At the time of signing a mutual funds contract agreement, an investor agrees to the chances of risks involved in the investment. The cautionary note — mutual fund investments are subjected to market risks — hardly invites a second glance.
For credit risk funds, the disclosures are even more detailed. But the promise of mouthwatering returns is so overwhelming that it can instantly blind even normally astute investors. There is now an alarming frequency about the fallout — investment calls going horribly wrong and investor money going up in smoke and almost every stakeholder groping in the dark.
Thanks to these disclosures, a fund manager has little to worry — legally — about wrong business calls that ruin investor wealth.What do the Sebi rules say?
Take a look at the regulations of the capital market watchdog for mutual funds. Sebi only insists on transparency and disclosure of these investments. It gives broader guidelines for mutual fund investments and borrowing limits but it is yet to lay down specific rules on fund allocations and liquidity assessment time to time in each type of funds.
Sebi regulations for fund houses only speak of high standards of integrity and professional judgment sticking to the objectives in the offer document.
“Trustees and the asset management company shall render at all times high standards of service, exercise due diligence, ensure proper care and exercise independent professional judgment,” Sebi rules say.
But the regulator can slap a penalty of up to Rs 1 crore on mutual funds for violations relating to investment of investors’ funds, fraudulent and manipulative acts. If violations are severe, Sebi can even suspend or cancel registration certificate of the fund.
Yet, absent are regulations that can hold a fund manager responsible for his wrong business calls. “If he (fund manager) is smart enough, he will lie low for a while and return to a similar role later,” said Naresh Malhotra, a former senior banker with SBI. “It is nearly impossible to hold anyone responsible for business failure under any regulation,” he adds.
But there is an unwritten promise between a firm and client that investors will get their money back no matter what. A fund manager’s legacy and track record is usually the biggest draw for a mutual fund investor.
Fund managers have long been busy preaching to investors that mutual funds are much safer investment bets.
Moreover, mutual funds (MFs) scheme sellers especially target people who aren’t confident enough to invest directly in equities (high risk, high return).
MFs were sold as products that could yield far higher returns than a vanilla bank fixed deposit but less risky than stock market. The notion was that experienced fund managers were skilled enough to see the pitfalls ahead.
With the Franklin Templeton fiasco sinking in as a reality in investor psyche, all those ideas are up for a hard relook.Follow all of our coverage on Franklin Templeton crisis by clicking here
A case for tight regulations?
In the Franklin mess, no single individual can be blamed, according to experts. “In any failure, the responsibility cannot be pinned on an individual, unless decisions were non-transparent, in this particular case, investments were made against the declared risk policy and all investments made were in public domain. Therefore it will be like finding an escape goat for the problem,” said J N Gupta, a former SEBI executive director and founder of proxy advisory firm SES.
"One could say Investor was aware of the high risks. However, managing the risk was business of the mutual fund,” Gupta said.
According to Gupta, Sebi has only set the broader guidelines for mutual funds to invest in companies and it is up to the fund managers to choose the companies and allocation. Sebi cannot micromanage. “We are all intelligent post event,” said Gupta.
Gupta said the debt fund structure was fragile due to high risk. "When COVID-19 came, lack of liquidity made the structure brittle and it crumbled under redemption pressure against low liquidity and the whole thing fell flat."
Not everyone shares Gupta’s view. “Sebi, in light of repeated cases in the past, should have seen this coming. Also, rating agencies and the fund managers can also be held directly responsible for such a situation,” said Jayant Thakur, a well-known chartered accountant.
“Rating agencies and fund managers need to be investigated in the event of a failure and punished if found guilty. In such cases, strong punishment should be given including suspension of licences,” Thakur said.
Rating agencies have often acted late in warning investors attracting penal actions for failing in their duties. For instance, in December last year, Sebi slapped Rs25 lakh fine on ICRA, CARE and India ratings for lapses in assigning credit ratings to non-convertible debentures of IL&FS.
The Franklin Templeton mess has happened despite the stamp of rating agencies on the investment papers. AA/A+ rated papers are lower quality than AAA papers but still indicates holder’s capacity to pay obligations.
There is a long list of AA and below rated papers in Franklin’s list. According to a Mint analysis, the six debt schemes which were wound up on Thursday have high exposure to AA and below rated paper, in one scheme -- Franklin India Low Duration Fund — the exposure is as high as 64.7 percent, Dynamic Accrual Fund has 44.6 percent, Credit Risk Fund 50.2 percent, Short Term Income Plan 58.9 percent, Ultra Short Term Bond Plan 23.9 percent and Income Opportunities Fund 41.3 percent.
Mutual funds are (not always) safe
In its statements after the closure of the funds, Franklin Templeton has blamed COVID-19, illiquid markets and redemptions as the reason for pushing the stop button. True. Markets have been turning illiquid. The depth of Indian corporate debt market is far less compared with global peers. But Templeton’s way of managing investor money, risk diversification strategy, and the selection of papers the fund chose to invest are questionable.
Most of the investments that these funds made under the credit risk category were for AA and below rated companies. The cash flows of these companies were severely impacted in a slowing economy. These include firms like Piramal Capital and Housing Finance Ltd (PCHFL), and Essel Infraprojects, which have 100 percent exposure to Franklin Templeton’s funds. SBFC Finance, another firm in Franklin’s list, posted a net profit of Rs 24.4 crore in March, 2019 and has a total debt of Rs 842 crore.
High concentration in low-rated papers boomeranged?
Santosh Kamath, the fund manager of Franklin Templeton, was once a celebrity among his ilk. There was a time when no one would think twice before handing him a cheque. Kamath carved a new market for debt investors with high-risk AA and below papers. The logic was these funds are unique for investors with high risk appetite for a short-duration. But what investment logic drives a fund manager to be the sole lender to one third of the companies it has invested?
Franklin Templeton was the sole lender to 26 of 88 top borrowers in its six debt schemes, according to a report by B&K Securities. In other words, these firms had 100 percent exposure to Franklin schemes for overall borrowing of Rs 7,697 crore. The names include Small Business Fincredit, Incred Financial Services, India Shelter Finance Corp, Renew Solar Power, Xander Finance, OPJ Trading Pvt Ltd, Vistaar Financial Services and so on.
Clearly, Kamath failed to diversify the portfolio risk and stretched too far in search of lucrative yields. Kamath designed the portfolio for good times, but didn’t prepare for the bad times. The cardinal rule every investment manager dealing with public money — expect the best and prepare for the worst — was given a convenient miss.
As Moneycontrol reported earlier , the logic of selection of some of the low-rated papers are also questionable. If high risk, high return is criteria is surprising. Franklin invested in Edelweiss Agri Value Chain papers at a coupon rate of 8.7 percent, maturing in 2027; Coastal Gujarat Power papers (9.9 percent, maturing in 2028), Nuvoco Vistas Corp (8.57 percent, 2020) and Uttar Pradesh Power Corporation (10.15 percent, maturing in 2021).
It also put money into several lesser-known companies such as Aadarshini Real Estate Developers, Small Business Fincredit, Rishant Wholesale Trading, Northern ARC Capital, and so on. In the backdrop of Franklin fiasco, there are calls for investigation into Kamath's investment decisions from experts and investors.
AMFI does damage control
Franklin fiasco also raises questions on the efficacy of self-regulation of the mutual fund industry. Association of Mutual Fund Industry (AMFI) was quick to assure investors that their money is safe and Franklin is a one-off case.
This is unlikely to calm investors. The tragedy at Franklin’s six schemes didn’t happen overnight. The redemptions began long back in August 2019. The total assets under management (AUM) under the credit risk category declined from Rs 80,756 crore in April 2019 to Rs 58,361 crore in March, 2020, according to AMFI data.
What was AMFI, as an industry body, doing to safeguard investors’ wealth? Also, what is the assurance that similar collapse won’t recur in other schemes? Franklin isn’t a one-off case. What does the impact of Franklin on the industry? According to B&K, it is important for investors not to panic sell and assess the liquidity position of the individual fund house. Of the total fixed income AUM of Rs 13 lakh crore, about 83 percent is invested in high rated bonds.
But investors are unlikely to merely look at the statistics for relief. The trust on high-risk funds is lost. There could be an exodus of money to safer assets. Within the next 12 months, Franklin Templeton has Rs 8,084 crore worth of maturities lined up, said the report. This include names like Edelweiss, ReNew Power, JM Fin and Munjal Group.
PMC, Franklin … which is next?
There is a larger question of investor protection in India. Regulators often hide behind technicalities when unruly executives in financial institutions take investors for a ride. Franklin is not the first, and won’t be the last. Take for instance, the case of PMC bank, where investors’ money is still stuck.
Similarly, Yes Bank, one of the leading private sector banks too collapsed under accumulated bad loans allegedly due to corruptive business practices followed by previous management under Rana Kapoor. The bank was bailed out two months ago by a clutch of banks.
The point here is that be it PMC, Franklin or PMC, regulators have not been able to act in advance to protect investor wealth. The underlying, grim message is that the Franklin Templeton episode won’t be the last.
(Financials of SBFC Finance updated)