotted units under the Regular Plan.

Assuming that it was a clerical error, I wrote an email to the fund company explaining the facts of the case. To my surprise, they wrote back saying “With regards to your query, we would like to inform you that a broker code (ARN Code) was mentioned in the application submitted by you, hence we allotted the units in regular plan. We request you to kindly contact with the respective branch for further assistance.”

I haven’t engaged a distributor for several years now. Furthermore, even if that were the case, the fund’s Scheme Information Document (SID) states that in cases where a broker’s code is mentioned and the plan mentioned is ‘Direct’, the default plan is deemed to be ‘Direct’.

In effect, the fund company had violated its stated guidelines.

After a significant back and forth over email and several tele-conversations, the fund company grudgingly agreed to modify the plan from ‘Regular’ to ‘Direct’.

This episode got me thinking about why my investment had been earmarked under the Regular Plan instead of the Direct Plan. As was evident from the email, it wasn’t an oversight. Rather, the fund company staff was following laid down procedure. Simply put, they had been instructed to act in a manner that was in contradiction to what the SID stated.

But why would a fund company indulge in such skulduggery?

It is common knowledge that despite Direct Plans having been in existence for nearly four years now, a bulk of mutual fund assets continue to be garnered by distributors under Regular Plans.

Moreover, Direct Plans have a lower expense ratio as compared to Regular Plans since distribution expenses et al are excluded. Also, no commission is paid to distributors under the Direct Plan.

In other words, assets under Direct Plans can’t be utilised to compensate distributors. Sadly for some fund companies, that’s unacceptable because in their books, distributors are more important than investors.

Don’t get me wrong. I’m not making this out to be a 'distributor versus investor' debate. However, the fund company has done so, by creating a mechanism to surreptitiously transfer investments from Direct Plans to Regular Plans.

Distributors have an unquestionable role to play in the mutual fund industry. Fund companies are entitled to utilise their services and compensate them as deemed fit. However in their zest to provide for distributors, investors’ interests shouldn’t be compromised.

Investors on their part must evaluate a fund company’s pedigree while making investment decisions. Fund companies that fail to watch out for investors should be steered clear of.

Mr. Portfolio Manager: It’s About Conviction, Not Guarantees

Over the years, in my several interactions with portfolio managers most have claimed to be big investors in funds they run. Perhaps it was politically correct to do so. Then again, there was no way to independently verify their claims. However, with market regulator SEBI mandating that investments made by managers and the fund company's top brass be disclosed, the scenario has changed.

The disclosures have been startling to say the least. Several long-tenured managers running large diversified funds have nominal investments to show for, while others have chosen not invest in their funds. It can be safely stated that the principle of having ‘skin in the game’ hasn’t been embraced by many managers.

Recently, a manager who has no investments in his funds came up with a novel justification. He stated that a ‘manager investing in his own fund doesn’t guarantee performance’; hence, his investments (or lack of them) are immaterial. To clarify, he isn’t the only manager to have taken that stand. In my opinion, this line of thought is both naive and flawed.

Given their market-linked nature, mutual fund investing entails taking on risk. While the degree of risk may vary depending on the kind of fund chosen, risk is pervasive nonetheless.

So how do investors mitigate risk? By performing an evaluation. For instance, some may focus on quantitative parameters such as past performance, risk-return showing, while others emphasize on qualitative factors—manager skill, investment process et al. It isn’t uncommon for investors to combine the two either.

The portfolio manager’s investments in funds he runs is yet another evaluation tool. A manager investing substantial monies in his funds demonstrates conviction in his investment approach and acumen. It’s a classic example of putting one’s money where the mouth is.

None of the evaluation parameters can guarantee performance. But that in no way diminishes their relevance. Of all people, a portfolio manager should be aware that there are no guarantees in his domain. Investing in markets akin to a business of risk, not a business of guarantees. Does the fact that there is no guarantee of returns, prevent the manager from exhorting investors to invest in funds he runs?

I have no doubt that some managers will continue to steer clear of investing in funds they run. But they would do well not to trivialise the importance of having ‘skin in the game’ using inane arguments. As for investors, I am certain that like me, most will be wary of the chef who doesn’t eat his own cooking.

Why Indian Fund Companies Shouldn’t Fear Greater Transparency

Media reports suggest that several Indian fund companies are at loggerheads with market regulator SEBI. The latter wants to increase transparency by disclosing commissions paid to distributors in investors’ statements of accounts. On the other hand, fund companies believe that doing so will be detrimental to their interests. According to reports, industry body AMFI has communicated its reservations to the regulator.

Reasons for opposing the move are varied: some fund companies think disclosing commission-related information will dissuade investors. Others feel that bombarding investors with too much information will be detrimental. 

To my mind, the concerns raised by fund companies are both misplaced and weak. To begin with, the proposal doesn’t alter the working of the fund industry in any manner. Fund companies pay commissions to distributors for selling their products (and rightly so!); all they need to do is disclose the same to investors (who bear the cost). No one’s suggesting that fund companies should stop compensating distributors.

As for fears of investors becoming upset by learning about commission payments, or becoming confused on account of too much information—those are weak arguments. Fund companies would do well not to underestimate the investor’s intellect. To assume that an investor who is satisfied with his investment will turn his back on it, because the agent’s commission is disclosed is a fallacious argument.

When an investor invests in a mutual fund, effectively he engages a fund company to manage his monies. The fund company charges a TER (comprising everything from operational expenses, the fund company’s fees, to the distributor’s commission) for the service. An unambiguous disclosure will aid investors better understand the fund’s working, and thereby make informed investment decisions.

For instance, a fund company which keeps costs (including fees and commissions) low and thereby enhances the fund's returns can benefit by communicating the same to investors. It can be safely stated that such disclosures will go a long way in winning investors’ patronage.  Conversely, the investor has a right to know if his fund is losing its competitive edge on account of exorbitant commission pay-outs.

Case for more disclosures

I’m surprised that in its quest for greater transparency, SEBI didn’t start at the top of the pyramid i.e. with fund companies. There is a strong case for making public, information related to the fund company’s compensation policy for its investment staff (portfolio managers and analysts), and also information regarding a portfolio manager’s personal investments in funds he runs.

Taken together, the two can reveal a lot about the fund company’s culture, its attitude towards investors, and a manager’s commitment to his fund—all of which can be vital in helping investors make better decisions. 

Admittedly, from the perspective of fund companies, revealing information that hitherto was private can be discomforting. But it is in their interest to embrace this change. Greater transparency isn’t an end in itself. The intent is to improve investors’ investment experience, and in turn make mutual funds more appealing. And when the investor wins, so will fund companies.