Opinion | Portfolio Yoga

It’s a Mad, Mad, Mad, Mad World

Not a day goes by these days without someone commenting that the market is ripe for a correction. After all, the economy as we see it through our eyes is worse than at any point we have come across in the past and yet the stock market is rocking. It’s a conundrum that is confusing the best of investors.

The Nifty 50 PE ratio which is seen as more representative than the BSE Sensex PE ratio is now at an all time high. The Sensex PE Ratio while not at an all time is currently around the same level where we saw it in January 2008. But the consensus that one comes across seems to suggest that looking at PE ratio is faulty since the drop in earnings which has subsequently boosted the Price to Earning Ratio is a one off due to the compulsory closure of much of the country in Quarter 1 of 2020. The impact of this quarter’s damage will get wiped out in years time, but the question is where will the Indices be by that juncture.

This dichotomy between stock markets and the economy is not being seen only in India. In fact, S&P 500 – the barometer stock index in the United States made a new high this week. This while even the US is suffering immensely from the damage caused by Covid. This from a New York time post

“The Federal Reserve Bank of New York’s weekly economic index suggests that the economy, although off its low point a few months ago, is still more deeply depressed than it was at any point during the recession that followed the 2008 financial crisis.”

While Robinhooders, the moniker attached to small retail investors who trade through the RobinHood Application has been blamed for exacerbating the relentless rise, the fact remains that we, the small retail investors are generally the weak hands. Yes, once in a while we get it right while the highly paid Institutions get it wrong, but for most of the time it’s the opposite.

Since November 2013, we have seen just 3 months where Net Equity Inflow was negative for Mutual Funds. The first was in March 2014, next came in March 2016. June 2016 was another negative month but could be ignored given that outflow was just 45 Crores. The last outflow has come in the last month – July 2020.

The question that needs to be asked is if smart retail is turning out to be ahead of the crowd. The reason for using the smart prefix is because even in July, we saw Inflows of 14 thousand Crores. It’s just that more money was withdrawn resulting in Net negative for the month.

Between the months of January 2008 to March 2008, Mutual funds saw an inflow of around 24000 Crores. Rest of the year basically was flat even though markets kept getting cheaper. In fact, the biggest outflow for 2008 was in October when markets hit its lowest level. On the other hand, when markets recovered, retail started to sell back with total net outflows between September 2009 to October 2010 being to the tune of 24000 Crores. Nifty though did not waver much as it continued its upward journey.

Nifty has been on a major uptrend since 2009 and yet for anyone who has been invested for the last 7 years, returns have been suboptimal leading one to wonder that with all the problems that surround us, are we better off with a lower exposure today than before.

The question hence is where we do go from here. I wish I knew the answer. On one hand there have been serious reports suggesting that we may be on the cusp of a new bull run. While it may not be to the tune of the 6x Nifty saw between 2003 to 2008, even a doubler in next few years may be much more than what many seem to be anticipating at the current juncture.

On the other hand, there is the economy and all the dire calls about how the ballooning of the Federal Balance Sheet means that we don’t have as many bullets as we had earlier. But this has been heard of before. A perma bear in the US projected in 2011 a best case upside of 3.4% for S&P 500 and worst case being negative returns. The reality turned out to be a CAGR of nearly 14%.

Having said that, even a broken clock can be right twice a day and it’s possible that markets may have found a new peak from where the only path is downwards. To get a better estimate other than valuations, I have been working on what I call “Weight of Evidence” Indicator. Basically it’s a Indicator build using a combo of Trend, Breadth and Sentiment Indicators. The Indicator as of now moves between the range of -7 to +7 and currently stands at 5.

What is interesting is the future returns when the Indicator is at a certain level. We moved to +5 this week. In March of this year, it was -5. The table below outlines the average one year return and the number of times the indicator has reached those levels (Weekly data points, Time frame being 2005 to 2020).

Not surprisingly we can see that when the Indicator is extremely negative (-5 to -7), the future returns are strongly positive. But markets have been there for only 7% of the time. On the other hand, the next best set of returns are when the Indicator is between 4 and 5. Basically while on the negative side, Markets are mean reverting, on the positive side it seems that momentum begets momentum.

Of course, as the data also shows, this indicator has its fair share of failures. When it has reached 5, only 75% of the time has the market been positive at the end of year 1 from that date while 25% of the time it has ended in losses.

One of the things I have learnt in my years in the market is that the upside generally is a surprise even to the most bullish analyst. Buying when blood is on the streets is a great philosophy, but as even Buffett actions recently showcased, it’s not easy to buy especially when the cost of failure can be very high. Buying when the coast is more clear could be a better strategy for those who missed out on the earlier opportunities.

Saving Early or Saving Late

One of the often repeated mantras in the world of finance is that if you don’t start saving early, you lose out on benefits in the long run. Theoretically it’s true – the earlier you start saving, the more you end up with. Just look at Warren Buffett, he purchased his first stock when he was 11 years old and look at where he is now.

I passed out of school and later college when the Infotech revolution was just starting to bloom. Most of my classmates chose to do an Engineering Degree and later joined Infotech firms. On the other hand there were a few guys like me who chose a different path. One of the poems I studied at school and love it to this day is “The Road Not Taken” by Robert Frost and it’s amazing how deep the poem goes about life in general.

Thanks to technology, keeping in touch today is much easier than in earlier days and in many ways it’s amazing the divergence in paths that most of us have encountered. But paths aren’t set in stone and as much as early saving habits are good, it doesn’t really add up when you look back over time.

One friend who did not choose to go for Science and then Engineering started with an ordinary job. His life would have been ordinary if not for a decision he made a few years down the lane. He emptied his savings, took on Debt and flew to a foreign land to get himself an MBA.

While I have no clue about the savings of my friends, I can hazard a guess that this friend of mine who chose differently both in terms of career path and later is how to utilize his meager savings is in the top quadrant vs friends who started to save early.

When I passed out, a basic Engineering Degree was good enough for being taken up by any of the Infotech companies at salaries that were at a premium to general wages. Today, even Computer Science graduates have a tough time getting jobs and even those who get the salaries aren’t as juicy as they used to be earlier. A study that came out a couple of years back said that entry level salaries at a reputed global infotech firm had remained the same for the last 10 years.

One reason is the supply and demand dynamics. Karnataka for instance had 60 Engineering Colleges in 2001. Today, it stands at 300. In addition, the number of seats that are available have increased exponentially. So much is the excess capacity that AICTE has shut down 128 engineering colleges across the country between 2016 to 2019.

Everyone has similar goals – Retirement, Kids Education, Buying one’s own house being the primary goals. Yet how much you can save in absolute terms means a huge difference in the lifestyle as well as goals one hopes to achieve.

The path most of us take in life is the result of various factors with luck playing a large role. But luck can do only so much without the right skill set. In 1996, getting an Analyst job was all about being in the right place at the right time. Today in addition to being at the right place and time, it’s also about whether you have the right skills and that generally means either a CFA Degree or an MBA. Just being passionate about investing and research in general doesn’t tend to work out great for a prospective employee.

It’s easy to preach from the high temple about the need to save more, tougher is to show how to earn more for absolute savings finally is about your earning capacity (for majority). There will always be one off cases where just saving with a low base alone was enough, but that is always the minority.

Nothing Works all the Time

Collective2 is a US website where you can sell a strategy that trades / invests on markets or if you are an investor, track and invest along with the strategy. Think of it like the smallcase in India but without the hassles of having to go for SEBI registrations and as such you can build a model, launch it on the site and if it works as you think it will, keep collecting the subscription fee from your users.

As a free subscriber, I get newsletters sent weekly showcasing the “Trading Strategy of the Week”.

If you notice, there is no single strategy that repeats itself. While this could be to market different strategies, the general reason is that you don’t want to flaunt something that worked earlier but not working now. In fact, since I have a hoard of their letters, I went back to strategies that were recommended to be checked out a couple of years ago. 9 out 10 had vanished showing how low the chances of success is.

In markets, you continuously see some industries that dominate only to wither off over time and some other industries take the leadership. Currently it is Pharma that is dominating the news but a few months back, it would have been Quality and a bit before that it was Large cap and even before that it was Small Cap.

The other day, a fund completed 10 years of successful investing. While the fund returns have been fantastic, the article pointed out how just 911 investors were invested throughout the journey. Clients were to blame

It reminded me of an old blog post about Fidelity where it said that the clients that did the best were the ones who were dead. The second best performing set of clients forgot they had Fidelity accounts.

It’s not the case with every investor of course. I have had my family invest in Mutual Fund Offer for Sale in the late 90’s and we hold many of them till date. One of the better investments I can claim to be invested since day one of the fund is Franklin India Technology Fund. The return since inception is 18% – wonderful right. Should have really boosted our family’s net-worth.

Unfortunately, nope and the reason is twofold. One is of course how much we invested in 1998 when it was first launched – we invested a measly 5000 bucks (the minimum investment if I remember right). That was a very small part of our family’s net-worth as on that date. So, it was just one another investment – not THE investment.

Second reason is that we did not add to it over time. This meant that what was already a small percentage over time became a rounding off error in a sense. So, while the 18% looks great, its value as part the total net-worth is negligible.

It was based on the thought process, I asked this question to my dear followers on Twitter

https://twitter.com/Prashanth_Krish/status/1284552707005534208

The answers were as usual very interesting, but most were against the principle of investing all of one’s money other than maybe in the Index. This is not surprising especially in light of recent events such as Franklin Templeton’s debt funds – it’s bad to have a small holding, think about if this was the only investment.

As I write, a mailer from Motilal has landed in my Inbox. Motial is launching a new Multi Asset Fund with the title, Different asset classes outperform each other at different times. What is different for a Multi Asset Fund from a Multicap Fund? In both, the fund manager has the ability to move assets towards sectors or caps where he believes lies the greatest opportunity. The only difference though is that while a Multicap fund would essentially buy only stocks, a Multi Asset Fund is more of a Fund of Fund and one that invests basically in other funds (mostly from their own house as far as possible).

These days, passive investing is seen as the key for data shows that 90% or more fund managers are unable to outperform the same. Passive investing hasn’t grown as much as the hype we see on Twitter though for the simple reason that the monetary gains to be gained by selling a client and servicing him are nothing compared to active funds.

But how much of that is the genuine belief that no manager can out-perform the top 50 or 100 stocks of India in the long term vs recency bias due to current better performance by the large cap indices vs say the small and mid cap indices. This applies for even N100 or PPFAS which is suddenly being seen as the cool investment to be invested into

But back to my question – why is it so tough to make a choice when it comes to a fund. The reason is simple – we are afraid to take a call which in hindsight may look foolish. For all the talk about Fund Manager, Process, etc, our focus is extremely short term and looks back at the returns – nothing wrong in that perse, but that also means we lack the confidence in both our own approach as well as the approach of the fund manager.

As an Investor, you really are at your peak when you start to think like a Fund Manager – which is what one is essentially with the only difference being that rather than other people’s money we are dealing with our own money. Every decision has to be seen in the light of what it brings to the table when relative to the rest of what you hold. Once you get an understanding of it, the choices in front of you become very easy to make.

The objective of this post is not to hold a gun to your head and make you choose a single fund but to provide a perspective that more may not indeed be better. The better we understand what we are invested into, the easier it is to navigate during tough times as it is during the good times.

The Price of Uncertainty

Post leaving my last job, I spent a few months basically meeting people – both who I thought I could associate with and those who I thought maybe interested in partnering with me for the new venture I was planning. The former did not work out for various reasons and the latter did not work out for the single reason that starting a new venture is one bridled with uncertainty and it’s not easy for anyone to leave out a job he doesn’t like but one that guarantees food on the table. Investing is no different.

In March of this year, there was a great deal of uncertainty which also meant stocks were cheaper relatively than most were for a long time now. When a friend asked for my opinion on what to do with his equity exposure, this is what I had to say

“I don’t believe that we should exit equities at the current juncture. In fact, I am personally adding more to equity (reducing from Debt)”

Uncertainties offer opportunities and while I would have been happy to have deployed big time, the fact was that even I got cold feet after speculating on the second and third-order effects. As much as I try to keep myself away from the Media and more importantly perma-bears who can really make you question your thesis at the worst possible time, this time I fell to their spell and wondered if this was only the start with much more to go.

History in a way provided a similar view for when markets went down 30% or more in the past, it usually went well below 50% and with limited money on the sideline I wasn’t willing to dive into the deep end.

Markets have recovered tremendously and what is interesting is the fact that it has done so in record time even as the Virus continues to have an impact on the day to day life and business is not as usual for most. It’s as if we have accepted that earnings this time will be bad but the future holds promise and hence lets bet on that future instead of betting on the current despair.

Some time back, I was looking at the chart of Nifty in 2008. If one had entered the markets after it had fallen in August when the Index was seemingly bottoming out, he would have seen a draw-down of 50% in the next couple of months.

It’s not impossible to catch the bottom or close to the bottom. Was lucky to have caught ITC at 145 which I would say is as close as it comes. But what is impossible is to allocate in full at the bottom. The ITC allocation was the single biggest stock for my brother’s PF, it was still a single digit allocation in the overall scheme of things.

The only way to take advantage of falls like these is to be prepared well before the fall happens. In addition, you also need to know what you are willing to pay – markets sometimes may provide you that opportunity for a small time frame, but the speed of this rally is astonishing even from historical to the extent that unless you were prepared to bet with no worry about how the stock may perform in the coming days and weeks, opportunity got lost pretty fast or did it?

The markets made a low on 24th March though it actually closed positive for the day. The lowest close was made on the previous day when Nifty fell an astonishing 13% – something we had not seen ever. The largest fall was the 12.2% fall Nifty had seen on 24th October 2008. Interestingly then too, the next day was the lowest ever reached and a level that is unlikely to be ever seen again other than by using eccentric patterns on charts.

Nifty gave a clear signal to me using what is known as the Lowry Indicator on 7th April 2020 when the country was in a lock-down. It’s amazing in hindsight how the trend shifted right under our noses while most were still arguing how much damage the virus could have and how low the index could go. In fact, on 9th April, Nifty made its first higher high – a clear and simple signal to say that the trend has turned.

The 200 day EMA is seen as the barrier between Bull and Bear Markets. Nifty crossed it a few days ago. While more and more signals are confirming a bullish trend, the narrative has shifted underneath to – what is going on in the markets which suggests that way too many have missed the boat. But the uncertainty about the markets haven’t changed

There are charts and data trying to showcase how lopsided this rally is and that may well be true – but the only way to make sense out of that data is to compare it to historical data and see if it was different then. I say it may well be true because breadth data which I use is suggesting otherwise – in fact, one of the indicators I have developed using breadth (and as any indicator has its bad calls) went long in the markets on 29th May 2020. In fact, if you were to track PMS returns, I found that June for most has been a better month than April when Nifty went up 14%.

Personally I regret missing out on buying some stocks at what really were mouth watering valuations, but what I will regret more is if I stay out of the entire rally due to anchor bias. Its okay in my opinion not to be able to catch the low, as long as the valuation is still worth and the company is available at prices not seen for a while, I think its okay to jump in though the risk today may be slightly higher than what it was in March. But that is the price we pay for more certainty.

The risk though is that markets may come back down to their March lows or lower. This fear is what keeps most investors out for there is no honest answer. It’s a coin toss probability at any point of time. With people supposedly making millions left, right and center, you may question whether this time ain’t much different from the past and there will be a price to pay.

Once again, I don’t know the answers but sitting in cash post a crash and hoping for another crash is not a strategy either. Having a plan and sticking to it are two different things but that ultimately is the only way you can have a great career as an investor in the market. If that is too much, its no shame to just push your money into Index Funds for in the long term, the index generally goes one way – up (there are exclusions, but lets for now assume that India is not an exclusion).

Calling it Out

A few years ago, I was having a severe case of a running cold. After days of torment, I finally decided to go for a specialist who I hoped would know and treat me better. The Doctor took one look at me and prescribed a CT Scan. This was to be done at a specific facility which meant a kick-back, but suffering as I was, I decided to get it done.

CT Scans are expensive and used only when the Doctor suspects something serious after the patient has been treated and not responding to usual therapies. But here I was taking a CT scan even before taking any medicine. The CT Scan came out clean and I was then prescribed a dose of antiBiotics. Few days later, the cold and the headache vanished. But for me, I lost trust in the Doctor who is very famous and continues to be recommended by friends.

In the United States, Millions are unemployed and unlike in India where they need to worry about where their next meal will come from, most are getting paid more as Unemployment Benefits than what they used to earn before COVID took away the jobs.

With Americans being more exposed to the Stock Markets than others, it hasn’t been a surprise to see huge activity by new traders who are betting the unemployment money which many consider as a freebie in order to try and make more.

Enter Dave Portnoy. Before Covid, David Scott Portnoy was a blogger, and founder of the satirical sports and pop culture blog Barstool Sports. Today, he is New York Times calls it, “Captain on the Day Traders”.

His claim to fame though – calling Warren Buffett and I quote ““washed up” investor who’s no longer relevant.”. This after calling him a Idiot for selling Airlines stocks which he supposedly loaded up on and made a great deal of money.

On Twitter, his word now reaches to 1.5 Million followers many of whom I am sure have no clue about how markets work or what kind of risk it is to buy bankrupt or close to bankruptcy companies, but there is a belief that this new age of traders are now able to move the price of stocks to the extent that a Bankrupt Hertz is trying to sell 1 Billion worth of what will soon be Worthless stock to the new age traders.

A chart says a thousand words and here is one such chart

In a way, this is not too different from what we have been seeing in India especially with regard to Options with claims of profits that should make anyone swoon and promises of teaching you the holy grail for a low cost 25K + GST.

When I bought Franklin Funds, it was not without knowing the risk though I never imagined that they would need to shut down the fund to ensure orderly payment. Today, it’s fantastic to talk and write about how investors were blindsided by the fund manager. What has been missing though is any fund manager coming out before or even after in the open and saying what needed to be said. Maybe they are afraid of “Virtue Signalling” given the bad state of many of their own Credit Funds.

Finance is a domain where there is a direct observable cost. It’s why advisors are said to observe fiduciary duty when it comes to advising – both for clients and for the general public thereof.

What is measured as “Investor Gap” – the return gap between what the fund produces and what the investor is able to capture is basically the cost paid by investors due to misleading advice. One of the observations of my time when I was a stock broker has been that people who lose money following bad advice basically quit the markets. In other words, they throw the baby with the bathwater.

We all make bad decisions and there isn’t anyone who doesn’t get it wrong. Investors buy the wrong stocks, Fund managers bet on the wrong sector, Planners recommend investing in the wrong assets. The key is not to be sure never to make a wrong decision for you will make wrong calls, but to take the good and the bad with equanimity.

Buying bankrupt company stock is a bad decision, advising people to buy such stock is fraud. As Morgan Housel writes,

“Experiencing something that makes you stare ruin in the face and question whether you’ll survive can permanently reset your expectations and change behaviors that were previously ingrained”
Morgan Housel

Fraudulent advice shatters not just dreams and hopes but future financial comfort of many. Makes calling out all the more essential. Trust is the key to success both from an advisory point of view and the client point of view. Misuse of Trust though can mean a heavy price for the client though it may or may not impact the advisor. It’s unfortunate how much it’s loaded against the small investor and in favor of the large advisor / fund manager.

Before I end, one small piece of advice – don’t use leverage – especially in the financial markets at least till you have experience of a decade or more. This means No Options or Futures. Leverage is the biggest killer of small clients who hope to make it big but end up losing everything they have and more. Don’t short circuit your journey into a world of business and knowledge by trying too hard too early.

Forecasting the change is a mug’s game.

Not too long ago, investors were told to focus on process and returns, when returns started getting subdued they were asked to focus on the process. Today, we have shifted it completely to “Don’t worry about Returns, Focus on your Goals”.

Achieving your financial goals that you set based on inputs from your advisor seems to be the only thing that matters with the rest thrown to the dustbin. Not that goals are not important, they are important in the sense of knowing where you wish to reach, but the focus on goals at the expense of everything else is to me defeating the very purpose of life.

The picture below is showcased to signify that even when it comes to investment, success isn’t straightforward

As investors, we are too easily swayed by the soft talking skills of fund managers – they became fund managers not just because of expertise in markets but also ability to convince others. On Twitter, they try to make themselves likeable to the extent that it’s easy to believe that they are as commoners as are even though what they earn in a year or two is most probably your goal to achieve by the time you retire.

We all know that we will die one day but what motivates us and where we find comfort is the fact that we don’t know the date. Assume for instance you knew that you shall die on a certain day – while the facts don’t change otherwise, your ability to look forward would decrease substantially owing to the fear that one is coming closer and closer to the deadline.

Ever since the Franklin debacle and the markets meltdown just before that, one common trait I find is among those who missed out on either of the two. Advisors who for whatever reason did not get caught with Franklin funds in their kitty today flaunt that as the reason why you need an advisor and one who understands risk better than the fund manager himself.

On the other hand, we have advisors who were able to stay out of the markets just before the little boy dropped today are happy to showcase how they were able to stay out of the markets and why their method is superior compared to other styles of investing. Dare you have a draw-down is their tag line today.

I am one of the poor folks who not only was invested in Santhosh Kamath’s fund but also continued to have exposure even as markets dropped. If not for the fact that I have a bit of experience when it comes to markets and advisors, I would have thought that I am the worst investor around.

There is always something that has worked wonders at some point of time. Hedge Week for instance reported “Hedge funds were down 6%, global equities, -14%.CTAs were up 1.90% in Q1, outperforming other major strategies.”

CTA’s are nomenclature for Commodity Trading Advisors who manage funds using trend following methodology. With negative correlation to S&P, they are seen as the absolute best funds to hold during market weakness or even better when all asset classes are weak. But the last time they showed exemplary performance? Well, that was way back in 2008.

India doesn’t have any CTA’s – but if there were such funds, I am sure that this would not be flaunted as the best investment strategy to be invested into as is the case currently with Hybrid funds that due to the nature of their stye are uninvested in equities and hence have borne the least amount of damage.

Coffee Can Portfolio is today seen as the punching bag for every advisor. This ain’t based on returns, mind you – even today, the stocks that qualify and the portfolio that could be built around it is one of the best portfolios measured on risk to return. The anger stems from the fact that how can something so expensive generate returns while the cheap stocks that I hold continue to lose money.

Unlike Saurabh Mukherjea, I am not sold about buying high quality stocks at any value – but I recognize that the strategy has value. It had value a few years back when I invested a small sum and will have value some time in the future as well. Nothing is permanent in this world.

As an investor, your Goal is simple – get the highest possible return with the lowest possible volatility. In other words, a strategy that can deliver a high sharpe ratio. Doing that consistently is all that is required to live a life that you can afford while at the same time ensuring that the future requirements could be adequately met.

But that also means that you shall have to stray away from the herd at some point of time while being with the herd at other points. 2017 was the years to be massively invested in Mid and Small cap stocks, 2018 to 2020, not so much. Large Caps would have been a better fit.

Asset Allocation is today looked at mosty from the split between Equity and Debt. But what also matters is the kind of stocks you invest in equity and the kind of debt you risk upon in Debt. A conservative investor can be conservative when it comes to debt and aggressive when it comes to equity and yet ensure good sleep by having an overall allocation that is conversvatie in nature.

From Real Estate to Gold to Bitcoin to Bonds to Equity, risks exist everywhere and you cannot really overcome it all. But understanding the nature of that risk and accepting when that risk becomes real is what can help you stay the course.

“A ship in harbor is safe — but that is not what ships are built for. In finance, if you can sail through life with no reason to risk – don’t risk. It’s not worth the additional few pennies for the stress you may have to put up with. But if you need to take risks, remember that no strategy is ever going to give you rewards without you having taken commensurate risks – knowingly or unknowingly.

Risk is exposure to change. Nothing lasts forever. The situation will change eventually. Forecasting the change is a mug’s game. The future is not sure yet. history helps us build models that can provide us perspectives on the risk – that is all we can need to accomplish.

Random thoughts around Debt Funds

When you make a deposit at a Bank, you are paid a certain percentage of interest. But if you take a loan from the same bank, you pay a much higher rate of interest than what an investor gets paid. This in financial parlance is called “Net Interest Margin”.

This margin is what makes running a bank attactive. Higher the differential, Higher the income you earn and if you are able to ensure that most of your loans that are given out don’t end up becoming a non performing asset, in the long run you may also be seen as a potential candidate for the Finance Minister of the Country.

The average Net Interest Margin for Public Sector Banks is 2.4% for Public Sector Banks, 3% for the large Private Sector Banks and 3.4% for new age Private Sector Banks. Out of this goes all bad loans, all expenses incurred and any other line items before net profits are calculated. A 3% doesn’t seem like much, but banks overall create new money and hence is a leverage business. More the leverage, better the margins.

It’s a nice cosy relationship. If you are a large depositor, at best you will receive a glossy calendar and a dairy at the beginning of the year to make you feel happy. On the other hand, if you are a small borrower, you will have mostly probably pledged your body and soul to get the working capital you require for the business. A large borrower can command better terms but there is such a fight for them that they know that they can get away with the lousiest of collateral – even figments of imagination in some cases.

Your Margin Is My Opportunity is a famous quote by Jeff Bezos. Amazon over the years has turned out to be a bull in a china shop. Previously great companies were grounded when they confronted Amazon. Personally, as an avid book buyer, it’s been the best thing to happen for me. The cost has been borne by those who were either unprepared or did not have the capital to compete with the giant.

In a way, Mutual Funds and Non Banking Financial Companies, better known as NBFCs have been the disruptor in recent years. Being smaller in size and more nimbler, they were able to take away the cream leaving the rest to be fought over by banks.

The reason for NBFCs to exist is basically because of lacunae by larger banks when it comes to lending to the risky segment of markets but one whose are small in ticket sizes or risk seemingly large. They basically borrow from Banks (and used to from Mutual Funds too) and lend it out with the profit being the difference they can make.

One of the biggest reasons for Debt Mutual Funds to exist as a category essentially comes down to one aspect – taxation. Today, you can buy Government Securities directly. But without a Mutual Fund wrapper to protect you, the interest you earn from lending to the safest entity out there is taxed at your bracket (as is the case with Fixed Deposits at Bank).

When we talk of risks, you can divide it into 2 categories – Credit Risk and Interest Rate Risk. What happened at Franklin and we shall come there in a moment was Credit Risk that blew up in their face.

Corporates are the biggest users of Debt funds since Current Accounts where they have their monies don’t provide interest while FD’s offer lower returns (for the shortest duration) than comparable liquid funds.

The biggest attraction to Debt Mutual Funds lies in the fact that there is no middle man to take away the cream of the returns. What the mutual fund earns is what you get (post the expense ratio). If a Mutual Fund is able to lend at 10%, you get 10% (minus expense as usual) versus getting 4% in a Fixed Deposit. You see the attraction, right.

As of 31st March 2020, this was the split among debt funds (16 styles).

Pure Credit Risk funds – funds that are meant to take credit risks comprise just 5% of the total assets under management. Some of the funds performance there is so bad that someone said that they should be renamed as Capital Risk Funds.

The bigger risk and one that Franklin showcased was not about Credit or Interest Rate but Liquidity. This risk is there for any firm that takes deposits from the public to lend it further but has to pay back the depositor on demand.

On the NSE, around 1500 stocks trade every day. Mutual Funds on the other hand are concentrated more or less in the top 400. It’s not that the rest of the stocks are worthless, it’s just that the liquidity is so poor that fund managers will rather ignore such stocks than own something they cannot easily sell in a hurry.

Debt is even less liquid with very few securities carrying the ability to be sold any day without having to resort to a fire sale. When DSP sold their DHFL funds at a yield higher than the rate at which the previous deal happened triggered speculation and while the core had rotten inside, this precipitated the fall of DHFL from what once was a AAA rated firm to D as was the case with IL&FS before.

Having to provide instant liquidity is the bane for any fund. Yes, it’s easy to just go with the flow and buy only Debentures of the highest rated firms or just deposit with Banks, but that solves no problem for anyone other than being a way to arbitrage the tax disadvantage.

Since the Franklin debacle, reams have been written on that episode with 90% of the blame being attributed to the fund manager and 10% to investors who were foolish enough to risk money on a strategy that was bound to fail. While its right to blame the fund manager for the omission and commissions of the fund, the overwhelming finger pointing will mean that Debt funds will never be the same again.

Debt funds as a category is not going anywhere till the tax arbitrage is removed, but what will happen for sure is that like in equity mutual funds, much of the funds will concentrate most of their portfolio on a select few companies they believe are worth taking risk upon. If even that is seen as too much of a hassle, enterprising fund managers will just place a fixed deposit with banks and collect his fee.

Share this:

Share this:

Share this:

Share this:

Share this:

Share this:

Share this: