The Indian debt market witnessed a series of major set-backs over the last 18 months or so, triggered by the IL&FS default towards the end of 2018, followed by a spate of collapses — most notably of DHFL and YES Bank — culminating in the present phase of gloom and doom occasioned by the Covid-19 outbreak in March, 2020. Among other consequences of the convulsions, there has been an unprecedented outflow of funds from the open-ended, close-ended debt/fixed income schemes and hybrid schemes of mutual funds in India.

In 2019-20, the net outflow from open-ended and close-ended debt/fixed income schemes were ₹4,778 crore and ₹33,810 crore respectively. Some reports put the gross outflow in March, 2020 at a whopping ₹1.94 lakh crore.

Amid the debt market turmoil, Franklin Templeton segregated its investments in certain debt securities of YES Bank and Vodafone Idea from six open-ended debt/fixed income schemes and one hybrid scheme, taking advantage of a dispensation permitted by SEBI for this purpose in December 2018. Around the same time, two more MFs announced delay in redemption of several of their close-ended debt/fixed income schemes, on account of their large exposures to the struggling Essel group.

These developments attracted attention of the authorities, resulting in the announcement of a ₹50, 000-crore liquidity support measure for MFs by the RBI on April 27. This, however, proved to be a non-starter as its actual utilisation was a paltry ₹2,000 crore. A bit of comical relief in this otherwise dire situation was provided by a high-profile politician’s attempt to politicise the events by stating that the government should have rescued the FT schemes in question.

Deeper causes

It is easy and tempting to attribute the segregations by FT and the redemption difficulties in two other MFs as caused solely by the present severe liquidity difficulties in the debt market. But a deeper look reveals that the liquidity stress has only brought to the fore the underlying shortcomings in the portfolio management of the schemes that went unnoticed for a long time — too much credit risk for comfort.

This, in turn, was caused by a significant departure from the tenets of professional portfolio management relative to a benchmark, taking advantage of the inadequacies of the regulatory prescriptions .

In general, a portfolio benchmark serves the following purposes: One, it embodies the risks the portfolio manager is expected to take to achieve the strategic return objectives of investors. Two, the total rate of return on the benchmark provides a measuring gauge for the actual portfolio return. Three, the deviations in terms of risks (credit, interest rate and liquidity risks in the case of debt/fixed income schemes of MFs) of the portfolio vis-à-vis its benchmark can only be tactical, not strategic. Four, from the point of view of the investors, the expected risks of the portfolios (schemes of MFs) are those underlying their benchmark. Hence, in all professional arrangements for portfolio management of funds, the permitted risk deviations from the benchmark are defined and disclosed upfront.

An upshot of the foregoing is that if the actual risk exposures of a portfolio usually differ too much from those of its benchmark, then the benchmark is a faulty one. If such faulty benchmarks are permitted, then they create the wrong incentives for portfolio managers to take excessive risks at the cost of the investors. A comparison of the risk profiles of the seven schemes (post-segregation) of FT as on March 31, 2020 and their benchmarks will drive home this point (see Table).

Excessive risk-taking

Excessive risk-taking has never benefitted investors, as the schemes underperformed their benchmarks, most notably in 2019-20. Both the one-year and five-year return performances of all the seven schemes of FT were way below their respective benchmarks. The brutal truth about taking too much credit and liquidity risks vis-à-vis a benchmark, as a matter of strategy, is that the impressive extra returns that this may generate for in a few years get more than wiped out in one bad year. This is most vividly illustrated in the case of Dynamic Accrual Fund as well as of Ultra-Short Duration Fund, where the risk and return divergences vis-à-vis their benchmarks were kind of extreme. In fact, the high credit risk taken in both of them defies any logic.

However, to be fair to portfolio managers, another truth must also be told: credit ratings of debt issuances in India have little use, from a risk management point of view. Inevitably, managers are guided by their own assessments in risk decisions in a flexible manner. This explains the preference for aggregate benchmarks over any of their sub-indices, which would better reflect portfolios’ risk exposures.

Regulatory inadequacy

SEBI’s regulations on the choice of benchmarks by MFs are imprecise, and therefore prone to misuse. For debt schemes, there is a requirement that the benchmark be a ‘suitable index that is a representative of the fund’s portfolio’, which has been interpreted by different MFs in ways that suited them. And, of course, any excess portfolio return vis-à-vis the benchmark has routinely been publicised as ‘alpha’, even when with significant risk differences between the two.

Fund management in a fiduciary capacity is not a fun-filled way to earn high bonuses by garnering smart ‘accruals’ — a desi term for extra yield coming from debt instruments with higher credit and liquidity risks.Regulators owe it to the investors to undertake meaningful reforms in the MF and credit rating businesses in India.

Through The Billion Press. The writer is a former central banker and a consultant to the IMF