|»The Honest Truth by Ajit Dayal|
Small and mid-cap funds: A trap for investors?
1 NOVEMBER 2017
The financial services industry is not generally one that "serves" its customers.
Instead, it tends to find the best way to serve itself by offering products that may not be suitable to its clients or - even if suitable - the risks are never fully disclosed.
True, there is a generic SEBI disclaimer.
But the SEBI-mandated disclaimers - like disclaimers by regulators around the world - are like factual statements that don't necessarily bring about any behavioural change.
We often hear saints (not religious heads, but saints) advising us to "Live a good life and be a good person because one day you will die."
Well, that does not really result in a better behavioural or business attitude.
We still treat most people with contempt and disrespect - or a desire to extract the maximum out of someone.
This is particularly true of the business honchos who populate the financial services industry.
As a few leading lights of the financial firms have owned up to in a series of past confessions (they see their statements as a beacon of light for others to follow on the path to wealth creation - I view them as confessions of sinners), the leaders of financial firms will serve you whatever "level of spice" you wish to be served.
Their school teachers told them "Don't be too honest".
Anywhere. Anyhow, Anytime. They need to make money.
The "financial" in "financial services" is of paramount importance: the financial profits to the company!
"Service" is what they serve to themselves.
The financial firms believe that the fiduciary responsibility to warn you that excess spice may cause you heartburn - or worse, financial ruin - is not their responsibility.
In the US, despite all the failures of the financial firms to serve their customers, the legislators and regulators have been unable to ensure that looking after clients' capital is a "fiduciary" responsibility.
While the powerful lobby of the lawyers in the US would like to see that change (the opportunity to profit from litigation increases!), the more powerful lobby of the financial firms has ensured that customers are exposed to more extraction.
Investor Education or Investor Eradication?
The example of the craze for mid-cap and small-cap funds in India is interesting.
Most fund houses have sold with great zeal the concept of investing in mid-caps.
The mid-cap and small-cap indices are zooming.
Backed by such powerful images and facts, selling an open-end mid-cap and small-cap fund is as easy as selling candy to an innocent child.
The AuM of these small-cap and mid-cap funds are now significantly larger than in 2013: partly due to market action and partly due to the continuous inflows of the marketing machines willing to give you, the customer, whatever level of spice you wish to have. Whether it will result in heartburn is your problem, not theirs!
The unfettered growth of these small cap and mid cap funds may have a dangerous side -effect to your portfolio because:
I looked at the liquidity of five of the more popular small cap and mid cap funds based on the following assumptions and logic:
The results of this analysis (see Table 1) bring up a few interesting points:
Table 1: Your NAV may not be realizable, but your level of spice and heartburn may be!
Source: Personal FN, ACEMF, BSE, NSE
In the case of the HDFC Midcap Opportunity Fund, as of March 31, 2017 their Top Holding in the portfolio was Tube Investments. The Fund owned 72.8 lakh shares worth Rs. 457 crore (2.9% of the Fund's portfolio). The average daily trading volume for Tube Investments was 107,071 shares on the NSE and the BSE. This suggests that this Top Holding of the Fund could take the fund manager 206 days to liquidate in an orderly fashion without causing a disruption in the market price of Tube Investments. The assumption is that the selling by this specific Fund (other HDFC Mutual Funds may own this stock but I am assuming that they don't sell their holdings) should not be more than 33% of the average daily volume of that share for the past one year - as a level of over 1/3rd of the average daily volume may cause a "disruption" in the price pattern of Tube Investments.
Within the Top 10 Holdings of the HDFC Midcap Opportunity Fund, the most liquid stock could be sold in 2 days (Minimum Days) and the least liquid stock would take 206 days (Maximum Days).
By September 30, 2017 the AuM of the Fund has increased by 13.9% (my estimate is that 6.7% due to NAV appreciation and 7.2% due to new units being issued) but the liquidity of the portfolio has deteriorated.
The fund accepted more money by issuing more units and ended up with a portfolio that was less liquid!
The Top Holding will now take 364 days to exit (from 206 days).
The most liquid stock amongst the Top 10 Holdings will take 6 days to sell (from 2 days).
The least liquid stock in the Top 10 Holdings will take 364 days to exit (206).
In both time periods, it seems that the Top Holding was the least liquid stock within the Top 10 Holdings - and would take the longest time to sell.
No safety belt?
If you buy a Maruti car, you would expect that whether you buy the 1st car that rolls off the production line, the 100,000th car or the 4 millionth car that rolls of the production line - it would have the same versatility, the same safety, and the same characteristics, as described in their colourful brochures.
If Maruti cannot deliver a versatile and safe car after the 100,000th car is sold - they will stop selling new cars.
If the 100,001st car is inferior in comfort, safety, speed, or any characteristic important to the performance of a car, then Maruti will halt production.
Not so the manufacturers of products in the mutual fund industry.
You are a willing buyer, they are a willing seller.
The product is hot.
Why will they refuse the next order?
The financial logic to grow AuM is clear.
Larger AuM is larger revenues for the AMCs.
Larger revenues are larger profits.
Larger profits are larger salaries and bonuses for the people working in the AMCs.
This is capitalism: raw and brutal - and at its worst!
The one symbolized by the movie Wall Street where "Greed is Good" is the motto that rules the financial world.
Capitalism, as defined by Adam Smith in his "Wealth of Nations" in 1776 and as envisaged by Sir Jamsetji Tata, was not about maximizing profits but about providing a service and earning a profit - but not any "excess" profit!
The Investor Education money spent on "education" does not warn you about the implicit and explicit hazards of being in a fund that has taken more money in - but retained its characteristics of being illiquid.
What is true for HDFC Midcap Fund is probably true for the other 4 in the list - and probably for the other small-cap and mid-cap funds not in this list! I took the detailed example of HDFC Midcap Fund because it is the largest in this category, not to single it out in any way.
Will many investors redeem simultaneously?
A key assumption in this analysis is that a large number of investors will redeem at once to force the Funds to liquidate a large part of their holdings to honour the redemption requests. Hence, the underlying liquidity of the stocks owned by the mutual funds is important.
Placing a minimum net worth criterion on an AMC is a highly suspect way of ensuring "safety". Big is not innocent. Note that the providers of these more popular and risky large mid cap funds are "big" fund houses with supposedly local or global "institutional" backing!
Risk needs to be controlled at the product level just as it has been done for the valuation of bonds in liquid and bond funds. If the mutual fund industry continues to ignore the risks in its chase of AuM, it will (and must) face the wrath of the regulator - as the industry has witnessed in its wrongful support and promotion of opaque practices on distribution commissions in the past.
Regulations and best practices are designed for stress - for the extraordinary, not the ordinary.
Sadly, in this day and age, the extraordinary happens pretty often!
It has become an ordinary event!
In December 1994, after the Mexican Tequila crisis, we had huge redemptions in the Funds that I managed then - and this taught me to respect liquidity!
The Asian crises in 1997 again caused a sell-off in mid-caps and small-cap stocks and a rout of the NAVs of such mutual funds.
As did the bursting of the tech bubble in 2000 (and the K-10 lafda).
And the SARS crisis in March 2003.
And the Lehman crisis in September 2008.
In August 2013, Ben Bernanke's "twist" and desire to raise interest rates in the USA broke the Indian stock market and the Indian Rupee.
And, in March 2016 - 20 months ago - local investors redeemed nearly Rs 5,000 crore from mutual funds because we had a brief market meltdown in February 2016.
Yes, investors can panic and redeem or cancel their SIPs faster than you can chant the mantra "Mutual funds are subject to market risks; read all scheme related documents carefully."
You must be in a mid-cap or small-cap fund, risk permitting!
Don't get me wrong.
Investors with a risk appetite must have an exposure to small cap and mid cap funds - there are many fund houses with capable managers who have built an enviable track record on such products.
These funds deserve to win investor support.
There is no doubt over the advantage for many investors to have an exposure to small-cap and mid-cap funds.
However, these fund houses need to ensure that greed for AuM - either driven by ignorance or by a desire to chase a higher salary and bonus - does not enhance the illiquidity risk of the trusting investors.
Plus, a darker risk that stares us in the face with these large dominant and illiquid holdings by these funds in less liquid companies is the possibility of manipulation of NAV.
What if, to prop up an NAV, someone has to buy just a small volume of shares to keep the share price of the Top 10 shares at elevated levels?
The NAV will be open to blatant manipulation.
Allegedly the original UTI did prop up stocks and markets, on behalf of various governments and business houses in the 1990's. The end result was a Ponzi-like scheme that imploded.
There was no Unit Trust of India after that and there was no trust in India's capital markets. UTI AMC is a remnant of that meteorite explosion.
The capital markets took a few years to recover from that episode.
After four years of sitting in the penalty box from mis-selling the BRIC nonsense to gullible investors, the mutual fund industry has shown signs of recovery on the back of Prime Minister Modi's election victory in May 2014.
To retain that momentum requires responsible behavior from the mutual fund houses - not a chase for AuM.