Lessons from the Franklin Templeton imbroglio and tips for fund selection

Now that the Franklin Templeton issue is more or less settled, or at least we have a perspective on how it is going to be settled, let us look at the lessons learnt.

Shutting down of funds, in the manner FT did it, was the first time ever, and hopefully would be the last time ever. Having said that, a mutual fund cannot shut down a scheme unilaterally without taking the consent of the unitholders. This is about the interpretation of two different Sections of Sebi’s MF Regulations, and apparently under one Section, referred to by FT, it is possible to simply shut down a fund. From the judgment of the Karnataka High Court, it is now clear that it requires unitholders’ approval.

Portfolio composition or quality of portfolio in debt funds is important, not only to gauge the credit risk, but the liquidity risk as well. While there were a few defaults in the FT portfolios, that was not the primary reason for the shutdown of the schemes. The primary reason was that there were huge redemption in a period when the debt market was tight. The portfolios of these funds were such that it could not be liquidated at the valuation-level prices. FT used to take pride that 26 of the 88 issuer companies in the credit exposures of their portfolio were unique to them. No other AMC had exposure to those 26 issuers. In challenging times, it haunted them as there were no takers for these.

Risk management practices: Risk management practices followed by an AMC is relevant for all debt funds. In ‘AAA’- oriented funds, the risk is lower and in credit risk funds, the risk is higher. The reported forensic audit report findings on the practices followed by FT on risk management and liquidity management will be debated in the court of law. AMCs communicate their internal practices on risk management to investors and advisers. Investors, who do not have the bandwidth to follow as much, can take guidance from advisers/distributors.

AMC Selection

• Track record: The result of the risk management practices followed by an AMC is there in the public domain. Almost every AMC has a credit risk fund, and this category is most exposed to credits as a matter of rule, which is why we are talking of this as a test case. As much as 65% or more of the portfolio has to be invested in instruments rated ‘AA’ or below, as per regulation. Since we had a credit default cycle, starting with IL&FS in September 2018, funds (all categories, including the ‘AAA’-oriented ones) have undergone a stress test. We are talking of real-life stress test here, and not the ones followed by financial entities as per regulation. There are credit risk funds that have come out unscathed with zero default, e.g. ICICI Prudential and IDFC, and there are funds that suffered multiple defaults and returns are still in red. And there are funds that are in between i.e. with moderate impact of defaults.

In FT, in a sense all the six funds shut down were credit-risk-oriented funds, given their portfolio composition. In other AMCs, apart from a few medium duration funds, others are of decent credit quality. The credit risk fund is the gauge for their risk management abilities.

• Portfolio quality: The usual gauge is the credit rating of exposures in the portfolio e.g. AAA, AA etc. This is easy to track and is most widely followed. The higher the exposure to higher-rated instruments, the better it is. Apart from the credit rating per se, also look at the shades. In top rated exposures, higher the component of government securities, the better. In A1+ securities, bank CDs are relatively better than NBFC CPs. Within AAA, PSUs are better than private sector.

Nowadays, there is another gauge to assess credit risk: the debt fund fortnightly portfolio disclosure. Apart from the portfolio, it also discloses the valuation yield level. In case there is a sudden spike in valuation yields, not in tune with market yield movement, it means the market is giving a message on the quality of that exposure. Look at the diversification as well; more diversified the portfolio, lower is the risk on one exposure.

• Skin in the game: As a matter of rule, a mutual fund is required to have a stake of Rs 50 lakh in a fund. But given the large size of some funds, Rs 50 lakh is on the lower side. If an MF has a higher stake, particularly in a credit risk fund, it shows their confidence.

• Liability-side management: Not just the asset or investment side, the liability or unitholders’ side is also relevant. The more diversified is the investor base, the more stability it lends to the corpus.

Conclusion

From the investors’ perspective, all AMCs are regulated by Sebi and there is no scope for any scam in the MF industry. Market risk will always be there, as MFs are vehicles for investment in the market. What we have discussed here are the learnings and some parameters for fund selection, so that you go with the AMCs that follow the best practices. You can take guidance from your adviser/distributor for further details.