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In the normally cosy club of asset management companies (AMCs) and distributors, something unusual happened last month. A distributor, Mumbai-based Subras Investments, broke ranks and put together some investor complaints about HDFC AMC and sent them to the Securities and Exchange Board of India (Sebi).

The investors’ complaint was about HDFC Equity Opportunities Fund Series II - 1100 days, a three-year closed-end scheme launched in July 2017 with “downside protection" embedded in its structure. It had delivered a return of about -17% (-5.4% CAGR) when it matured in July 2020. The AMC asked investors to roll over (extend) the scheme by another 18 months and some Subras Investments’ clients agreed. But the damage had been done and the distributor wanted some answers to how a scheme, with “downside protection" could underperform so badly.

In comparison, the S&P BSE 100 TRI was up about 13.2% over the same period, in absolute terms.

The HDFC case is not isolated. A Mint analysis shows that approximately 26,000 crore sits in closed-end funds, most of which were launched in 2017 and 2018. By and large, they have a three-four years tenor and their three-year average return is currently close to zero. This, though, is not hugely different from what active funds have delivered. For instance, the three-year average return for multi-cap funds is 2.5%. However, the horizon of three to four years simply isn’t long enough for equity funds.

But the responsibility for offering these funds is not with the AMCs alone. Complaints notwithstanding, distributors who sold them must share the blame.

The HDFC Case

HDFC Equity Opportunities Fund Series II - 1100 days was launched on 15 June 2017 with a tenor of three years. It’s USP was “downside protection" through the purchase of put options, a premise that seemed to be wise given the years of market stagnation and crisis that followed. Put options give the holder the right but not the obligation to sell a security at a specific price (the security can be the index itself). These options gain value when stock prices fall.

The scheme’s illustration showed a 12.8% return if the Nifty was at 11,000 levels at maturity. Illustrations are subject to ifs and buts but the actual compounded annual growth rate (CAGR) turned out to be radically lower at -5.4% (-17% in absolute terms) when it was rolled over.

According to the complaint, HDFC AMC misrepresented the scheme to investors and then mismanaged it. The complaint raises several technical points with respect to the scheme documents and advertising material.

Legal arguments aside, Yash Sanghvi, head, business development team, Subras Investments, spelt out three major grievances with the HDFC scheme in a conversation with Mint. First, the scheme had the downside protection feature. However, when the market did finally correct in March 2020, the fund didn’t exercise the put options and make use of the protection, he said.

Second, the scheme changed its benchmark from Nifty 500 to Nifty 50 soon after launch but invested in the broader market more aligned with Nifty 500. This created a mismatch between the actual portfolio of the scheme and the downside protection it had.

Third, it ended up with three different fund managers over the course of its life.

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Photo: iStock

A person with knowledge of the matter, who spoke on the condition of anonymity, clarified that the fund manager exits were beyond the control of the AMC and that it was not humanly possible to time the markets by exercising puts in March. He added that the broader markets had underperformed select large-cap stocks causing the fund to also underperform. Also, it was not possible to buy puts on Nifty 500. The person also added that HDFC AMC has only launched three closed-end equity schemes so far, a much lower figure than its peers.

Emails to HDFC AMC did not elicit any response.

Lessons from the case

The HDFC matter will be settled by Sebi, but there are some wider questions it raises.

First, for an industry preaching the value of “long-term" investing, the practice of launching three-four years closed-end equity schemes is an embarrassing episode. This is particularly apparent when the large number of such funds launched in 2017 mature this year with poor returns.

Second, the idea of closed-end funds itself is a questionable compromise on an investor’s liquidity. “I do not recommend equity at all for time frames of less than three years. I also do not recommend closed-end funds. A lot of things can change in a scheme such as the fund manager or the benchmark and I should have the option to exit in that case. Apart from this, even an investor’s goals might change and he might need the money early," said Suresh Sadagopan, founder, Ladder 7 Financial Advisories.

Sadagopan added that he found no evidence of closed-end schemes outperforming their open-ended counterparts.

The industry itself soured on them after 2018, with closed-end equity fund launches nosediving in 2019 and 2020. This was more a result of the abolition of upfront commissions by Sebi in September 2018. Upfront commissions involved payment of several years of commissions at the beginning itself. Charging this was particularly easy in closed-end funds.

Closed-end funds also come without track records and, hence, get culled out of the recommendation lists of some planners.

“I only recommend funds with at least a 10-year track record. Most of such funds have not been able to do what they are expected to," said Kirtan Shah, chief financial planner at Sykes and Ray Equities (I) Ltd.

Last but not least, take the generic macroeconomic analysis in sales presentations with a pinch of salt. As per the investors’ complaint by Subras Investments, the sales material referred to themes such as bottoming of the non-performing asset cycle, recovery in the capex cycle and shift from unorganized to organized sector, but many of these analyses were either incorrect or simply not implemented in practice. Mint has seen the sales material.

Investors who want to buy closed-end funds in the future should approach them cautiously. A short time frame such as three years for a closed-end equity fund is a major gamble. Note that you are required to exit closed-end funds after the specified tenor unlike equity-linked savings schemes, where your money gets locked in for three years but you can stay in the fund for longer.

The lack of liquidity can also hit you hard if there is an emergency. Be doubly cautious if the fund comes with exotic features like put options that make the illustrations and back tests look good.

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