The Rs 24 trillion Indian mutual fund (MF) industry may have many attributes that it can boast of, but sadly, standardisation is not one of them.
After Dewan Housing Finance (DHFL) defaulted on its interest payments on 4 June- and the subsequent downgrades by credit rating firms on 5 June- different fund houses chose different ways to deal with the crisis and stem the rot.
Tata Asset Management was the only fund house that segregated the bad asset (DHFL papers) under a rule called side-pocketing in MF industry parlance. Other fund houses have either chosen to restrict inflows or just imposed exit loads on investors who choose to come after the DHFL crisis enfolded last week. In doing so, most of the affected fund houses- with the exception of Tata Asset Management- appear to have put their own interests ahead of their investors’.
And here’s what is ironic.
In September 2015, Amtek Auto defaulted on its debt papers, causing huge losses to JP Morgan Asset Management (India) unitholders of two schemes holding those papers.
JP Morgan carved out its holdings in Amtek Auto to minimize the damage to the rest of the portfolio. Back then, there were no formal rules on side-pocketing. Since then, the mutual fund industry had been pushing SEBI to allow side-pocketing. Initially the regulator was reluctant, fearing that a safety mechanism would embolden mutual funds to take needless risks. Eventually, SEBI relented and in late 2018, mutual funds were allowed the option of side-pocketing.
Strangely, other than Tata Asset Management, none of the other funds seem eager to use this mechanism when common sense dictates that bad assets be quarantined.
Let’s try and understand why fund houses are behaving thus.
To ensure that fund houses do not misuse the side-pocketing rule and take additional risks, SEBI put down a number of conditions when it did allow segregation of bad assets. From taking trustee approval prior to creation of a segregated portfolio and communicating with all its investors as well as issuing the press release announcing the logic of its decision, SEBI also mandated a number of disclosures about the segregated portfolios in their scheme information documents, of net asset values of both the good as well as the bad (segregated) portfolios, and so on. SEBI also said that performance incentives of fund managers associated with the affected schemes should be reduced. The latter was one of the two big deal breakers.
The other deal breaker was the exit option that SEBI mandated fund houses to give its investors. To be able to use side-pocketing, a scheme’s information document must have a provision for it. Whether or not the scheme uses side-pocketing in future is another matter.
Because SEBI has classified side-pocketing as a fundamental attribute, amending the scheme information document means all investors get a 30-day exit option. They are free to exit the fund, without paying an exit load, during these 30 days.
All this, for just enabling the fund to use side-pocketing in future, if and when the need arises. The need may never even arise, but what if investors get spooked and choose to exit before that?
Fund managers and CEOs of some fund houses told Moneycontrol in private that this exit option for a period of 30 days without paying an exit load, if present, is risky in these markets.
Already, fund managers say, investors are jittery because of the steady flow of bad news in debt markets. Giving an exit option could lead to a stampede, particularly by investors in schemes with exposure to troubled corporate groups like IL&FS, Essel Group and ADA Group.
That seems to be a lame excuse. Fund houses had a lot of time to start their ground work. SEBI allowed them side pocketing at the end of 2018. The Essel group fiasco unfolded towards the end of January 2019 and concerns about ADAG group’s ability to repay debt started trickling in around February 2019. The DHFL episode happened this month. But fund houses, we hear, were busy negotiating with SEBI to reduce the onerous conditions on implementing side-pocketing, mainly those relating to fund manager bonuses and the exit option. SEBI didn’t budge and precious time was wasted in the process.
This column- as well many fund houses in private- believes that side-pocketing is the cleanest and most transparent way of tackling bad assets in an MF scheme. When bad assets are segregated and inflows and outflows are stopped in the segregated unit, the infection is isolated. As per the norms, inflows and outflows continue in the good units. Side-pocketing also ensures that new investors do not come in the fund in anticipation to make high gains if and when the fund makes recovery from the bad asset. That is because the bad asset is ring-fenced. When the fund makes the recovery, only the existing and affected investors recover all the money.
Many DHFL affected schemes, except those managed by Tata AMC, have stopped inflows “temporarily”. But how temporary, no one knows for sure. Would the MFs keep these schemes shut for months on end till DHFL pays them the dues? Six of BNP Paribas Asset Management India’s schemes closed its doors for new investors on 6 June following the DHFL downgrade. But DHFL paid its dues to two of these schemes on 7 June. The recovery got added back to these schemes, the NAVs went up and the schemes were re-opened yesterday, on 11 June. But how long would all the other “temporarily” closed schemes remain shut? No one knows.
UTI Asset Management seems have taken it to a whole other level. Neither has it opted for side-pocketing nor has it stopped fresh inflows. It has merely imposed exit loads on fresh investments made on or after 7 June; 3 per cent if redeemed before three months, 2 percent if redeemed on or after three months but before six months, and so on. Allowing investors to enter could jeopardize existing investors if UTI AMC recovers its dues from DHFL. New investors would also benefit from the gains. If the NAV gain is substantial, these fresh, albeit opportunistic investors may not even mind paying some exit load and getting out. Meanwhile, the fund house earns its asset management fees on the new investments as well. Many of its marquee debt schemes have been caught out holding DHFL papers; what’ll happen to the fund house if it indiscriminately shuts its doors for all these schemes!!
To be sure, the fund house has marked down its schemes holding DHFL papers by 100 percent, instead of the mandated 75 percent as other funds have done. But that is little consolation if they allow fresh investors a chance to take part in the gains, if and when they happen, at the cost of existing investors.
The fund houses have walked into this mess on their own so it is necessary to walk out on their own as well, especially when Sebi has now allowed them to segregate portfolios, as per their own request. Segregation of portfolios is a neat and clean process and business goes on as usual for everyone. Will the fund houses now start the segregation process before the next catastrophe strikes?