When Funds Run Riot – The DHFL Hungama

Multiple times in the past I have tweeted that one shouldn’t try to generate Alpha through Debt. Debt is for Capital Preservation, Equity is for Growth. Yet, when one is full time involved in finance, we understate our own limits.

Warren Buffett in the past has talked about Quotation Loss and Permanent Loss. If you invested in 2018 in a small or mid cap mutual fund, you may currently be finding yourself in hot waters with the NAV being lower than what you had purchased. But give it time and you should at some point of time make up for the loss and start gaining on your investment.

But, if you were invested in a stock, the probability of recovery is slimmer for the return is dependent on the company bouncing back from troubled times. Some do, majority don’t.

Tuesday was a market holiday and yet FinTwit was fully active thanks to the deep cuts seen by many funds. While it’s one thing to see Credit Risk funds get hit when companies they bet go down the drain, what was surprising but one that we now should have got used to was the number of Ultra Short Term and Low Duration funds that got hit.

What is interesting is how sharply things have deteriorated. At the end of January, DHFL was an AAA rated company. Just 4 months later, its gone to CARE D. In other words, the company has lost 13 notches – something that showcases how quick things can turn bad.

Here is the Chart of one such fund which has been affected by the Crisis – UTI Treasury Advantage Fund.

In August of 2018, just before shit hit the fan for DHFL, the scheme was managing a corpus of Rs. 11,630 Crores. By end of May 2019, this had dropped to Rs.4,554 as investors tuned to the portfolio and the risks preferred to exit the scheme than take a chance of DHFL paying off the interests and the Principals which is due in 2021.

Once shit hit the fan for DHFL and the company stopped disbursing any fresh housing loans and instead preferring to pay back its debt, its end was written for one and all to see. Bonds traded in the secondary market showed the panic as Yields shot up to 30%+.

If you were a Mutual Fund Manager with a large dosage of the company’s bonds, the problem here was that you had literally no buyers, especially given the size of investment you would have had in DHFL.

Smart Investors quitting the scheme though had to be paid back and this was paid back by selling other bonds and holdings which were good. The interesting thing is that DHFL as % of the AUM barely moved. It was 6.74% of NAV in August 2018 and 6.78% – this despite a 50%+ fall in AUM.

Yet, the NAV over the last two days have fallen by 11.20% over the last two days. This shows that either the weights have changed over the period for which we don’t have data or there have been some other funds that have gone bad either. I would imagine the former than the later.

UTI has now written down 100% of its exposure to DHFL – in other words, it doesn’t expect to be paid back. This is good accounting practise since the NAV is now more or less fair. What isn’t fair to existing investors and this is not just for UTI funds is that other than Tata AMC, no other fund house has closed the fund to new investors to allow for side pocketing.

What is Side Pocketing?

Side Pocketing is a term used to denote the practice when a mutual fund separates the bad paper from the rest of the portfolio while rest of the investment continue to remain in the fund.

You have a fund with, say, 5% of Zee promoter paper, and the NAV is 100. Zee promoter paper defaults. The fund decides to side-pocket. So your NAV will fall to 95 on the fund. You will get another fund with an NAV equivalent to the remaining 5. The second fund is the side pocket – you can’t buy or sell units, but you will get money as and when the fund recovers money.

What this does is ensure that the fund need not close the fund to eliminate risk of arbitrage seeking hot money flow while at the same time ensuing that those who were invested in the fund and suffered due to the impact of the bad paper have an ability to claw back any monies that could be available in the future. {Source: Capitalmind.in}

What now?

Mutual Funds for long attracted Corporate Investors who were able to generate a small return for funds that instead would have been idling in their current accounts. In recent years though, Retail has become a major player thanks to the huge push by way of #MutualSahiHai and the arbitrage created by the government thanks to the differential way it treats income from Debt via MF’s versus Fixed Deposits.

While we have seen big mishaps in the past, what is different this time around is the number of fund houses that have been affected. Almost every other fund house manager seemed to be on a path to maximize returns without regard to risks.

It’s easy today to lay the blame squarely at the Credit Rating Agencies, but that misses the point that you are paying a full time fund manager who is supposed to know what he is getting into. A 20% cut in an Equity Mutual Fund is something that can recover, a 10% cut in Debt funds on the other hand is literally non recoverable.

In my last post, I wrote that one should stay away from Fixed Maturity Plans – yes, the past has been beautiful, but we don’t know how the future will unfold. Now, I am coming to the clear conclusion that unless you are good at understanding companies, their financial situations, monitor mutual fund portfolio’s every month and so on, you are better off with funds that invest in short term government securities.

Long Term GSec funds carry their own set of Risks and hence not advisable to any one other than those who understand Interest Rate Cycles and are able to know when to get in and when to get out.

From my limited review of Mutual Funds, only Quantum Liquid Fund and PPFAS Liquid Fund make the cut in terms of having a portfolio with close to Zero Risk of default eating up not just your interest but also your principal as we have seen in multiple funds featured above.