Opinion

Time for a rethink on MF regulations

Himadri Bhattacharya | Updated on May 22, 2020 Published on May 22, 2020

The recent MF woes were a result of excess credit risk; this shows that portfolio management is not in line with the benchmark

The Indian debt market witnessed a series of major set-backs over the last 18 months or so, triggered by the IL&FS default towards the end of 2018, followed by a spate of collapses — most notably of DHFL and YES Bank — culminating in the present phase of gloom and doom occasioned by the Covid-19 outbreak in March, 2020. Among other consequences of the convulsions, there has been an unprecedented outflow of funds from the open-ended, close-ended debt/fixed income schemes and hybrid schemes of mutual funds in India.

In 2019-20, the net outflow from open-ended and close-ended debt/fixed income schemes were ₹4,778 crore and ₹33,810 crore respectively. Some reports put the gross outflow in March, 2020 at a whopping ₹1.94 lakh crore.

Amid the debt market turmoil, Franklin Templeton segregated its investments in certain debt securities of YES Bank and Vodafone Idea from six open-ended debt/fixed income schemes and one hybrid scheme, taking advantage of a dispensation permitted by SEBI for this purpose in December 2018. Around the same time, two more MFs announced delay in redemption of several of their close-ended debt/fixed income schemes, on account of their large exposures to the struggling Essel group.

These developments attracted attention of the authorities, resulting in the announcement of a ₹50, 000-crore liquidity support measure for MFs by the RBI on April 27. This, however, proved to be a non-starter as its actual utilisation was a paltry ₹2,000 crore. A bit of comical relief in this otherwise dire situation was provided by a high-profile politician’s attempt to politicise the events by stating that the government should have rescued the FT schemes in question.

Deeper causes

It is easy and tempting to attribute the segregations by FT and the redemption difficulties in two other MFs as caused solely by the present severe liquidity difficulties in the debt market. But a deeper look reveals that the liquidity stress has only brought to the fore the underlying shortcomings in the portfolio management of the schemes that went unnoticed for a long time — too much credit risk for comfort.

This, in turn, was caused by a significant departure from the tenets of professional portfolio management relative to a benchmark, taking advantage of the inadequacies of the regulatory prescriptions .

In general, a portfolio benchmark serves the following purposes: One, it embodies the risks the portfolio manager is expected to take to achieve the strategic return objectives of investors. Two, the total rate of return on the benchmark provides a measuring gauge for the actual portfolio return. Three, the deviations in terms of risks (credit, interest rate and liquidity risks in the case of debt/fixed income schemes of MFs) of the portfolio vis-à-vis its benchmark can only be tactical, not strategic. Four, from the point of view of the investors, the expected risks of the portfolios (schemes of MFs) are those underlying their benchmark. Hence, in all professional arrangements for portfolio management of funds, the permitted risk deviations from the benchmark are defined and disclosed upfront.

An upshot of the foregoing is that if the actual risk exposures of a portfolio usually differ too much from those of its benchmark, then the benchmark is a faulty one. If such faulty benchmarks are permitted, then they create the wrong incentives for portfolio managers to take excessive risks at the cost of the investors. A comparison of the risk profiles of the seven schemes (post-segregation) of FT as on March 31, 2020 and their benchmarks will drive home this point (see Table).

Excessive risk-taking

Excessive risk-taking has never benefitted investors, as the schemes underperformed their benchmarks, most notably in 2019-20. Both the one-year and five-year return performances of all the seven schemes of FT were way below their respective benchmarks. The brutal truth about taking too much credit and liquidity risks vis-à-vis a benchmark, as a matter of strategy, is that the impressive extra returns that this may generate for in a few years get more than wiped out in one bad year. This is most vividly illustrated in the case of Dynamic Accrual Fund as well as of Ultra-Short Duration Fund, where the risk and return divergences vis-à-vis their benchmarks were kind of extreme. In fact, the high credit risk taken in both of them defies any logic.

However, to be fair to portfolio managers, another truth must also be told: credit ratings of debt issuances in India have little use, from a risk management point of view. Inevitably, managers are guided by their own assessments in risk decisions in a flexible manner. This explains the preference for aggregate benchmarks over any of their sub-indices, which would better reflect portfolios’ risk exposures.

Regulatory inadequacy

SEBI’s regulations on the choice of benchmarks by MFs are imprecise, and therefore prone to misuse. For debt schemes, there is a requirement that the benchmark be a ‘suitable index that is a representative of the fund’s portfolio’, which has been interpreted by different MFs in ways that suited them. And, of course, any excess portfolio return vis-à-vis the benchmark has routinely been publicised as ‘alpha’, even when with significant risk differences between the two.

Fund management in a fiduciary capacity is not a fun-filled way to earn high bonuses by garnering smart ‘accruals’ — a desi term for extra yield coming from debt instruments with higher credit and liquidity risks.Regulators owe it to the investors to undertake meaningful reforms in the MF and credit rating businesses in India.

Through The Billion Press. The writer is a former central banker and a consultant to the IMF

Published on May 22, 2020

A letter from the Editor


Dear Readers,

The coronavirus crisis has changed the world completely in the last few months. All of us have been locked into our homes, economic activity has come to a near standstill. Everyone has been impacted.

Including your favourite business and financial newspaper. Our printing and distribution chains have been severely disrupted across the country, leaving readers without access to newspapers. Newspaper delivery agents have also been unable to service their customers because of multiple restrictions.

In these difficult times, we, at BusinessLine have been working continuously every day so that you are informed about all the developments – whether on the pandemic, on policy responses, or the impact on the world of business and finance. Our team has been working round the clock to keep track of developments so that you – the reader – gets accurate information and actionable insights so that you can protect your jobs, businesses, finances and investments.

We are trying our best to ensure the newspaper reaches your hands every day. We have also ensured that even if your paper is not delivered, you can access BusinessLine in the e-paper format – just as it appears in print. Our website and apps too, are updated every minute, so that you can access the information you want anywhere, anytime.

But all this comes at a heavy cost. As you are aware, the lockdowns have wiped out almost all our entire revenue stream. Sustaining our quality journalism has become extremely challenging. That we have managed so far is thanks to your support. I thank all our subscribers – print and digital – for your support.

I appeal to all or readers to help us navigate these challenging times and help sustain one of the truly independent and credible voices in the world of Indian journalism. Doing so is easy. You can help us enormously simply by subscribing to our digital or e-paper editions. We offer several affordable subscription plans for our website, which includes Portfolio, our investment advisory section that offers rich investment advice from our highly qualified, in-house Research Bureau, the only such team in the Indian newspaper industry.

A little help from you can make a huge difference to the cause of quality journalism!

Support Quality Journalism
  1. Comments will be moderated by The Hindu Business Line editorial team.
  2. Comments that are abusive, personal, incendiary or irrelevant cannot be published.
  3. Please write complete sentences. Do not type comments in all capital letters, or in all lower case letters, or using abbreviated text. (example: u cannot substitute for you, d is not 'the', n is not 'and').
  4. We may remove hyperlinks within comments.
  5. Please use a genuine email ID and provide your name, to avoid rejection.
You have read 1 out of 3 free articles for this week. For full access, please subscribe and get unlimited access to all sections.