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Honey, I shrunk the portfolio! - Views on News from Equitymaster
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  • May 16, 2000

    Honey, I shrunk the portfolio!

    A statement like that from your fund manager is sure to shrink your confidence in him by a measure equal to the shrinking of the fund portfolio. And lack of confidence in the fund manager is never a good thing for the mutual fund investor.

    The roller-coaster ride of the BSE Sensex has not spared anyone. It has taken in its wake all elements related to equity markets. And since mutual funds (MFs) constitute a very critical element of the markets, the market melee has had its impact on the mutual fund investor and the fund manager. The latter is of particular interest to us in this report.

    The above chart explains why roller-coasters have been largely associated with the BSE Sensex over the past one month. In April the BSE Sensex has lost close to 400 points, a decline of 7.8%. While there was some reprieve when Yashwant Sinha played He-Man and tried to rescue the markets by introducing some sops for the pharma and software sectors, sentiment has been largely negative. The new golden triangle- technology, media and telecom (TMT) witnessed a distressing fall in valuations to what some people associate to the meltdown (read correction) on the NASDAQ.

    Fall in TMT
    The free-fall in TMT stocks was particularly distressing for mutual fund investors who had pumped in money in technology funds only to see their net asset values (NAVs) dive - in some cases upto 40% in just one month. Mutual fund investors reacted just like other equity investors and exited in hordes. However, their distress was nothing compared to the distress of fund managers who had taken huge exposures to software stocks to ride the software boom in the country. In fact quite a few cases even Balance Funds had such large exposures to software, that the demarcation line between a growth fund and a balance fund became invisible. Balanced funds not so well balance. The situation would have been even worse had it not been for some inflows from investors who are looking to collect some quick dividends. Dividend stripping - bane or boon

    Double blow
    The slump in software stocks dealt fund managers a twin blow. On the one hand they saw their portfolio valuations diving rapidly, and on the other hand they had investors lining up for their redemption cheques. Faced with little choice they were forced to offload stocks (mainly software) at prices, which were far lower (at times by over 40%) than their purchasing price. So we had the family silverware being sold for peanuts. Of course some fund managers were lucky enough to hold liquid stocks like Infosys, Satyam, NIIT.

    Other fund managers were not so lucky. For some inexplicable reason these fund managers chose to invest in illiquid stocks. This tightened the screws on these managers who found it difficult to offload these stocks in a falling market. So when redemption pressure was its peak they could not generate cash to pay nervous investors, who wanted to exit. And to compound matters most fund managers were short of cash when volatility was at its peak and redemptions according to some news reports crossed Rs 25 bn. Managers sold big as was apparent from figures released by SEBI.

    Company 60 Day SMA (vol)
    Visual Soft 7,013
    Fortune Info NA
    Sierro Optima 3,525
    Aftek Bus. 23,895
    Odyssey Tech 34,096
    KLG Sys 10,602
    IEC Software 10,309
    Compudyne NA

    SMA - Simple Moving Average

    The fund managers with illiquid stocks (like the ones mentioned above) were confronted with a classic 'checkmate' situation and had to borrow money to clear redemptions. Regulations permit fund managers to borrow up to 20% of their net assets. According to rumours flying around, some fund managers violated that regulation by borrowing in excess of that limit. Infact market grapevine has it that atleast two funds are still grappling with a payment crisis of large proportions.

    But what is the rationale behind holding illiquid stocks? Keeping illiquid stocks in the portfolio can work in the fund managers' favour in a steady market. This is because as the stock is thinly traded, all the buying and selling is done by a few other players in the market. Therefore the volume of trades in most of the stocks mentioned above is very low and a significant portion of the stock is cornered by a handful of players. This insulates the fund portfolio to the extent of the holdings in illiquid stocks and protects the NAV (net asset value) of the fund from sharp fluctuations.

    However, in a falling market, the story is quite different. What works for the fund manager in a rising market, works against him in a falling market. When the fund manager needs cash urgently to meet redemptions (as was the case) he will find it difficult to get buyers for the illiquid stocks. And when he does find a buyer, the manager will not be in a position to dictate the price.

    Lessons to be learnt
    The recent volatility has some important lessons for both investors and fund managers. Investors have learnt that like stocks, mutual fund NAVs can also decline sharply, sometimes upto 20% in just a week. As advised by Mr B. G. Daga (Executive Director of Unit Trust of India) investors must outline their investment objective before entering a fund and must understand the risks.

    Open-ended, IT Schemes NAV
    Alliance New Millennium Fund (Growth) 9.9 -21.8% -31.5% -35.4%
    Birla IT Fund (Growth) 23.3 -20.0% -27.2% 19.5%
    IL&FS eCOM Fund (Growth) 8.1 -23.3% -31.7% -40.3%
    Kothari Pioneer Infotech Fund (Growth) 34.1 -20.2% -22.0% 231.0%
    Prudential ICICI Technology Fund (Growth) 7.2 -20.5% -27.3% -27.3%
    Magnum Sector Funds Umbrella - IT Fund 19.6 -26.3% -30.5% 175.0%
    UTI Growth Sector Fund - Software 26.2 -26.0% -31.9% 106.7%

    NAV as on 21st April, 2000

    For the fund managers one thing must be pretty clear - greed never pays, at least not in the long run. Heavy (and unjustified) exposure to TMT stocks gave them impressive returns last year and resulted in huge inflows. But when the markets fell, this very over-exposure (to TMT stocks) did them in and investors fled in a hurry. Conservative mutual funds like Zurich India MF and Templeton India MF did not witness sharp fluctuations in their NAVs as the managers stuck to their investment objective and gave their portfolios a truly diversified look. Ultimately fund managers must realise that their investors do not expect them to post excellent returns day in day out. All they are looking for is decent returns over a fixed time frame. So managers must curb the urge to undertake risky investments just to show great returns. Because what's great today, may not look so great tomorrow.



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