Black swans, Black crows and Fund lies
In our conversations with investors, we find the emphasis is largely around returns and very little attention is paid to risk. In this piece, Ajit Dayal, who is not one to pull his punches, especially when it comes to the mutual fund industry, brings out the perils of not using risk-adjusted returns in the context of the recent debt mutual fund fiasco. He argues why the risk-reward for debt funds is simply unsuitable for retail investors to whom these funds have been sold as a superior return product to fixed deposits without a note on the attendant risks.:
“..there are a range of funds that invest in debt instruments: Liquid fund, Ultra-short liquid fund, credit fund, debt fund and others – each of which have a prescribed combination of securities issued by the government and securities issued by the private sector. The rating agencies categorise these various securities on a sliding scale basis from supposedly safest AAA and sliding down to default. The AAA paper carries a lower interest and the less credit worthy company gives a higher rate of interest precisely because it is more risky. It is a simple risk-return equation which is rarely explained in detail to the less sophisticated investors. Fund managers and their CEOs have been irresponsible and have allowed their funds to invest in less safe debt instruments even in the liquid and ultra-short funds category to enhance their NAVs and attract more AuM”
He holds the rating agencies accountable too:
“What makes the debt market more dangerous is that many debt instrument issued by a company can barely be understood and assessed by credit rating agencies with specialised teams. Credit rating agencies continue to falter and rarely accurately predict a company about to default. The credit rating agencies act more like the technician at the morgue pouting over a dead body than a nutritionist recommending a healthy portfolio to stay in good shape. It is a tough business. If credit agencies are not able to catch the collapse, if well-informed corporate treasurers struggle with the basics of risk and return, how is an individual investor expected to understand the underlying risk in a portfolio that promises higher returns? Why are these risky funds being sold to retail investors? Why is any fixed-income fund with any “credit risk” being sold to a retail investor?”
He then goes on to highlight why the whole thing shouldn’t be passed off as a Black Swan event caused by the Covid induced market stress, for this isn’t a Black Swan as market dislocations like this are not that rare anymore citing several such events over the past three decades. So, given the risk profile of the funds, this was an outcome of non-trivial probability.
“The claim on national TV by some fund managers that this is a black swan – an unpredictable event beyond what is normally expected – is a falsehood.
This is a black crow event: it is common-place and frequent to have these dislocations. When you buy junk bonds to fool the investors into believing you are giving good returns, a bad outcome is guaranteed. COVID is the excuse, their greed for AuM is the reason.
Since India opened its economy in 1991 and since the birth of the mutual fund industry in 1993 – with the liberalisation of the capital markets – the AMCs have been witness to and impacted by multiple, so-called, black-swan events. Given their frequency, one can argue these exceptional, unanticipated events are getting to be as common place as black crows sitting by the window screaming for some money to be thrown their way…[cites a long list of market disclocations]…That works out to 17 black swan events over 26 years – each of which have caused a dislocation in the world and in India. 15 of these events were not really black swan events (9/11; SARS were black swan events) – they were results of excessive greed and lack of risk assessment by the perpetrators of these crisis: the banks and mutual funds”
He also warns against a bailout citing moral hazard:
“Now that the mutual fund industry has loaded up on debt issued by private companies (many unlisted), and these companies are in trouble, they are back at SEBI, RBI and Ministry of Finance for a rescue package. Money that could be used to build hospitals, feed the migrant workers, or be used as investments to kick-start a dead economy will be diverted to a bailout.
Some give the example of the UTI bailout as a profitable outcome for the government. That is a false comparison. The UTI bailout was the government taking over a large equity portfolio to square off defined obligations to unit holders. UTI’s special investment purpose vehicle was nationalized. UTI AMC was owned by the government. The government, to our knowledge, is not nationalising the AMCs who are asking for help – but maybe they should take the AMCs over for a nominal price.
The rescue package envisages the government and the RBI being offered the illiquid debt and rubbish junk bonds owned by the mutual funds because no one else wants them. There is a difference between lack of liquidity of a security due to market conditions (a genuine problem) and owning some ridiculous debt of a bad company which these mutual funds invested in because that company offered 2% more interest than safer government bonds.
Make no mistake about it: many fund managers invested in companies that even a 5th standard child would not invest in. They invested with their eyes wide open for a deliberate reason: they could show a higher return and NAV for their mutual fund. Then this higher return could be waved at unsuspecting investors by the distribution channels to collect more AuM from innocent individual investors.
More AuM meant more revenues and more profits for the AMC.
More profits for the AMC meant more bonuses for the fund managers and the CEOs.
Bad incentives lead to bad outcomes.
It is as simple as that. It always has been: whether it was in the Indian debt funds or in the loans given by banks for mortgages in USA in 2004.”