Franklin Templeton – The Unkindest Cut Of Them All?
Oh, look what you've done.
You've made a fool of everyone
Oh well, it seems likes such fun
Until you lose what you had won
- Jet, the Australian Rock Band
Let this sink in: Rs 30,000 crore of debt assets for an asset management company translates to approximately Rs 300 crore of revenue loss per year. Then the harder-to-calculate other losses – namely in reputation, a flight of other assets, etc. For an AMC to take such a stance must not have been easy.
Franklin Templeton – the fund house that taught a whole generation of advisors and investors what mutual funds are; in many senses, it is a group of best practices in the industry. For it to pull the curtains down on such a large quantum of assets seems almost like a bad dream.
It was well known that they had a maverick fixed income team headed by a man who ‘understands credit’, has been investing in ‘unheard of’ names but has been churning out juicy returns. That was never a secret. Even so, when they shuttered six funds overnight, it was overwhelming news. I am sure there is hurt all over, in addition to shock and disbelief.
The morning after, when I was able to think clearly again, I dove in to carry out some research and looked at data. My inference is broken down into three segments.
1. What On Earth Did FT Do And If It Is Wrong, How Wrong Is It?
The firm has explained in its public note and conference calls that it shuttered six investment schemes in the best interest of clients.
It’s the law of weights.
If as a fund manager, I assign 10 percent weight to each of 10 investments in my fund and people rush to redeem, I have to create liquidity by selling the most liquid investments. Eventually the less liquid ones become larger and larger in weight. In that sense, some investors benefit from liquidity; the ones who don’t act fast end up holding the crying babies. Eventually, to create liquidity I will have to undertake a distress sale and erode value, even substantially so.
The Franklin Templeton note illustrates that it tried every other option available; borrowed to meet redemption pressures, approached SEBI, and increased the borrowing limits in some cases. It even considered disallowing redemptions for a while and then finally decided to shut the funds. Investors will get the money when each instrument comes up for maturity or pays interest, obviously after meeting the borrowing obligations. This seems legitimate and in the best interest of the existing investors.
(The shuttering of schemes tells of how hopeless the fund manager must have felt. I’ll discuss why later.)
Problem No. 1
The peculiarity of our Indian debt market, for a long time, has been that central and state government bonds and public sector undertakings’ bonds have always crowded out private sector borrowings. Even in the very small portion of the market that does cater to corporates, there is hardly any depth – most people like to deal with only AAA or AA rated bonds. Several market observers and participants have been clamoring for the creation of a secondary bond market for lower categories like other countries have. After the Insolvency and Bankruptcy Code, 2016 was legislated, there was some opportunity for policymakers to create a ‘junk bond market’ and gradually nudge larger institutions to participate so that legitimate, non-willful defaulters could find ways to refinance their debt. Anyway, that didn’t happen.
However, in this backdrop, mutual funds were continuously allowed to run funds that would buy bonds in the high-risk category, the below AA kind.
Problem No. 2
Creating an open-ended structure that declares a net asset value every day is adding another layer of complexity. When there are defaults, mutual funds have to take haircuts and the funds have to be marked to market. Contrast this to what banks do when they extend a loan to perhaps the same entity – they can wait for quarters before marking it off as a non-performing asset. Therefore, even under normal circumstances, one might say this is a risky business.
Problem No. 3
Troubles in the economy and credit markets were already showing up. Several mutual funds took haircuts in the last year, marked down some investments to zero, segregated or side-pocketed some investments and were, generally speaking, firefighting. After the Covid-19 pandemic-related lockdown, the risks have grown manifold. Enterprises now need to borrow even more than usual to tide over a long period of no revenue.. But no one is ready to lend. Franklin thought it best to freeze things rather than fight the impossible and start booking heavy losses.
- In public statements, FT announced that it is shutting the ‘managed credit suite’ of six funds and all is well with their ‘high credit suite’. I was at a loss as I often am – maybe I have missed this clear demarcation before?
So I asked around, was there ever any marketing collateral that had identified these six funds as the ‘managed credit suite’ at some point? Any point? The website maybe?
The world learned on the day the shut-down was announced.
- When the regulator clearly says that ultra-short duration funds, by definition, must have a portfolio duration in the range of 3-6 months, why does the fund have over 45 percent of its debt investments maturing in more than a year? 37 percent will mature in 2021, 13 percent will mature in 2022, 12 percent in 2023.
- As on March 31, the Income Opportunities Fund was not left with any debt paper maturing in 2020, and only about 6 percent maturing in 2021. Moreover, it had over 16.64 percent in stressed accounts. Negative cash was over 12 percent of the portfolio. Should at least this fund have been flagged off earlier? Before waiting for a moment like this?
Frankly, beating a dead horse yields no outcome so let us turn our attention to what the other well-known AMCs are up to.
2. What Bearing Does This Have On Similar Schemes Run By Other Mutual Funds?
Franklin Templeton is hardly the only fund house to have invested in higher risk paper. Since the IL&FS crisis, a few of us have tracked closely the exposure fund houses have to business groups in financial trouble.
Here’s what it looked like for top fund houses as of March 31:
So Franklin has much company. But wait, it isn’t quite the same. If you were to go deeper into say the UTI AMC data, you will see a large number of its schemes may have high-risk exposure but are mostly closed-ended. This is what you’d find.
Now of course, Franklin’s schemes too are closed-ended. (Pun intended)
Frankly, it gets worse. Franklin Templeton was the sole lender to 26 of the 88 securities in its portfolio.
Let me also point out the denial that pervades the industry. As discussed earlier, the structural issues confronting corporate debt and risk concentration are an industry-wide concern. But four AMC heads that were on a business news channel spent most of their time defending their funds, and were indifferent about the need for any emergency action from the central bank.
Nevertheless, a day later they got it. The Reserve Bank of India has permitted banks to borrow at the repo window and lend to fund mutual funds. But in the current risk-averse environment that may not amount to much. Fund managers know it. But continue to ignore the elephant in the room.
3. What Lies Ahead
At the end of this storm, what stays with me is the hopelessness in Franklin Templeton’s decision to shutter the schemes, blemishing a 25 year-track record. Had there been any hope of an economic rescue, improving bond market, financial sector reforms, it’s unlikely the fund would have shut the door on its own foot.
There’s a message in that for the regulator. The Securities and Exchange Board of India has been posting red flags. Recently it ordered a reclassification of funds and ensured better labeling of schemes; ‘credit risk’ funds not ‘credit opportunities’. But higher vigilance and monitoring must accompany better, clearer investor information.
The same responsibility falls upon the adviser community.
Because, it is in moments like these that investors realise the value of high-quality professional advice.
Because, 2020 has only just begun.
Updated to reflect the data revision done by Morningstar.
Abaneeta Chakraborty has close to two decades of experience in managing money for ultra-HNI families. She founded the firm Abanwill Consultants LLP in 2017 to provide independent views on investing.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.