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Important lessons for investors from Franklin Templeton fiasco

Aarati Krishnan | Updated on June 12, 2021

SEBI’s order on FT funds reveals lesser-known facets of debt fund performance

Indian investors hit by financial product failures often suffer long waits to get back their money. They rarely get to know what went wrong. For investors in the six wound-up debt schemes of Franklin Templeton India, the story is playing out differently. Thanks to Court orders, they’ve been receiving some payouts from the liquidated funds. SEBI’s completion of investigations to pass an order last week also throws light on the behind-the-scenes action in FT funds that led to this crisis. Here are some useful lessons from the 100-page order for investors.

Read: How Sebi’s latest risk matrix promises value-add for debt MF investors

Look beyond category

After SEBI’s categorisation exercise in 2018, which boxed all mutual funds into 36 types, investors were told that their mutual fund choices would now become simpler, with more truth in labelling. But the FT India order shows that the categorisation is far from watertight and that a scheme’s name can still be a poor indicator of its true nature.

SEBI’s order suggests that though FT’s troubled debt schemes were slotted into low-risk categories based on their portfolio duration, they carried above-normal credit risks. In December 2019, Franklin India Low Duration Fund (LDF) and Short Term Income Plan (STIP) had 84 per cent and 80 per cent, respectively, invested in bonds rated AA and below. This was not very different from Franklin India Credit Risk Fund’s 86 per cent.

Though the scheme names Franklin India Dynamic Accrual Fund (DAF) and Income Opportunities Fund (IOF) do not hint at credit-based strategies, their portfolios had 84 and 86 per cent allocations respectively to AA and below bonds. IOF, DAF, and STIP also shared a lot of common holdings ranging from 59 to 69 per cent, with Franklin’s Credit Risk Fund, suggesting that despite being in different categories, these schemes were quite similar.

When choosing funds, investors cannot place too much reliance on a scheme’s stated category or its label. Portfolio composition is the only accurate guide to risk-return characteristics.

Be suspicious of yield

Analysts and advisers often puzzled over how FT’s debt funds consistently managed higher yields than peers, irrespective of rate cycles. But there’s no arguing with returns and they ended up recommending them, anyway. But details in the order suggest that if you don’t understand exactly how a debt fund makes its returns, it may be best to stay away.

To earn yields that bettered peers, FT managers adopted unconventional methods. They invested a good portion of their portfolios in what SEBI calls ‘bespoke’ bonds — privately placed bonds where FT was the main subscriber. In March 2020, 56 to 77 per cent of the six schemes’ portfolios were in bonds where FT held over 70 per cent of the issue. Being the largest buyer of a bespoke bond may have given FT the clout to demand high rates, but such bonds were not readily tradable. When the issuer landed in trouble, it fell to FT to sort it out alone.

FT also dabbled in bonds with periodic interest rate resets, without exit options. The resets may have helped FT get better yields but also led to it holding disguised long-term bonds in its short-term funds. In calculating the Macaulay duration of such bonds, FT used interest reset dates rather than final maturity dates, which downplayed their rate risks. In their desire to hold on to the high-yield bonds, FT’s managers also refrained from exiting when they could, deferred put options, and agreed to moratoriums for issuers.

While these strategies helped FT sustain high yields, they also pegged up the credit and liquidity risks.

Portfolio disclosures from debt funds only tell you what issuers they hold, but not the underlying structure of these bonds, which may peg up risks. Given the under-developed nature of the Indian bond market, where most bonds are privately placed and subject to informal agreements, when it comes to debt funds, what you see may not be what you get.

Regulatory gaps

Most advisers recommending mutual funds to investors make the argument that the vehicle is tightly regulated. Debt fund regulations have seen multiple rounds of tightening after the IL&FS and DHFL defaults. But the FT saga tells us that despite all this, there are yawning gaps in the rules that funds can exploit.

SEBI’s order shows that senior FT officials cashed out of the affected debt schemes before the winding-up was announced, while being in possession of non-public information about FT’s troubles. Stringent insider trading regulations that apply to shares do not apply to mutual fund units. This leaves the door open for insiders to indulge in personal dealings with their mutual fund units using information that only they are privy to.

It is vague drafting of SEBI’s regulations on winding up that allowed FT to propose the unilateral winding up of its debt schemes without seeking investor consent first. FT also shuttered its open-end funds without any commitment to investors on the date or quantum of repayments and borrowed more than the 20 per cent regulatory limit. All these actions set unhealthy precedents that other funds could exploit unless SEBI quickly moves to plug the loopholes in its regulations.

Stars can implode

A very important takeaway from the FT saga is that a star fund manager at the helm should not be our chief reason to invest in a fund.

Santosh Kamath, who oversaw FT’s debt assets, was considered one of the most skilful managers of credit in the Indian market. Advisers widely recommended his funds to risk-averse retail investors on the belief that he could do no wrong.

Yet, Kamath failed to foresee how assuming high credit and liquidity risks in open-end schemes could land them in hot water in a crunch situation. SEBI’s order reveals that his star status may have proved to be the funds’ undoing, with the AMC paying little heed to the warnings from the risk management team.

The FT saga is a cautionary tale that stars can implode if they shine too brightly.

Takeaways

A fund’s name or category may not reflect its risk profile

Debt fund portfolio disclosures don't reveal everything

Beware of loopholes in SEBI’s winding up, borrowing, insider rules

Star managers can take on too much risk

Published on June 12, 2021

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