Shyamal Banerjee/Mint
Shyamal Banerjee/Mint

Lessons to learn for mutual funds from Amtek Auto default

The typical mode of selling a debt mutual fund is on the basis of past or projected returns. However, different funds carry differing risks

There has been a minor storm brewing in the debt mutual fund space. The proximate cause for this has been a default by Amtek Auto Ltd in redeeming the bonds issued by it. This has raised numerous questions relating to the operations of mutual funds, the bond market, rating agencies and so on.

Here are 10 lessons that were learnt from the Amtek episode.

Rating agencies are not infallible: We need to accept this once and for all. We have seen this in the international context in 2008 with regards to the ratings given to subprime mortgages. Even otherwise there have been numerous occasions where these agencies got it wrong. Hence, their opinion can at best, be only one among many factors while deciding the credit worthiness of a borrower.

Fund managers should diversify, especially in debt funds: The opinion on concentration versus diversification is mixed as far as equity funds go. Indeed, you could have a situation where the best stock idea may go up five times, while the second best idea only gives a 20% return. However in the case of debt securities, most issuers with a similar credit risk pay interest which is not very different from one another. In such a situation, putting too much money with one borrower does not give any benefit but makes the fund very risky.

All debt funds are not created equal: The typical mode of selling a debt mutual fund is on the basis of past or projected returns. However, different funds carry differing risks. One has to go through the portfolio of the fund to understand the credit risk that the fund is running. If you are using the services of a distributor or an adviser, ask them to evaluate the credit risk for you. Indeed it is their duty to do so for the fees earned by them.

Immediate recognition of the problem helps: If there is a problem with certain investments in the portfolio, the net asset value (NAV) should be marked down immediately. Delay in recognising the problem only helps those who redeem early at the cost of the remaining unit-holders.

Create a vibrant corporate bond market: Even if a fund were to identify a problem early, currently there is no mechanism to exit the investment or to correctly value it. In order to create a vibrant corporate bond market, one needs to increase the number of participants and reduce the per trade lot size. Early signs of the success of this approach are visible in the tax-free bond market where a lot of high net worth individuals (HNIs), corporations, individuals and so on are investors. We should replicate this approach with the general corporate bond market. In the absence of a large number of investors and lower trade sizes, the market would remain stunted.

Restricting redemptions and creating side-pockets: While it seems unfair to restrict redemptions and create side-pockets in open-ended mutual fund schemes, it is probably even more unfair if redemptions happen at unrealistic NAVs. In a scenario where there is no market price for a large portion of the fund’s assets, people who manage to exit may leave the residual unit holders with a fictitious NAV comprising of illiquid assets which may not be realised anywhere close to the declared NAV. We should have a system and a code of regulations in place whereby investors, regulators, asset management company officials, trustees, registrars and distributors are clear as to what will be the course of action that will be taken in case of market disruption, or when there is a run on the mutual fund, or when a large portion of assets become illiquid, or in the case of a default. Such a code will eliminate arbitrariness and avoid panic and also help resolve the situation at the earliest.

Amtek Auto’s default is not the first and will not be the last: One should not try to get quick fixes or convey to investors that this is a one-off event. Not all money lent by banks gets repaid. In the same way not all money lent by mutual funds will come back. The risk is ultimately to the investors account.

There should not be any attempt to try and get someone to bail out the fund: There is a temptation to shift troubled assets to some other pocket. Many would try to get the sponsor to buy off the asset. It should be clearly understood that a mutual fund is a non-guaranteed product and all the returns and risks are to the investor’s account.

There should not be a blanket ban on investments in lower rated papers: This would be harmful to the development of a bond market in India. One may explore the possibility of allowing only HNIs in debt funds investing in lower rated papers. This category of investors is presumable well-informed and has a higher risk appetite.

Recognise that mutual funds are pass through vehicles: And temptation to have capital adequacy kind of thinking—as in the case of banks and insurance companies—should be resisted. The main thing with mutual funds, is investment competence, compliance and discipline. Having large capital and promoters with big balance sheets is no guarantee that things will not go wrong.

Rajeev Thakkar, chief investment officer and director, PPFAS Asset Management Pvt. Ltd.