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Liquid funds: reality of expense ratios

Some liquid funds borrow from the market to meet redemptions, instead of selling underlying securities. So, the declared expense remains lower

What happens if your mutual fund scheme is faced with redemptions? Ideally, it should sell its existing securities, generate cash and pay that to investors. But mutual fund industry experts tell Mint that many liquid funds manage their redemption in an ingenuous way—by borrowing money from the market to meet their redemptions, instead of selling their underlying securities; a practice that goes against the principles laid out by the Securities and Exchange Board of India (Sebi) mutual fund regulations. Investor returns do not get hit here, but this practice shows tricks by which mutual funds try to pump up returns, even if artificially. Should you be worried?

Does it matter to you?

Yes. Your mutual fund returns are generated from its underlying securities. When your fund has to meet redemption demands, it should ideally sell these securities to generate cash. Although Sebi guidelines allow fund houses to borrow only to meet temporary liquidity (or, redemption) needs, if your scheme borrows often instead of selling its underlying securities, it violates Sebi guidelines in principle. “This is called leveraging and it is unfair to borrow frequently when Sebi has allowed us to use the tool temporarily," said a senior executive of a fund house, on condition of anonymity.

Further, many fund houses don’t account for borrowing costs. Experts said some fund houses add this to the total expense ratio (TER) internally but surreptitiously don’t disclose it “to keep TER at a consistent level," said the executive quoted above. This results in the disclosed TER being lower than the actual one. A few asset management companies (AMCs) take this cost on their own books, instead of passing it to the scheme, thereby keeping the expense ratios artificially lower.

“An artificially reduced expense ratio paints a wrong picture. If we borrow and pay interest on it, the scheme has to be charged for it, since the borrowing is meant for that particular scheme only," said the chief executive officer of a fund house.

In March 2017, Sebi had written to Principal PNB Asset Management Co. Ltd for “showing lesser TER in books by excluding component of interest on borrowing while calculating percentage TER"; as per the mandatory disclosures in the scheme information documents of Principal PNB Asset Management Co. Ltd’s mutual fund schemes. Senior executives of the fund house were unavailable for comment.

How fund houses manage expense ratios

Assume that your liquid fund’s assets under management are Rs1,000 crore. On a given day it gets a redemption request of Rs200 crore and an inflow of Rs100 crore. Assume the scheme’s portfolio has short-term scrips like treasury bills (T-bills), certificate of deposit (CD) or commercial paper (CP) worth Rs100 crore. Ideally, the fund has to sell such securities and meet the rest of the redemptions from the inflows. But if the T-bills get a return of, say, 7%, the scheme borrows money, typically from the Collateralised Borrowing and Lending Obligations (CBLO) market, where it pays lower interest of, say, 6%.

Since the fund hasn’t sold any securities to meet redemptions, it continues to earn interest on the entire sum of Rs1,000 crore, and its performance is enhanced.

The way ahead

On 5 February 2018, Sebi asked all fund houses to mandatorily disclose expense ratios of all their schemes, on a daily basis. But in the absence of a clear directive about how to account for borrowing costs, fund houses have taken different paths to account for their borrowing.

Mint sent emails to some of the largest fund houses that also manage some of the largest liquid funds, such as ICICI Prudential Asset Management Co., HDFC Asset Management Co., Reliance Nippon Life Asset Management Ltd, Aditya Birla Sun Life AMC Ltd and UTI Asset Management Co. Ltd. We had asked them:

1. How frequently had their liquid funds borrowed from the CBLO market in the last 6 months to meet redemptions.

2. If they make such a borrowing, do they add the borrowing cost to their TER?

3. If they don’t add it to the TER, how do they account for it?

Mint also emailed the Association of Mutual Funds of India (Amfi) for its comments on this industry practice and whether it has issued any guidance to fund houses. We did not receive any response till the time of going to Press.

A representative of a small fund house told us, on condition of anonymity, their auditors had told them that on days that its liquid scheme borrowed money from the market, it should use the inflows of the same day only to repay the borrowings, and not deploy that money in any other way; limiting the benefits. The head of the fixed income arm of a mid-sized fund house told us, yet again on condition of anonymity, that his liquid fund maintains a constant expense ratio, and if and when there is a borrowing cost, the asset management company absorbs it.

Although the impact on the investor is little, such sharp practices, through which fund houses choose to interpret regulations in ways that benefit them, don’t bode well for an industry that seeks trust from investors. Even if they claim such moves benefit investors, finding regulatory loopholes is just a race to the bottom.

On 5 February 2018, Sebi asked all fund houses to mandatorily disclose expense ratios of all their schemes, on a daily basis. But in the absence of a clear directive about how to account for borrowing costs, fund houses have taken different paths to account for their borrowing.

Mint sent emails to some of the largest fund houses that also manage some of the largest liquid funds, such as ICICI Prudential Asset Management Co., HDFC Asset Management Co., Reliance Nippon Life Asset Management Ltd, Aditya Birla Sun Life AMC Ltd and UTI Asset Management Co. Ltd. We had asked them:

1. How frequently had their liquid funds borrowed from the CBLO market in the last 6 months to meet redemptions.

2. If they make such a borrowing, do they add the borrowing cost to their TER?

3. If they don’t add it to the TER, how do they account for it?

Mint also emailed the Association of Mutual Funds of India (Amfi) for its comments on this industry practice and whether it has issued any guidance to fund houses. We did not receive any response till the time of going to Press.

A representative of a small fund house told us, on condition of anonymity, their auditors had told them that on days that its liquid scheme borrowed money from the market, it should use the inflows of the same day only to repay the borrowings, and not deploy that money in any other way; limiting the benefits. The head of the fixed income arm of a mid-sized fund house told us, yet again on condition of anonymity, that his liquid fund maintains a constant expense ratio, and if and when there is a borrowing cost, the asset management company absorbs it.

Although the impact on the investor is little, such sharp practices, through which fund houses choose to interpret regulations in ways that benefit them, don’t bode well for an industry that seeks trust from investors. Even if they claim such moves benefit investors, finding regulatory loopholes is just a race to the bottom.

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