This is a guest post by Dheeraj Singh. Dheeraj was a fund manager for many years specializing in fixed income. He used to head fixed income at IL&FS Mutual Fund (before it got taken over by UTI) and subsequently worked with Sundaram BNP Paribas Mutual Fund (now Sundaram Mutual Fund) heading the fixed income desk. He runs Finanzlab Advisors, a treasury and risk management consultancy.
Four years ago, I’d written about how the “Promoter Put” – an implicit assumption that promoters of mutual funds would protect investors from large losses in case of adversity – had led to investor complacency and eschewing of prudent risk assessment. This in turn led to an anomalous situation that investments in funds were decided based on perceived brand value of the promoter entity rather than the actual performance of the fund or skills of the fund manager.
The signalling effect of the “Promoter Put” was strong enough for large investors to invest based on the likelihood of the parent bailing out the fund house in case of adversity. The thinking was – they have a reputation to protect, so why worry – they’ll take a hit to protect us.
Recent developments may have put a small dent to that belief, though, and rightly so.
When RBI clamped down on liquidity and raised some interest rates in an effort to rein in exchange rate volatility, the direct impact of the move was felt in the bond and money markets. Yields on short term securities went up sharply by about 2%. In other words, prices of those securities fell sharply. One category of funds for which this was of special import were liquid funds. Liquid funds are products where you expect the NAV to rise by a small amount every day. Also, since liquid funds hold securities which are of a short maturity, they are allowed to ignore actual price deviations (which in the normal course are generally small) and accrue income at a fixed rate.
However, when actual price changes become large, the value of the funds’ securities (as reflected in it’s NAV) may vary significantly from it’s true market value. When the NAV becomes significantly overstated (meaning the actual prices of the securities in the portfolio are much lower), savvy investors redeem (since they are aware of this divergence in values) and the fund comes under liquidity pressure.
A situation like this was seen on July 16 when liquid funds witnessed large redemptions (largely from bank investors) at a time when prices of the underlying securities fell sharply. This was in the wake of RBI’s actions on the night of July 15.
Even more morbid was the fact that these very same investors would then try and buy the securities (or invest in other alternative securities) at a much higher yield. This would place the fund under even more pressure since selling at a higher yield means locking in the true value of securities which would lead to a fall in NAV. In the past fund houses have tried to protect the fund’s investors by either trying to generate liquidity through alternate means (and thus avoid selling securities) or sell the securities but absorb the losses elsewhere (possibly the asset management company).
A similar situation was witnessed in October 2008 when the fund industry faced a full blown liquidity crisis. What started as a small problem related to exposure to real estate assets in one segment of the industry (viz FMPs) turned into a full blown crisis as funds (in their own wisdom) decided to ignore the true market price of securities and protect investors from losses. The result was that savvy investors walked away and the remaining investors were left holding the baby. When the trickle of redemptions became a flood within a couple of days, there was no shelter and the industry faced a serious liquidity crisis. Even during the extremely stressful days of October 2008, liquid fund returns displayed remarkable stability. Of course, valuation guidelines in 2008 were relatively lenient as compared to what they are today and this allowed the funds to remain within the law in spite of the crisis. However, in their effort to prevent losses to investors, the asset management companies and their parents had to absorb some losses.
Cut to today, and July 16 witnessed conditions similar to October 2008. As is typical in such situations, the industry did face large redemptions once savvy investors realised that the true value of securities had fallen sharply. Most of these investors were banking on the “promoter put” – that they would be protected, and therefore it was better to scoot as early as possible before the situation got out of hand.
However, on this occasion, the industry closed ranks and decided to pass on the valuation losses to investors (in the form of reduced NAV) even in liquid funds. Mutual Funds decided to mark their securities to the true value that they would fetch in the market place. The result was that, possibly, for the first time in the history of mutual funds in India, the liquid fund category gave negative day on day returns (on July 16) across most fund houses.
And rightly so. Mutual Funds are pass through products and investor get to share not just the upside but also the downside. The one day loss suffered by liquid funds on July 16 wiped out about 10 days of returns. This loss will however be recovered in the next 7 days (assuming short term interest rates remain stable). So, the worst affected would be liquid fund investors who invested on or about July 5. They would not witness positive returns for about two weeks. While they may be disappointed, this is fair enough. The RBI action was something that nobody had anticipated, and somebody will eventually be affected adversely.
Had this happened in the past, fund houses which gave a negative return would have faced a backlash and be subjected to outflows to the extent that they may have to almost down shutters. Many people feared the same may happen on this occasion too. However, what actually happened surprised many. Some banks which had redeemed in large numbers decided to cancel their redemption requests, once they realised that the industry was passing on the losses to investors in the fund. Even more importantly, now that the security valuations had been marked down to market yield levels, the daily accruals from the fund also reflected the market yield levels. This meant that fresh investors were duly and fairly compensated on their investments. Liquid funds are now accruing income at close to 10% which should cheer the new investors. These funds should therefore see healthy inflows.
RBI has opened a window of liquidity support for funds. I do not, however. expect funds to use this in a big way. There will be no need to. Even if they face redemptions, fund managers can now sell securities to generate cash since the securities are now marked to their correct market values, and there will be no further loss on an actual sale of securities.
The decision to correctly mark securities to market was an easy one to take, since it was the entire industry which was affected at the same time. The notion of “Promoter Put” being consigned to the dustbin would however be tested only when fund houses face similar situations which are not industrywide. Courage would be on test then.
The events of the past few days have however reinforced one simple belief: It is always good to do the “right” thing.
Disclosure : I have been a senior professional of the fund industry in the past. To that extent, some bias may creep into my writing. Also, I may possess information of and about the industry that may not be generally known. This could have a bearing on how and what I write.
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