The Mutual Fund Show: Red Flags And Triggers Investors Must Watch Out For

Prableen Bajpai: Triggers or red flags are slightly stronger words. I would say these should be filters, or that these themes can probably be put in the watch list for investors when they see these changes.

The first one will be a fundamental change in the scheme's objective or structure. This is usually due to some regulatory change, which has been introduced by the regulator–by SEBI–and because of which the scheme has to undergo some structural change. So, investors, at such points have to just check whether the scheme is the same as it was after the structural change, in terms of suitability. Will it serve the purpose for which it was originally taken in the portfolio?

The second one for me is very important, which is the keyman or the organisational hierarchy of a particular fund house where one is investing. This is not only true for AMCs, but also very important even if you have other investment options, be it PMS and even for the firm to which you are probably investing.

So, in passives, this doesn't really matter but with a lot of newer AMCs or older AMCs coming into the limelight at times because of exceptional performance, it becomes important for investors not just to go and pick a scheme. I would say, are they able to name two or three key people from that AMC? That is very important. That's a question they need to ask themselves: Who's responsible for the overall management? How strong is the hierarchy in the organisation? Is there a process (in place)? We have just seen the case of HDFC Ltd. It's a very big organisation. So SOPs and a lot of other standard procedures are there.

But how about a smaller AMC where one person is the main person who's running the show? Keyman risk is not only for AMCs, it's also seen in companies. That is why there's actually an insurance which is called keyman insurance to even insulate businesses.

Third is the performance of the scheme–underperformance over seven to eight quarters, as compared to peers as well as compared to the benchmark. A good measure in terms of active mutual funds should be the information ratio. It's sort of a measure of the fund manager’s performance because it is giving you risk-adjusted returns, not over and above a risk-free asset, but over and above the benchmark.

One more (trigger) I want to highlight is from an investor's portfolio point of view. There should be a trigger for them, or caution should come in place if they see that the markets are in euphoria, and the tenure is very little–let's say one to two years.

Here I will quote the story of Joe Kennedy in 1929, what commonly came to be known as the “Shoeshine Boy” story. His shoeshine boy actually suggested some investment tips and that was a sign that the markets are in euphoria, it's probably the end of the good cycle. So, I think that is a very crucial time for investors whose investment tenure is now barely two years away. They should exit from equity and gradually consolidate the returns that they have made.

Broadly, these are the ones. Of course, too much allocation to a particular fund house should not be there for an investor. So, that's something again that they should check. There should not be more than 1/5th (allocation) in any particular AMC.

Mohit Gang: Prableen has covered a fairly comprehensive list of triggers. If I were to add a few more, the first one is if we see a change in the market cap allocation of the scheme. That's actually very true with the flexible kind of schemes–multi-caps, flexi-caps, value funds, ELSS–and all those kinds of schemes which are blended.

So, what kind of a composition has typically the fund been following–how much in large cap, how much in mid cap and how much in small cap–becomes extremely pertinent with respect to the risk profile of the investor and with the kind of risk he wants to undertake with the fund.

And if you see a dramatic change in the philosophy, let's say a particular fund has been running a large cap dominant strategy with a miniscule composition to small cap and around 10-15-20% in mid cap, and you want that kind of profile of the fund.

But, suddenly, if there is a dramatic change and incremental small cap is fairly high or mid and small cap suddenly overpowers the large-cap allocation, then you need to know or have a discussion on whether it's the right time to exit the call because that was not the objective with which you entered into the scheme. That was not the mind frame at that point of time. So, the composition of the market cap is a critical factor.

Prableen touched upon key personnel but to my mind, a narrowed down, focused approach is on the fund manager himself. To me, the money invested is as good as with whom it is invested.

It is obviously the broader framework of the fund house and their philosophy, so on and so forth and processes and everything.

But the man who's managing the money finally is the one who's responsible for giving you returns.

And if I was comfortable with Prashant Jain for 20 years of my life, and if there is a sudden change now and there's a new guy at the helm of affairs, I might not want to continue.

To me, my investment was more safe and secure whatever be the cycles of returns, but I was more aligned with the Prashant Jain philosophy, and I would want to continue with that kind of a philosophy.

You also need to know who's managing your funds. Too many changes of fund managers at a particular scheme to me is a very big red flag. You can't have schemes changing hands every now and then.

Mohit Gang: At smaller houses definitely, the fund managers keep moving up. They try and pick up the ladder and move to newer fund houses. So, at smaller fund houses you will see these changes a lot.

But even in mid-sized fund houses, I have often observed in the smaller schemes–not the flagship ones–there are shuffles around fund managers. There are co-fund managers being added, there is a third fund manager being added, and the first one being taken out.

So, all those kinds of shuffles are fairly frequent these days in the industry because the number of schemes are increasing, new NFOs and fund houses, and so on and so forth.

One more point which I would perhaps want to add is the change in investing style. There could be a fund manager who was kind of avoiding cyclicals or real estate and commodities and infra per se as an investment philosophy. But suddenly you see because of a particular market cycle or news event or a particular budget, you start seeing the fund house loading up on infra stocks or real estate stocks. Then, perhaps you just want to cut out from that because that was not the objective or philosophy with which you aligned with it in the first place. Those are a few key trigger points.

All of these are much more nuanced in terms of doing a deep dive on the underlying stocks and the composition of the schemes per se. So, that's where the investors will have to go down because finally if you really want to align your portfolio with the new market realities, you will have to go down under and see how things are shaping up below the carpet.

Prableen Bajpai: Flexi-cap is, let's say, the younger cousin of the large cap category. In large caps, we have 80% mandatory allocation to large caps, and we have a 20% leeway. If you look at the flexi-cap portfolios, the minimum that they are holding in large caps is around 50%, and it actually goes as high as 85% in large caps.

Essentially, the bigger AUMs are gravitating towards having a large cap-oriented portfolio.

So, flexi-caps in the current format, you have the flexibility. It's totally legitimate on the part of the AMC to actually keep shuffling. So, if I am going in for a portfolio where I am thinking that I need a large cap, instead of an active large-cap fund, maybe flexi-cap can be actually added. That's a good way to do it.

Flexi-cap is a good addition to a core passive strategy. If I have to create a portfolio for somebody where I have given a large-cap passive strategy and a mid-cap passive, then a flexi-cap is not a bad addition because you get allocation to large caps, mid caps, and other segments as well. And those segments may actually be missed out by the index itself.

So, it can be a decent fit. Its usage actually depends on the portfolio and for whom it has been constructed.

Mohit Gang: That's a very valid point which Prableen made. Flexi-cap is the new replacement of the large cap in any portfolio today, in today's context because typically more and more portfolios are getting aligned towards the passive strategy on the pure large cap side. So, it's better that if you really want to play active out there, you go with flexi-cap.

I'll give an example. It's a stated philosophy for Kotak Flexicap Fund, which is perhaps one of the largest out there at around Rs 39,000 odd crore AUM that they will steer it predominantly towards large caps. They will keep almost 70% plus large caps in the portfolio. And when you know that it's the stated philosophy and you get into the fund with that philosophy, then you will know that you are replicating a kind of an active large cap in your portfolio.

But a sudden change there could disrupt the philosophy with which you enter and that you have to keep in mind. But otherwise, that's the way to look at flexi-caps.

Prableen Bajpai: Whenever there is a new fund in the market, what happens is that we all sort of are subject to listening to what is being told to us with respect to that particular category. I think we are more influenced then. So, amongst triggers, it is crucial for investors themselves to check why they are investing. Are they themselves subject to something like framing bias where they think that there is a perfect fund which is out there and they should invest in it or probably flexi-cap is a category that I have missed out on.

So, even for the existing categories or funds or a new category or funds, it is so crucial. Every scheme or category can play a role, but it is very important that you don't just go and pick anything. The right place in the portfolio can do justice to both sides.

Mohit Gang: Honestly, the triggers for the debt (side) are quite different from what you observe in equities per se. That is a much more complicated category. The first and foremost part when I invest in a debt fund is not whether I'll get 50 bps more or 50 bps less, but I think safety of my capital is the first principle when investing in debt.

So, the change in credit quality of a fund is one of the biggest triggers in a debt fund.

If I am investing in a complete AAA portfolio, I don't want that to be diluted under any circumstances. So, there are fund houses, there are fund managers whom I know will always follow a full AAA portfolio basically, and that's where I am comfortable.

Suddenly, if you see a rise in AA or A papers going beyond 10% of the overall portfolio, that's the biggest trigger and the first alarm bells should ring.

Every month when the portfolios are out, one should have a portfolio check. If you see the exposure has increased in low quality credits, one has to press the red bell out there. That is the first point.

The second obviously is in a situation of a credit event, if you see papers being downgraded consistently in a portfolio. Let's say you see Vodafone kind of events, where AGR dues are there and you find a ruling coming out in court, or you find a DHFL or an IL&FS kind of an event where papers are getting downgraded consistently in a particular portfolio. Then you might just want to cut your losses and exit the portfolio before any big credit event happens.

Even if a credit event has taken place and you know that the portfolio will get segregated now, and you know that whatever loss has been segregated out. It might not be a bad call actually to take an exit if you see the portfolio has produced one kind of a credit event. That has to be a calculated call on the overall portfolio. But yes, one can consider that.

The third point emanates out of the attributes of a portfolio, which is change in duration of the portfolio. Now, debt being interest rate sensitive, if I have invested in a short end of the curve–which is if I am investing in ultra-short term funds or low duration funds, or money market funds–I don't want my duration to go beyond two years or one year. I have a mental threshold to that and I don't want to take any interest rate risk in my portfolio.

But if I see a fund manager suddenly acting like a dynamic bond manager, let's say in a medium term trying to go 10-year duration. Those kinds of triggers are very high alarm bells for me. At that point in time, one needs to take a quick call on the portfolio, in terms of what kind of risk one wants to assume.

The last point on the debt side is a sudden drop in AUM. An AUM rise or fall can still be accommodated in equity.

Debt is mostly institution money, which means a lot of institution people have pulled out and they must or could perhaps be privy to more information than what retail investors are.

If AUM suddenly drops to a large extent in a debt fund, that's a very big trigger for us, and at that point in time, it's good to quickly take an exit.

Mohit Gang: It's a very big red flag because there is something which is going amiss, which we might not be privy to, and institutional investors typically have more information on these things.

I am not saying they know something that is happening inside the fund. But yes, because most of the debt dealers or bank treasuries or larger treasuries keep a close eye on the corporates, they know what kind of profile of corporates might miss payments or might go down or are facing trouble in their credit or things like that. They will be prompt enough to take an exit. If it pulls down the AUM of the overall fund then it's a trigger point and retail investors should avoid these kinds of zones.

Prableen Bajpai: As a retail investor, something that they need to check before investing in debt, which is very crucial is the YTM. Because if a YTM of the fund, yield to maturity of a particular scheme, is exceptionally high as compared to its peers and what the benchmark rates in the economy are, that means it's either taking a higher credit risk or there is higher interest rate risk. So, that is something for investors to watch out for while investing.

You have to see the YTM and there has to be a justification. So, they will either see the duration of the fund. If we see in today's times, it would be the longer duration funds which are giving you a good YTM or it will be the ones which have low credit rated papers.

Recently, in the newspaper, the cover page was of a 12.5% corporate bond. So, when your FDs are at 5%, struggling at 5-6%, why should somebody give you 12.5%? There has to be a reason behind it.

I think this is for any investment product, which is offering you exceptionally high returns, especially saying that it's a fixed income product because 12.5% is more than what I would even say for equities. We take 11% sort of calculations even when we talk about equities.

So, this should be a big red flag and something for investors to be sure about when they are entering because they are probably taking one or the other kind of risks. That is something they should understand.

Secondly, there is the concentration risk. Sometimes, a lot of papers of a particular sector are there. Let's say infrastructure is heavily present or a particular sector has higher weightage. That should also be avoided.

Honestly speaking, as a retail investor when you are doing your day job, it is very hard to go and check what is going to be the sector allocation. So, these are jobs for their advisor probably to do.

Other than this, Mohit has covered it. A very important thing for investors not to be disappointed in debt investments is to be sure about their investment horizon and then match the right fund to it. So that the returns that they are entering, the YTMs they are entering it with, they are able to actually get those sort of returns for themselves.

Mohit Gang: SEBI has come out with this new regulation around nomination. Every new folio which gets created now will have to mandatorily either opt in or opt out of nomination. And that opting in or opting out will have to be through a form basically.

So, the investor’s form, a physical form will have to be submitted along with this purchase order. Even if he is transacting on a digital platform, that physical form will be filled digitally and will be e-signed by the investor. If it's in a physical form, it will have to be submitted on nomination with a wet signature of the client.

So, if I as an investor tomorrow invest in a completely new fund which will create a new folio for me, I will have to either opt in of the nomination and provide a PAN card and PAN numbers of my new nominee, or I will have to say that I don't want to nominate anyone.

In either case, I will have to submit a form. Even opting out is now compulsorily through a form with wet signatures. The new regulation is effective from Aug. 1.

Mohit Gang: If it creates a new folio, yes, but if it is an existing folio, in that folio if the nomination is maintained, the remediation of the old folios, the cutoff date is till April 1, 2023. So, you still have one year for the old remediation to be done, but any new folio will have to mandatorily submit this.