BS Fund Cafe: Banks obviously have NPA issue, MFs don't, say fund managers

India's leading fund managers say it is unfair to compare the fund industry's issues with the banking sector's woes

What has gone wrong with debt investments in the recent past? Do you as an industry take the blame?

S Naren: Two years ago when we did any investor event in debt, the only question people had was about the yield to maturity of the fund. It was as if a product with a higher yield to maturity also guaranteed higher returns. If I told them I was not willing to take that additional risk for generating the extra yield to maturity, people would look at me and say you are an equity guy, and do not understand debt. So, as a fund house, we went through a more difficult time in 2017 than in 2019, as all the risks we were expecting in 2017, kind of played out. 

How do you see this as a value investor? 

Naren: Coming from a value investing background, the biggest challenge is when markets do very well. So, like 2007, people say I am a value investor but in 2007 my fund (equity) underperformed the benchmark 15 per cent but, the whole thing was reversed by 2009. In debt funds, when you have higher yield to maturity I would say risks are higher. 

Sebi (Securities and Exchange Board of India) did a brilliant job of creating a category in 2018 called ‘credit risk funds’ and clearly explaining that the highest risk products have to be put into that basket. After that it was very clear that if you wanted to take credit risk then that was the fund in which you should invest.
 

The worst is now over. If I manage Rs 1.8 trillion of debt money, it is not possible to never make any mistake. Investor greed, fund manager patience, and the fund manager’s capability of taking pain are all part of the framework. In 2007-09, we had gone through this in equity, this time it is debt. Equity markets matured in 2007-09, and we will see the maturing of the debt market now.

When the industry has credit risk funds for all these high-risk toxic assets, why do they find a place in other debt and liquid funds?

R Sivakumar: We had some credit issues and liquid funds actually had no problems. We’ve seen tightening after worries in the NBFC (non-banking financial companies) space, but we need to be careful in doing it in order not to create new unexplored risks elsewhere. 

Also, you need to have very tight positions limits. Suppose you are building a portfolio of AA or AAA bonds. You can have the same yield to maturity for the portfolio if you buy 10 bonds at a high yield or by buying a larger number of bonds at a lower yield. But if something goes wrong you’d rather have 50 bonds of which one bond goes wrong rather than 10 bonds of which one goes wrong. Part of the chase for yields also led to not adhering to position limits, as many funds took outright positions in some names, which went bad. 
 

Today the spread between AAA and AA is 150-200 basis points; if I had a 2 per cent loss it wouldn’t even show in my NAV (net asset value). So it is important to manage these risks and by doing so we should be able to deliver superior experience to the customer in credit products. Other than credit products, the industry has done extremely well.

Are there things the industry should not have done?

Anand Radhakrishnan: In India, entrepreneurs want to take multiple risks in multiple businesses. There are business groups which are successful in one business but are also interested in starting another business and then a third business. This is not seen in western markets. Bill Gates starts a Microsoft and does only that; it is similar for Mark Zuckerberg.

And how do you get the risk capital for it? You leverage the most successful business that you have and either through the dividends that you are getting or the use of your equity value in it, you fund the next business. This game is now unravelling and is amply evident in their failures. There is an urgent need for businessmen to focus on their core businesses and cut out the flab. It may go on for some time before some of the unprofitable businesses are transferred to stronger hands.

What is the message for investors?

Navneet Munot: In the context of the debt market, there are cycles. A period of stability leads to instability and that leads us back into stability. That is the nature of the beast.  So you have displacement, and then boom and then euphoria, the profit-taking and then panic and then a new cycle lasts. We have always been part of such cycles.

I don’t think there is anything unusual about this cycle. History doesn’t repeat itself but it often rhymes. Every time the industry has come out stronger. 

You’ve talked about toxic assets, all the mishaps and mistakes that everybody has made. Just look at the three-year returns of the so-called credit risk funds. Through this most volatile period; in terms of liquidity, in terms of interest rate risk in both the domestic and global environment, if investors earn far better returns than a fixed deposit in a bank, if they have delivered that, then I think we have done a good job.

Prashant Jain: In life we can’t focus only on the numerator and forget the denominator. One, I’m not saying that there have been no mistakes. I don’t think there is anyone who has not made a mistake in life or in their career. I think some mistakes have been made and in hindsight we can say that one could have acted one way or the other. 

That apart, if you look at the size of the problem, what is the total stress? The banking industry’s non-performing asset (NPA) ratio is 10 per cent. We are lending to the same (universe) and our ratio would be 1-1.5 per cent. And that is also stressed assets; it is not completely lost assets. So while there is always scope for improvement, the industry has, by and large, done a reasonable job. It would be wrong to say that this is a situation of crisis. If that was the case, the industry should be losing AUM (assets under management). But we see no evidence of that at all.

Are these apprehensions in media and elsewhere exaggerated? Are there no toxic assets? 

Jain: These are isolated cases, and that’s a fact. If you count the number of assets, the industry has lent maybe to a few hundred players. And how many are stressed? You can count them on your fingers. Toxic does communicate that something is really, terribly wrong; and I don’t think that is the case. Yes, there is stress in some accounts and some securities, but you will see that over time, at least a substantial part of this money will come back.

Are people chasing assets far too much, and then ending up in a mess?

Lakshmi Iyer: I don’t think that is true. I think communication has to be absolutely seamless and timely. And more importantly, it has to be two-way communication. What I mean is that, when I’m communicating, the audience also has to be listening. There are, and there will always be cases in the audience, where the eyes are open, but the ears are shut. I think a similar case is seen in the mutual fund industry, where assets have been garnered, predominantly in a legitimate manner, suiting the investment objective of the investor. 

However, the narrative changes when things go wrong, and the mutual fund industry gets the blame. The reason for this is that they are used to the cushy world of banking where a fixed deposit is equal to assured return. The rate of interest is known to you, and people have bank accounts since childhood, which is not the case with mutual funds. That is very, very critical.

It is the narrative which matters and it keeps changing from time to time. Today, people are asking fund managers if they own NBFCs in their fund. What’s wrong with NBFCs? They’ve not done anything wrong.

Isn’t 17 per cent exposure to one particular sector too high?

Iyer: Why is 17 per cent wrong when we know that not every NBFC can be painted with the same brush? Today, people are afraid of debt and not of equity. Now my question is going back to what Naren said talking about 2017 – out of 10 people in a room, 11 people were invested in credit; in 2018-19 out of 10 people not even half of have invested in credit. What has happened? Banks obviously have an NPA issue, mutual funds do not. I think it is a perception issue.

Is the media making a mountain out of a molehill?

Iyer: Let us understand that mutual funds function as if they are inside an X-ray. In the X-ray, if the mutual funds are weak that will show, the weakness of banks will not show in the same way. We pay the price of excessive transparency. That is the reality of the day. Does a cigarette manufacture tell you how each part of a cigarette is priced? But a mutual fund manager tells you what she bought, when she bought it, and when she exited.

What is your take on Sebi’s classification on market capitalisation? Was some of the carnage in small and mid-caps due to that? 

Naren: We converted one of our schemes to being called a small-cap fund which wasn’t earlier a small-cap fund. So on this entire debate on reclassification causing small and mid-caps to fall, we only ended up buying mid-caps and small-caps.

Sivakumar: The churn rate in terms of classifying the mid-caps and small-caps was high. With certain stocks becoming mid-caps and small-caps, fund managers were forced to sell. The active calls taken by the fund manager was higher than the index churn. I don’t know if that is a dominating factor, but it has led to creating some alpha opportunities over there.

Jain: My opinion is that this is not correct. You have look at what happened before the correction. Between 2013 and 2017, small and mid-caps were the highest outperformers against large-caps. I don’t think we can make a case that small-caps and mid-caps grow faster than large-caps (over the long-term). In isolated cases, it is possible. I don’t think the entire group of small-caps and mid-caps can grow more quickly than large companies. But for whatever reasons and we can give various explanations, small and mid-caps outperformed for three-four years and they had to revert to mean. And it is just a coincidence that this reclassification happened around that time. I see nothing wrong with what happened either with the regulations or with the way small-caps and mid-caps have corrected.

Radhakrishnan: Eventually, the best source of performance of any company whether it is large-cap, mid-cap and small-cap is earnings growth, etc. If there has been a disappointment, and there have been significant cases of disappointment vis-a-vis earnings growth, the stocks have seen corrections. Whether we rebalance or not, the stocks would have corrected because of the disappointment. If the underlying earnings had been pretty good and if there was a correction then I can get understand this dichotomy or discrepancy but since the underlying earnings have been pretty sub-par, it is logical that stocks correct.

How strong are the internal rating models?

Radhakrishnan: We have been the earliest in starting a credit risk fund and we have long been focusing on internal rating. I want to differ with Sivakumar on this where he said you could take 50 small positions on credit risk because if one goes bad the damage is minimised but you cannot do a good analysis of 50 companies. They say diversification is an excellent tool if you don’t know much. The only useful tool is to concentrate where your conviction of analysis suggests that the probability of default is lower. 

The more you spread yourself, the law of averages will catch up, and you tend to have more events in your portfolio. There is merit to have a more focused approach that would involve a lot of in-house research, but it is easier said than done. The industry gets a lot of money coming in the fixed income funds and they are under pressure to deploy it in a short period of time. Whatever be the efforts one puts in, there are bound to be some blind spots in which case you rely on external agencies.

What about rating agencies? 

Sivakumar: We consider rating agencies necessary but not sufficient. Rating agencies are not entirely aligned with you over the lifecycle of a bond. If you buy a three-year bond on which the rating agency gives you a particular rating; and six months later if he changes his mind and his rating, then you are still holding the bond for three years. Fundamentally it is very different, the manner in which you analyse the bonds as an owner and the way a rating agency does it.

Global experience has been very similar in terms of rating agencies and the way people used to rely on them pre-2008. You didn’t mention the role of auditors. These various ancillary professions which support the investment industry... if we are going through a clean-up of that in the same way the rest of the world went through maybe 10 or 20 years ago, so be it. That’s very important.

But we still cannot rely on rating agencies. And regulators, when they set rules, they set them based on ratings because that is the only criteria available to set rules. 

For example, mutual funds cannot buy below investment grade products. Can you be sure that every BBB is investment grade and every BB is non-investment grade? There is an exact line which says yes or no; and everything relies on rating agencies. We have to hold them to a higher standard.

Jain: Rating is an essential input for us, and we go beyond the external rating. We have been a little more conservative, and any issues seen have been limited. We have avoided highly rated papers based on internal ratings for long periods.

Naren: It is a fact known from the 2008 financial crisis that you can’t depend on ratings alone. Frankly, if you are dependent only on ratings, then you don’t need any fund manager, you don’t need a risk team, you don’t need anything. 

I believe everything is countercyclical — if a new rating is given by any credit rating agency today, it is something we should trust. The old rating was made when your caution standards were much lower. I would give any company coming out with a new rating more attention than before. Having said that, we always believed that it was only one part of the story. I believe that everything is cyclical, including ratings. The way people give AAA now would be very different than the way they would have given the same rating five years ago. If someone gives AAA now, then I would think that rating is really strong.

Iyer: If I can summarise, rating agencies are like Google Maps. When you want to get from one destination to another you need Google Maps. If it says 50 minutes, and if you are going to plan to reach exactly in 50 minutes, then God save you. You need to plan according to peak time, or whatever else it is.