»The Honest Truth by Ajit Dayal

Black swans, Black crows and Fund lies
27 APRIL 2020

Mutual funds are a great way for investors to channel their savings for long term investments and to generate returns.

But the way mutual funds in India are launched, marketed and (mis)sold has always led to a crisis for investors who flock to the mutual fund houses with a bagful of savings and a mountain of trust.

The bankruptcy of Lehman Brothers on September 15, 2008 engineered the Great Financial Crisis which was brought about by the crooks of finance. This led to the Great Financial Swindle which rescued those same bad actors at the cost of trillions of dollars to tax payers. The Financial Services Commission set up to investigate the reasons for the GFC asked: how did it come to pass that we cannot punish a bad actor because the very act of punishing the bad actor will punish the entire society?

In India, the mutual fund industry is becoming a veteran at seeking bailouts. First they create the mess, then they get into trouble, they put the entire financial system in jeopardy and then they stand in the bread line for a bailout! Of course, salaries, bonuses and ESOPs will remain firmly in the pockets of the fund managers and the CEOs - but the bail-out bill stays with the government and the tax payer.

Having mis-communicated and mis-sold debt funds in the 2005 to 2007 boom period, the Indian debt mutual funds took a knock after the Lehman bankruptcy. They quickly went to SEBI pleading for a bailout. Reportedly, the then Chairman of SEBI told them bluntly: you AMCs enjoyed the profits from high fees when you were (mis?)selling your funds, now solve your own problem.

Unhappy with the firm and correct response from SEBI, the well-connected owners of the AMCs went to the Ministry of Finance. Soon the RBI agreed to a line of credit and bail-out. Referring to that episode, former Finance Minister Chidambaram took great pride in a recent statement asking the Modi government to bail out the AMCs again. Mr. Chidambaram may go down in history as the Alan Greenspan of India - the maestro who thought he was helping the system but, by engineering a bailout, helped create the famous "Greenspan put". The UPA regime bailout of October 2008 was mostly for adding liquidity to the government and PSU bond market but that rescue also saved the corporate bond market. This allowed the rescued mutual fund industry to gamble with bigger bets for the past decade knowing that a precedent has been set to rescue them and forgive their gambling losses.

Governments may change, but the connectivity sustains.

Bad actors with bad intent.

Some argue that the bailout of 2008 worked. They are right: worked very well for the fund houses that caused the problem! The bad actors thrived. They are 5x to 10x larger than they were in 2008 - and they remain unfit and improper as ever. Proof that they cannot be trusted to follow rules, whether in law or in spirit? Many of these mutual fund houses went back and sold more debt funds to retail investors dangling the carrot of higher return as compared to FDs.

To be clear, I am using the phrase "debt funds" in this article in a generic sense to describe any investment in a security which promises a fixed rate of return over a fixed tome period. Mutual funds own an estimated Rs 13 lakh crore (Rs 13 trillion) in fixed income instruments issued by the government (low risk, 15%), AAA (low risk but higher than government risk, 60%) and the rest is of higher grades of risk. As the lockdown further slows economic activity and the past few years of miserable economic growth take its toll, even the AAA can become higher risk. So, it is possible that between 30% to 40% of the mutual fund industry's fixed income holding is no longer considered AAA equivalent. That is the nightmare which the industry may have to face.

In reality, 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 (see table below for a sample).

(Rs Cr)
Category Credit Quality,% of portfolio
AAA AA A & Below Govt Cash
Ultra Short Term 1,022 Ultra Short Duration 12.29 50.65 20.42   16.29
Ultra Short Term 6,155 Ultra Short Duration 33.56 58.36 7.30   0.78
Medium Term Bond 6,627 Medium Duration 35.10 60.56     4.34
Medium Term 2,896 Medium Duration 47.93 31.06 18.08   1.65
SL Dynamic Bond 2,481 Dynamic Bond 50.35 25.02 14.08 8.08 2.47
Prime Debt 911 Corporate Debt 70.58 21.20 4.74   3.48
Banking & PSU Debt 4,874 Banking & PSU Debt 72.11 16.24 8.71   2.94
As per Factsheets March 31, 2020

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?

My profit, my bonus - your loss.

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.

The investors in these debt funds were duped into a high risk product because they were sold the returns - the risks were never explained.

As the founder of the Sponsor of Quantum AMC, which manages the Quantum Liquid Fund and the Quantum Dynamic Fund, I know that the fund managers at Quantum Mutual Fund could have followed the same devious approach. Quantum Mutual Fund could have been a party to this scandalous game of boosting returns to gain more assets. Of course, every investment is a risk - all investments are risks. Yet, we set the tone at the top and made sure it reaches all the way down: no boosting the NAV books to collect more AuM. No misleading investors. Debt funds are not to take on private sector credit. They are to be invested in government debt; no investment in debt issued by Tata, Birla - or a junk company. This is part of the process built-in to this day - long after I have left Quantum! Our Charter of Principles sets this approach to keep it simple and stay focused on the interests of investors.

Black crow - not a black swan.

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. The continuous appearance of mutual fund veterans on TV channels is because of a concerted effort by the mutual fund industry to spread a narrative: we are safe; we don't have questionable investments in our portfolios for the past 18 months!

No fund manager and no CEO of any mutual fund house can hide behind the lie of "these are unusual times" or "this is a black swan event". 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.

Here is a partial list that may refresh their memory:

1994: the Harshad Mehta scam,

1995: the Mexico tequila crisis and the collapse of Emerging Markets,

1997; the Asian crisis and the collapse of Emerging Markets,

1998: the bankruptcy of Russia and hedge fund Long Term Capital Management,

2000: the collapse of the tech bubble,

2001: 9/11 and the bankruptcy of Unit Trust of India

2003: SARS, the Iraq war

2008: the bankruptcy of Lehman, the Global Financial Crisis

2013: Bernanke's twist led to India's collapse,

2016: demonetisation and the Great Indian Economic Slowdown

2018: bankruptcy of IL&FS,

2019: Cooperative banks and developers going bust,

2020: YES Bank, COVID-19

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. Sounds more like a jhoot boley, kauwa kaatey everyday crow than a series of rare and exotic black swans sighted once every 100 years!

If any research analyst or fund manager - or a CEO of a mutual fund house - believes that events that happen every few years are still to be presented on TV as a "black swan event" which supposedly happens once in a generation, then they are not fit and proper to manage mutual funds for retail investors under an AMC license.

Gambling for higher returns.

The COVID virus was not the reason for this mess.

It was the trigger for the mess that was building up for a large eruption. We had the mini-volcanic eruptions of IL&FS, we have numerous real estate companies default on loans taken from NBFCs funded by mutual funds, we have had cooperative banks default, and we have seen the default of YES Bank. Yet, the fund managers and the CEOs went about gambling on poor quality investments - all in the search for a higher return to tempt the next investor to come in.

The bets they have made were on the premise of the Greenspan put, so eloquently messaged by Mr. Chidambaram.

Like a bad apple, these fund houses are spoiling the marketplace which is now hindering the smooth functioning of the corporate bond markets. Companies with legitimate businesses and genuine liquidity problems will now find it difficult to gain access to necessary finance because the bankruptcy of smaller, poor-credit companies. That is the contagion effect. The greed of some mutual funds houses has led to this national calamity.

Yes, the government does need to step in and direct the RBI to step in.

But enough of a free lunch with multiple desserts - and mango with ice-cream to top it all.

Make a simple rule: those who take the bail out money from the RBI should surrender their AMC license. Wind up your portfolio. Return your money to the investors and step into the sunset - maybe with some claw-back of the bonuses and ESOPs you have extracted.

If the condition of a SEBI license to carry on the AMC "business" is to ensure that the entity is "fit and proper", these entities which stand in the gravy line have just lost their right to remain in business.

The Houdini act and the Greenspan put.

Or are these mutual fund houses so powerful that they will:

  1. get the rescue package,
  2. get to keep their bonuses, and
  3. then use all the lobbying power of the false gods of corporate governance to innocently ask SEBI to raise the capital required to be an AMC?

The large AMCs have done this Houdini after every crisis!

When in trouble, they start to cause trouble for the small, straight-forward fund houses. The larger AMCs know that a higher capital requirement will squeeze out some of the smaller AMCs that have played by the book in letter and spirt, leaving the larger AMCs more space to mislead investors until the next time the crow squawks!

Meanwhile, be careful with your cheque book, the mutual funds are coming for a rescue package - and you will pay for it, twice! Once from the haircut (if you were an investor in their mutual fund frauducts); and the second time via a bail-out package from institutions owned by the citizens of India...