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Two conversations over the last two years have led me to believe that the use of credit as a product in mutual funds was a ticking time bomb. First, a successful manager lamented about the Asset Liability mismatch inherent in such products. While the underlying investments are long-term in nature and often illiquid, the investor can redeem at NAV in just a few days. Second, an investor, a sophisticated, international one, spoke about the lack of data and analytics regarding credit in India. That, coupled with the penchant for name lending in India, and a widespread distributor community with varying knowledge levels and in a few cases revenue drivers (not aligned to investor interests), creates structural issues where similar failures can be expected.
As opposed to an investor in equities, who expects a possible loss, a typical investor in debt and credit mutual funds, who is risk-averse, is looking at returns beyond the return of principal. In a wide-spectrum debt market like India, it is easy to be tempted by the returns offered by credit funds. The small exit load gives these debt instruments an additional flavour of liquidity.
This is a wrong construct on twocounts – one, credit in India is an opaque, illiquid market. Often, companies and groups which have borrowed have not been stress tested. Fund managers devise their portfolios on ratings and do not have “first principles” thinking nor the team sizes required for intensive diligence. I am told that a few managers have single digit team sizes to manage credit funds in excess of Rs 10,000 crore. By the time an asset is a stressed asset, the mutual fund is behind the curve. Investors are a lot less forgiving of processes which are less rigorous for a product of this nature. Two, not much liquidity is getting to the NBFCs and through them to mid and small companies, exacerbating the situation, and creating fertile grounds for the contagion to spread. This is despite the TLTRO stimulus, which needs more continued support.
Often, the AMCs themselves are thinly capitalized, and it takes speculation on one or two credits to start a barrage of redemption requests which, of course, can’t be fulfilled because of the illiquid nature of assets. In some ways, the NAV itself represents the state of things in a normal market, but is a poor representation in a stressed market.
This begs the question – what should the mutual funds be doing?
For one, they should have a narrow range of plain vanilla, liquid products and not the illiquid ones. These should be products where enough reliable quoted data is available and can be easily understood. For the same reason, we don’t see mutual funds managing private equity, and investors interested in that segment would rather go to AIFs. The Securities and Exchange Board of India (SEBI) should take a serious look at what kind of products merit a mutual fund platform. AIFs, with a flexible fee structure and an ability to bring out closed ended products for HNIs, are more suitable as platforms. The tax arbitrage between mutual funds & AIFs should be removed and both product categories brought to parity immediately. AIFs, themselves, may need to be regulated more so that the Mutual Fund/ AIF regulatory advantage doesn’t start looking like the Bank/ NBFC one.
The other part of the question pertains to who might be held accountable in these events. For starters, the credit problem in India has less to do with the current pandemic and more to do with processes, risk architecture and governance in financial institutions and lately, market liquidity. Some of the problems in credit could be foreseen as long back as June 2018 and it would be helpful to understand why the key stakeholders didn’t implement active measures for this long. The resulting collateral damage to the market and brands will be significant and very difficult to erase over the next few years. I would argue that the monetary damage done by the news regarding these funds will outdo the well-intentioned money going behind the popular advertisement campaign to get investors into mutual funds.
Effectively, the debt and credit fund product category could largely be out of the asset allocation of several HNIs and retail investors for the near to medium term, if confidence measures are not taken urgently. SEBI should look to fix accountability, and fast, for this confidence to return.
One way to mitigate the situation is to create a risk and analytics cell under SEBI, funded by the AMCs, which focuses on products offered to retail investors, the products’ positioning and illiquidity, the quality of information, and eligibility. While rating agencies are evolving on their ability to call out credit defaults, they don’t publish portfolio risks which are more relevant for an investor.
Transparency around investments and risk and innovation through competition should drive the financial products market. Incentivising institutions, large corporates and HNIs to invest in alternate products through AIFs will help solve this problem to a good measure. AIFs can be a sandbox for products where risk is not fully known or measurable or where the market sizes are small.
Finding a way for providing liquidity lines to MFs and AIFs can provide a temporary solution for market volatility.
Above all, the right choice of products which mutual funds can create and sell to retail investors, is key to setting appropriate expectations for them and for avoiding ensuing panic, which could potentially upset both the equity and debt market.
Disclaimer: This authored article first appeared in Bloomberg Quint on 27 April 2020