A deeper look at Liquid Funds

Equity Analysis they say is complicated and yet I find Debt to be more complicated than Equity. Maybe this has more to do with the fact that much of my experience in finance markets has been with Equity compared to Debt.

In Equity Markets, I believe in applying my skillsets using Quantitative methods than Qualitative which can lead to Bias. In Debt, doing the same led me to errors that were realized when people who eat, breathe, and sleep debt pointed out that analysing Debt the way I was doing was error prone.

For much of the older generation, Debt meant one thing – Fixed Deposits at Bank and Post Office.  Over time though, Debt Mutual Funds have come with options to invest in a wider variety of instruments – from short term Commercial paper to Long Term Government Treasury Bonds.

Trying to understand Debt from the same lens as Equity is futile. Equity, especially once you eliminate low liquid stocks, can be compared against one another using methods such as Sharpe. Sharpe ratio penalizes for Volatility and this is a good framework when tackling stocks where all other things being equal, you would want to buy a low volatile stock versus a high volatile stock.

The same in Debt would lead to wrong results. An illiquid low quality bond may not trade as much as a liquid high quality bond resulting in Sharpe being higher for the fund that holds the low quality versus the other fund.

With nearly 42% of total assets under management in Debt funds being in the Liquid category, this static alone makes it very important to understand it’s working. Add Ultra Short Term and Short Term to this, and we have 80% of the total market out there.

Fixed Deposits are the deposits of choice for vast majority of investors. But over time, the way Interest on Fixed Deposits is taxed compared to Debt funds have made them unattractive other than for Senior Citizens whose Income may not come into the tax bracket.

A secondary risk is in terms of locking of Interest Rates. Currently SBI pays an Interest of 6.50% on Fixed Deposits with term of 2 years or greater.

While this may be good in times of falling interest rates, this lock in can yield sub-optimal returns. For Corporates who have large cash flows, the differential is even bigger since Current Accounts pay nothing. Just investing for the weekend can for many of them provide enough returns to make the task worthwhile.

So, how does one go about Analysing funds?

Investor’s key reason for being fixed on Fixed Deposits is the Risk of default. Most are happy with lower returns than take the risk of default that can wipe out a permanent capital.

On 22^nd February 2017, Taurus Mutual fund’s Taurus Liquid Fund dropped a massive 7.2%. The reason for such a large drop was the Default in Bonds of Ballarpur Industries.

To understand how large that drop was, it was enough to wipe out One year of Gains. Anyone who invested in the fund just before the incident would have seen his fund value come back to square one nearly one year after the said incident.

In September 2015, JP Morgan, a biggie in the world of Fund Management had its own fiasco as exposure to Amtek Auto led to two of its funds taking a hit on the NAV.

Liquid Funds which invest in securities with maturity less than 91 days are seen as equivalent to cash – ultra safe. While Taurus fund showcased the risks of even Liquid funds, such instances have been rare and far in between.

For fund houses that manage large corpus of funds, any such default is a death knell since it tarnishes the trust that is required. JP Morgan for instance bowed out of the Mutual Fund business shortly thereafter selling it to Edelweiss.

As Warren Buffett once said,

“It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.”

So, how does one go about Analysing funds in the Short Term to Liquid Fund stable?

Looking under the Hood – The Portfolio:

The key to understanding the Risk taken by a fund is by diving deep into the portfolio it owns. It’s not an easy exercise either as lot of firms borrow using the subsidiary route.

The above chart is the Sector Holding Chart of Aditya Birla Sun Life Cash Plus, the largest fund liquid fund in India. The fund holds 171 different securities and while a cursory look seems to indicate no surprising entries, it’s really requires time and effort for a retail investor to really understand whether there are any unkind surprises lying out there.

Now, let’s look at a fund I like (Disclaimer: I have no financial interest in Quantum) Quantum.

While it’s true that this fund size is a miniscule of the bigger one, this is much easier to understand. The only risk out here is Sovereign.

When it comes to Risk, Generally smaller firms are willing to take a larger risk versus large firms which wish to stay away from unnecessary risks. In the field of finance, one’s ability to draw assets lie from performance and how can one perform without taking a bit more risks that can pump up the overall returns.

A 2012 study by Marcin Kacperczyk & Philipp Schnabl of Leonard N. Stern School of Business, New York University came out with some interesting findings on

1. Funds had strong incentives to take on risk because fund inflows were highly responsive to fund returns.
2. Funds and other financial services took on less risk, consistent with their sponsors internalizing concerns over negative spillovers to the rest of their business in case of a run – Remember the JP Morgan Episode. One bad call and the fund essentially shut shop.
3. Funds sponsored by financial intermediaries with limited financial resources took on less risk, consistent with their sponsors having limited ability to stop potential runs – Quantum being too small a fund for example may be a reason for them not to take risks verus bigger funds which having the backing of their parents can take a bit higher risks.

If Portfolio Analysis and probable implications is not our cup of tea, what other data can help us chose the better fund?

Size of the Fund House:

Rare are the times when a big fund house decides to let a bad investment call impact investor returns in funds such as Liquid. JP Morgan proved an exception to that rule and paid the price. A Birla or DSP or Franklin on the other hand wouldn’t like to damage their credibility by allowing pass through of bad calls.

But that would also mean as Buffett wrote in his recent annual report,

“Charlie and I never will operate Berkshire in a manner that depends on the kindness of strangers—or even—that of friends”.

JP Morgan is one of the largest financial firms in the world and yet they decided to let the investors suck it up. In case there is a default by a large firm, how ready or willing would be the fund houses to take the losses on their books?

Return & Expense Ratios:

Should an investor aim for the highest return or the lowest cost?

As the President of a Large Fund House said

“Ideally, seeking alpha in liquid fund is a fools game as this category can’t generate alpha by design and mandate”

While Expense ratio is definitely something to be looked at, it cannot be looked at in a isolation. Bigger funds for instance can easily cross subsidize their products making some cheaper than the rest – all in an attempt to be the largest asset managers in town.

Amfi data reveals that Individual Investors comprise a very small part of the Assets under Management when it comes to Liquid Funds. It would been interesting if we knew the percentage of funds invested by Individuals in Liquid + Ultra Short Term + Short term funds since these not only makeup 80% of the Assets under Management but also aren’t as easily impacted by Interest Rate changes as longer duration funds (Medium Term / Income Funds, Gilt Funds, etc) are.

Large companies are able to ascertain risk and rewards on a granular level and constantly be in search for the better option, for the smaller investor, its better in my opinion to be safe than sorry. Unless you think you can decode compex portfolios, the simplest ones generally end up offering the highest peace of mind.

Do note, that you can always bump up returns by proper allocation between Debt and Equity than trying to squeeze the last rupee out of any fund.

Thanks to Yamini Sood and Kalpen Parekh who provided me with perspectives and context on how to analyse debt funds. Being an Equity person, understanding and learning about Debt from people who are in the business for decades is immensely helpful.