The evening of April 23, 2020 was a watershed moment in the history of mutual funds in India. Six Franklin Templeton debt funds were shut down by the management, due to redemption pressure and lack of liquidity in the secondary market for the underlying instruments. It was not the first time that a mutual fund (MF) scheme faced redemption pressure. Liquidity in the secondary market for bonds, particularly those rated less than AAA, has always been a challenge. Then what was different? It was the decision of the AMC (asset management company) / MF Trust to close down the funds.
There have been precedents earlier that a debt fund faces redemptions, and sells in an illiquid secondary market, thus resulting in losses. The negative NAV or negative returns lead to a vicious cycle of further redemptions from other unit-holders who become apprehensive. But those AMCs did not shut down any scheme, as mutual funds are vehicles for investment in the underlying market, and profits / losses are part of the game.
FT’s funds shut to avoid distress sale
These six funds, given the credit profile they had, delivered meaningful returns over the years. Due to the COVID-induced uncertainty in the debt market during March-April 2020, liquidity for bonds became quite limited. The decision to shut down funds, so as not to engage in distress sale in an illiquid market, but sell over a period of time to protect unit-holders’ interest, was a bold one. It was bold because it was obvious that there would be negative consequences – investors would go through anxiety, stress and fear of loss.
But FT’s expectation was that once secondary market liquidity normalizes, the outcome was likely to be positive for investors. There was a question of legality as well, in terms of interpretation of the provisions of the SEBI Mutual Fund Regulations, which has been clarified subsequently by the Karnataka High Court. MF schemes cannot be shut down unilaterally; they require unit-holders’ consent, and they voted in favour of the shut-down as that was the better choice in that situation. Now that it has been more than one year, and we have had a very pragmatic judgement from the Supreme Court of India in terms of handing over the sell-and-pay-back process to SBI Mutual Fund, let us look at the costs and outcomes.
Costs: Tangible and intangible
Liquidity: The premise for investing in open-ended MF schemes is the availability of sufficient liquidity. There is exit load charged by some schemes, but that is not an absolute lock-in, just an exit penalty. When FT shut down six funds, liquidity for unit-holders was non-existent, in the immediate term. As per SEBI rules, a fund cannot stop redemptions, but for some extreme conditions mentioned in its guidelines. However, when a fund is shut down, it goes into a different tangent altogether. The intention of FT was to start paying back unit-holders gradually, from accruals in the portfolio and fair-price sales. However, since the matter went to the court of law, liquidity was curtailed.
Reputation of the AMC: a shutdown leads to a negative perception about the business house, including the funds that are doing business in the normal course. Investors and prospective investors become jittery and tend to look for other alternatives.
Contagion: For some time, after April 23, 2020, there was redemption from funds of other AMCs, as there was a perception that “mutual funds sahi nahi hai” (something wrong with mutual funds). As the redemptions were being met by all the AMCs, investors gradually realized that there was no need to panic.
After more than one year, returns – NAV to NAV – from those six shut funds are not only positive, but mostly in double digits. This is after the regular accruals in the portfolio (interest on the instruments), selling off some of the holdings for paying back to unit-holders, valuation of the existing holdings as per current market levels and pre-mature pay-back by some of the issuers in the portfolio. Had the schemes not been shut, with liquidity being made available for unit-holders, distress sale in April-May 2020, would have resulted in a vicious cycle and negative returns.
On paying back unit-holders, as mentioned earlier, the Supreme Court of India delivered a pragmatic judgement. SBI Mutual Fund is in charge of selling the assets in the portfolio of these six funds and remitting the proceeds. It is pragmatic because while they are expected to do it expeditiously as liquidity is otherwise shut, there is no deadline per se. That is, fire sales at sub-optimal prices, just to pay back quickly to unit-holders, has been avoided. Sales of instruments in the portfolio are happening at market-based prices, which is evident from the returns of these funds till date. In terms of quantum, taking all the six shut funds together, a little more than half the dues have been paid back. These include the instalments of February 2021, April 9 and April 30, 2021.
They say, all is well that ends well. FT took a hit on its reputation. It boldly decided to shut the funds. Investors went through emotional stress, but given that more than half the money has been paid back and all the six funds are showing handsome returns, it is expected that in due course people will get back all the dues, along with returns.