The Hindu Business Line : Structuring MF in `tranches'

STRUCTURED mutual funds may soon be the order of the day. Benchmark Mutual has set off the trend with its proposal to launch the Split Capital Fund. This fund would tranche credit risk among various classes of unit-holders. It is not surprising that a structured fund should be tested first in the bond market. After all, that market has more institutional players than the equity segment. If SEBI clears Benchmark's proposal to launch the Split Capital fund, a case exists to test products that tranche market risk in the equity market. A look at how a structured equity mutual fund can be designed.

Tranching risk: Investment bankers have always designed products to custom-tailor the investor risk-return preferences. A typical example is the Collateralised Mortgage Obligation (CMO). Traditional mortgage-backed securities (MBS) did not attract institutional players who felt the prepayment risk was too much to bear. So, investment managers designed a structured MBS with various tranches to distribute the prepayment risk. This structured MBS is called the CMO. Benchmark Mutual's Split Capital Fund proposes to tranche the credit risk is the same manner.

At present, unit-holders of equity funds uniformly bear the market risk. A product that would tranche market risk according to the risk-return preferences of unit-holders would be well in order. Such an equity fund can have two tranches. Tranche I, benchmarked to the market index. Tranche II, an active fund following a certain investment style, say, mid-cap growth fund or a large-cap value fund. The portfolio manager can either follow active indexing or pure active management for tranche I.

Active indexing: This essentially means that the portfolio manager will not invest in the constituents of the benchmark index in the same weights. Instead, the portfolio manager will attempt to add value by actively investing in stocks that constitute the benchmark index.

Suppose tranche I returns 10 per cent through active indexing. Further suppose that the benchmark index return is 8 per cent during the same period. The structured equity fund will pay 8 per cent to the tranche I unit-holders. The additional 2 per cent, which is the portfolio alpha, will be paid to the tranche II unit-holders.

There is, of course, a trade-off. Suppose tranche I portfolio generates only 6 per cent return. If the index return is 8 per cent, tranche II unit-holders will have to forego 2 per cent returns to the tranche I unit-holders.

For instance, if tranche II generated 12 per cent, the fund will only credit the unit-holders 10 per cent and pay the balance 2 per cent to make good the shortfall in returns in tranche I. A pre-requisite for such a structure is that the portfolio manager has to maintain separate portfolio for each tranche. Essentially, then, such a structured equity fund is a combination of an active index fund and a pure active fund.

Active management: A more feasible and easy structure would be to manage a single portfolio for the fund. Each tranche will, however, have separate benchmarks. Tranche I will still have a market index as a benchmark. Tranche II may have a benchmark to suit the investment style of the portfolio manager.

Suppose the portfolio generates 15 per cent return during a period when the index return is 9 per cent. The fund will credit the tranche I unit-holders with 9 per cent return. Tranche II unit-holders will enjoy a 15 per cent return plus the additional 6 per cent that was not credited to tranche I. As is the case with the earlier structure, tranche II unit-holders will have to bear a higher risk for enjoying a higher return.

In either structure, the fund will have to report net asset value (NAV) for each tranche. Note that it may not be operationally feasible to design the product as an open-end fund. The reason is that a fund cannot distribute market risk to the tranches daily so that unit-holders can purchase and redeem units at the risk-adjusted NAV. Under the circumstance, an interval fund may be an optimal choice.

Benefits: In either of the above structure, tranche I unit-holders receive the index returns less the management fees. The returns are, hence, superior to what unit-holders earn through exposure in an index fund. In the latter case, management fees and tracking error drag the overall returns. The advantage for the tranche II investors is the higher return.

(Feedback can be sent to bvenky@thehindu.co.in)

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