FT Fiasco & Learning from therein . . .

26Apr20

jshah@capital-advisors.in

Late evening of Thursday, 23rd Apr 2020, Franklin Templeton India (FT) announced winding down of six of debt schemes, wherein Credit exposure is high, with immediate effect. The fund house stopped fresh purchase and redemption in these 6 schemes, wherein Assets under Management (AuM) is totaling closer to Rs.26k Cr.

Investors shocked !

Many sad stories are coming from FT investors. Retirees, new house down-payment, child's education fund, medical expenses.... lot many of such dreams have died. It has locked in savings, which were meant to be freely available. Basic tenets of MF investing is flexibility of easy exit - and that got compromised seriously by this action of winding down. Investors invest in Debt MF schemes for the flexibility, knowing that getting exit from direct debt instruments is a challenge. This purpose of MF investing was altogether defeated. Disciplined investors who follow the Asset Allocation, need to re-look at whole of Asset Allocation.

Let's look at the context. Franklin Templeton is ninth largest mutual fund in India. And they were supposed to be key player in the space of Credit. Credit Instruments are basically low credit quality fixed income investment instruments, which are supposed to generate better returns.  Generally speaking, in fixed income, if you wish to generate higher return, you need to take risks - duration risk and/or credit risk. Duration risk is basically betting on longer duration in anticipation of softening of yield and vice-a-versa. Credit risk is basically taking extra risk for extra bit of return. And one can keep on going down in terms of quality of rating, in anticipation of further better return.

FT fund management team were well known for their credit picks  (investing in highly indebted companies or stressed promoters) and that helped in generating extra return (perhaps 200-300 bps extra compared to high quality funds of peers) for last many years. In between, they had few small accidents - example JSPL, but it recovered. So, investors and advisors knew well in advance that what kind of pay-off credit strategy has.

The stress started in credit space after default of IL&FS. There were number of NBFCs and Corporate, which started delaying and defaulting - DFHL, Essel Group, Vodafone, ADAG Group and few more. With this, investors started turning cautious. But, still there were few investors and also advisors, who were still focusing on higher YTM - most of these FT Debt schemes with credit exposure were depicting YTM of 12%+, when overall yields were softening significantly. Widening credit spreads should have rang the alarm in minds of advisors and clients.

Additionally, there were few more data-points which should have raised alarms - dropping AuMs, borrowing in the MF schemes, etc - but were comfortably ignored. 

Now what?

Considering the market situation during lock-down probably, FT fund management team felt that this is the better solution & announced wind down. This is done to safeguard the interest of all the investors - to treat all investors equitably. Otherwise, after some time, exiting investors would have got exit without any penalty & continuing investors would have paid penalty of deteriorating credit quality of MF scheme assets.  In this process, they lose out on future business opportunity, besides trust factor of investors and advisors. 

Isn't this similar to experience of 2008? Many of open ended FMPs (Fixed Maturity Plans) then, were loaded with real estate developer exposures. And global markets corrected taking liquidity out from such debt instruments. Open ended funds experienced exodus of money and few fund houses placed restriction on withdrawals. Few parent companies took such debt papers on their balance sheet with-out any loss to FMP investors. As measure of risk mitigation, later on SEBI made FMPs as close ended product with listing compulsory. Bottom-line is Credit needs to have withdrawal restrictions. Liquidity can evaporate very fast in Credit space.

Now back to 2020 - this has lead to fire-fighting efforts by all fund houses - con-calls, webinars, TV interviews, Presentations, product notes....  - Trying to pacify investors  and advisors/partners, not to press panic button. These efforts itself show that something is seriously wrong and needs immediate attention... Many advisors withdrew Credit Risk Funds from their recommendation lists... Fund houses will be loaded with redemption requests in next few days... Can it trigger yield hardening? Highly possible ... Can it spread to high quality space as well? Possible & will need regulators support to rectify the situation .....

Probably, cascading effect shall be felt. Surely, regulators need to intervene and control the situation at the earliest. Otherwise this may have serious snowball effect. In this process, there are good lessons to be learnt for all stake-holders from this event -

Learning for Investors & Advisors -

1. Ask questions - more and more about investment style of the fund manager and risk profile of each of the investment products. Just don't get impressed by smartness or arrogance of the fund managers. Ask for more granular details, as a routine.

2. Don't try to over-simplify the process. Expected return is NOT reported YTM less expense ratio. Let's build in the credit risk here. Credit risk is binary - its not probability game. Assume all worse possibilities.

3. Advisors need to educate the investors with realistic expectations. PRESERVATION should ALWAYS be priority over GROWTH of Wealth. Chasing numbers may not be always in the interests of long term investors. Credit risk, at times, may result into PERMANENT Loss of Capital - irreparable. Whereas, Duration risk may get repaired over period of time.

4. Be vigilant & EXIT if you are not convinced. Changing economic environment suggests that one needs to be nimble footed.

Learning for AMCs & Regulators -

1. Better to have Credit Risk Funds only through close ended route - extension of 2008 experience.  Also, AMCs need to explore restricted withdrawals policies from such high risk funds, as a regular feature.

2. AMCs need to implement and disclose their credit appraisal process. AMCs need to monitor the liquidity aspect of credit products.

3. Regulators need to ask AMCs to invest in such high risk funds, as a Sponsor. AMCs need to have their skin in the game - say 5% in such close ended Credit Risk Funds - Its an extension of logic that goes into AIFs. 

4. Regulators with the help of government authorities need to broaden (depth and breadth) the Corporate Bond market - with wide variety of differently opinionated participants. Uniform opinionated participants can't grow the market & create serious volatility.

5. Regulators need to monitor that Mutual Funds remain space for Investment products and assure that they don't step into banking products / lending products. For the same, there would be need to empower fund managers of Credit Risk funds with standard legal templates for recovery, in case of defaults. Unfortunately, still we don't have solution to IL&FS problem.