Only knowledge of the product can protect you against mis-selling

On April 24, the news that Franklin Templeton, a highly-reputed fund house, would close down six debt funds sent shock waves among investors. The fund house attributed the closures to lack of liquidity and the high level of redemption pressure it was facing. Hopefully you are not among those whose money is stuck in those six funds (totaling around Rs 25,000 crore). Those investors face uncertainty not only regarding when their money will be returned but also about how much they will finally see.

Chasing higher risk: Even for those not directly involved, this episode carries several useful lessons. The fund manager invested in lower-grade papers in a bid to generate alpha in debt funds. While such a strategy may be pursued in credit-oriented funds, what was completely wrong was assuming higher credit as well as duration risk in shorter-duration funds, which most investors assume are low-risk in nature.

All this did not happen overnight. This was the denouement to risk that has been building up within the debt market for almost half a decade. Many corporates have defaulted on their debt repayment obligations and many more have been downgraded. IL&FS, DHFL, Essel, Yes Bank, R Com, Amtek, etc. have all contributed to the build-up of pressure within the credit markets in one way or the other.

These defaults and downgrades had an impact on the overall market. Liquidity started to become selective. On the one hand, yields of papers regarded as risky were rising while at the same time banks were depositing upward of Rs 1 lakh crore daily in the Reserve Bank of India’s (RBI) reverse repo window. Even though liquidity was abundant within the banking system, banks preferred to earn low interest by parking their funds with the RBI rather than make risky advances to earn higher interest.

Franklin Templeton has always been known for investing in higher-risk, lower rated papers to earn high returns. The fund manager was well known in the industry for his understanding of credit risk. There is no reason to believe that the fund house or the fund manager deliberately did things that jeopardised investors’ interests. Yet, in hindsight, it appears they overlooked the fact that a higher-risk strategy that works in a benign environment can spell trouble in a market where liquidity has dried up and a high level of risk aversion has crept in. As the more knowledgeable investors withdrew their money from Franklin’s funds, the fund house found it impossible to cope with the high level of redemption and was forced to throw in the towel.

Ways to cut down risk in debt funds

  • If you are highly risk-averse, stay away from them until the credit environment improves

  • Follow asset allocation and make debt funds a limited part of your fixed-income portfolio

  • Avoid funds that take high credit or duration risk

  • Even when investing in shorter-duration funds, have an expert check the portfolio for higher-risk papers

  • Avoid funds with high concentration (above 3 per cent) to a single issuer

Who bore the brunt? Let us now turn to the question of who invested in these funds and why. Retail investors in India have as little knowledge of credit risk as most of us have of nuclear physics or black holes. To believe that they really understand the difference between ‘high credit rating’ and ‘high yield’ would be naïve. Then why did more than Rs 25,000 crore of investor money flow into these funds? Some of it might be money belonging to high net worth individuals (HNIs) or corporates. But a large portion also belongs to smaller retail investors.

Intermediaries driven by commissions: The answer to the above question lies in the link between the AMC and the investor – the intermediary. Higher the returns (and risk), higher the commissions. Intermediaries, individual or corporate, are driven by commissions. Some do follow ethical practices and resort to basic financial planning and risk assessment of their investors. But many are completely clueless about basic bond market concepts, such as the inverse relationship between yield and prices, or higher sensitivity of bonds to interest-rate changes as their duration increases. Yet they happily sell these products to equally ignorant investors who only want high returns, unmindful of the risks associated with such products.

A survey done in July 2019 came up with the shocking finding that as many as 37 per cent of the intermediaries surveyed thought debt and equity are equally risky. If this is the level of understanding of such a large percentage of people selling mutual funds, is it any surprise that we have this fiasco of so much retail money going into high credit risk funds?

Let us go one step further and ask this question: Why do intermediaries have such a low level of understanding? To be fair to them, it is not entirely their fault. Earlier, the Association of Mutual Funds in India (Amfi) exams used to at least have negative marking. Now, the NISM Series VA exams have no negative marking. So, the structure itself does not incentivise in-depth learning.

Many times, sadly, the only discussion that takes place between the asset management company (AMC) and the intermediary is around commissions. Intermediaries are small-time agents and they sell what fetches them the highest return. Sometimes they know what they are doing. But many times, they are not even aware of the happening through them. They are the lowest-level link in the chain. This is not to say they are entirely blameless, but they are not the only ones who are in the wrong here.

What can investors do? This is not the first time that has resulted in such a fiasco within the financial sector. And it is definitely not the last time this will happen. The best way retail investors can safeguard themselves is by preparing themselves, rather than falling prey to the syndrome of the one-eyed leading the blind.

The answer lies in self-education. All those who come seeking your money are service providers. They are only interested in earning their commissions. It is up to you to make the required effort and increase your level of knowledge. It is your money and ultimately you alone are responsible for safeguarding it and making it grow.

The writer is a sector expert with the Department of Economic Affairs-National Institute of Financial Management Research Programme