Arbitrage Funds – Behind the Returns

arbitrage-funds-behind-the-returns

Honestly, this is a category which I have not completely understood for a long time. So for the last few weeks, I have been trying to research and improve my understanding of the category. This post is an attempt to share my perspectives on this category.

Backdrop

Arbitrage funds pre-tax returns historically has been very close to liquid funds. Hence, till date, I have only used debt funds for all my short-term requirements (less than 5 years).

arbitrage-vs-liquid

Source: Value Research as on 08-Sep-2016 – Link

But in recent times, arbitrage funds have been gaining popularity for addressing short-term needs between 1 to 3 years, as they are taxed like an equity fund and hence have zero tax after one year. On the other hand, debt funds (post July 11, 2014 ) have relatively unfavorable taxation as the returns are added to your total income and get taxed as per your current income tax slab for holding periods less than 3 years (after 3 years debt funds are taxed a 20% of inflation adjusted returns).

So given the tax advantage, we need to understand the arbitrage fund category and find out if they can be used as an alternative for debt funds.

How do Arbitrage funds work?

Arbitrage funds generate returns by taking advantage of the difference between the stock price in the cash market and the futures market.

In an arbitrage fund, a particular quantity of a certain stock is bought in the spot market and the same quantity of the same stock is sold in the futures market simultaneously. On the day of expiry of the futures contract, the cash and futures prices coincide, thus generating positive returns for investors. The difference between the cash market price and the futures market price is the return of the arbitrage fund. Since the position is perfectly hedged, any movement in the underlying stock price does not impact the return of the fund.

The returns from an arbitrage fund are thus dependent on the spreads available between the cash and futures position.

Example 1.a

arbitrage-example

Source: SBI Mutual Fund Presentation

As seen above, irrespective of the direction of the underlying stock price movement, the funds will be able to capture the spreads on the day of expiry (last thursday of every month)

Example 1.b

religare-arb-1

Example 1.c
religare-arb-2Source: Invesco Arbitrage Fund Presentation

While I have kept my explanation very basic here as there are several other articles which cover the working of arbitrage funds in detail. So instead of repeating them over here, let me provide a few links which can help us get our basics sorted: Link 1   Link 2  Link 3

So now we have some reasonable understanding of how an arbitrage fund works.

The next key question to answer is

What are the factors which influence the returns of an arbitrage fund?

The return potential of an arbitrage fund basically boils down to the spreads available between the cash and futures position every month

This keeps changing as seen below, based on several factors.

arbitrage-spreads-movement

Source: DHFL Pramerica Fund Presentation – Link

(The above chart shows the average short roll spreads of 50 companies
with the highest open interest in the stock futures market for that
particular month)

Returns of the funds in the arbitrage category are dependent on spreads and these are in turn impacted by the below 5 factors

  1. Size of the industry
  2. Sentiments in equity markets
  3. Domestic Interest rates 
  4. Currency hedging costs and borrowing costs of FIIs
  5. Stocks in the FII restricted list

behind-the-returns

1.The size of the industry

The returns of arbitrage funds is inversely proportional to the size of the industry

There are a limited number of stocks permitted to trade in the derivatives segment by Securities and Exchange Board of India (SEBI), which in turn means we only have limited set of arbitrage opportunities. So every time the size of arbitrage fund category increases, this puts pressure on the spreads  as more money starts chasing the same arbitrage opportunities.

In a way, arbitrage funds suffer from a strange paradox, where if the category does well, it attracts more money and in turn causes the performance to come down!!

Hence every time the category does well we must become cautious and monitor the category size.

As expected, given the tax advantage over debt funds and reasonable past returns, money has started to move into arbitrage funds – which means that at some point in time size will start impacting spreads and hence future returns.

arbitrage-fund-inflow-aug-2016

Source: Capitalmind

2.Sentiments in equity markets

Bullish and Range-bound-but-volatile equity markets are generally favorable while bearish equity markets are not favorable for arbitrage funds

Equity arbitrage funds typically do well under these two market conditions:

  • Bull markets
    • In bullish equity markets – people become very positive on stocks and someone going long on futures has a higher probability of making money. Hence investors are generally willing to pay a higher premium in bull markets. This implies higher spreads which in turn leads to higher return potential for arbitrage funds.
  • Range Bound but volatile markets
    • Volatile markets allow the arbitrage funds to unwind their trades intra month at a profit and thereby, increase the returns by increasing the churn. Refer to example 1.c for an illustration.

Equity arbitrage funds however will face a problem in:

  • Bearish markets
    • Since investors have become negative on the stock markets, the futures will generally trade at a lower price compared to the spot market. In this situation, arbitrage funds will not be able to carry on with their usual trade of buying spot and selling future. Since there are restrictions on short selling in the spot market, arbitrage funds cannot execute the reverse trade of “selling the spot and buying in the futures”. Thus arbitrage funds will find it difficult to perform in times of bearish equity markets.

3.Domestic Interest rate

If interest rates decline then arbitrage fund returns also tend to decline

There are 2 reasons

  • Investors going long on futures (who are responsible for the premium spread) can now borrow at a lower cost and hence take larger positions with the borrowed money. leading to lower premium in futures
  • If interest rates comes down then future debt fund return potential also comes down. But if the arbitrage spreads continue to be high, then money will move from debt funds to arbitrage funds, leading to more money chasing the same arbitrage opportunities and hence eventually leading to lower spreads and returns subsequently.

4.Currency hedging costs and borrowing costs of FIIs

The cost of borrowing and currency hedging cost impact participation of FIIs in the Indian arbitrage segment

In India, debt markets are not completely open to FIIs yet. Hence most of the FIIs use the equity market cash-futures arbitrage option to generate debt like returns. FII proprietary arbitrage books have traditionally formed a significant portion of the arbitrage market in India.

In the last few years, FIIs generally have made around 6-7% return on arbitrage trades and pay around 4-5% currency hedging cost. So, they make around 2% on a net basis. Since this is higher than their borrowing cost, they make money.

So, the cost of borrowing and the currency hedging cost play an important role in determining the extent to which FIIs are active in the arbitrage market.

Whenever currency hedging costs or borrowing costs for FIIs increase, their participation in the Indian arbitrage market will reduce thereby allowing domestic arbitrage funds to take advantage of the arbitrage opportunities.

5.Stocks in the FII restricted list

Trend in increase of FII restricted stocks augurs well for domestic arbitrage funds

Many sectors in India don’t allow 100% foreign ownership and there is generally a ceiling on the extent of FII ownership in the company. As FII’s have continued to increase their exposure in Indian equity markets a lot of these stocks have hit their ceiling limits. Eg HDFC Bank, Lupin etc. Therefore, FIIs cannot take fresh positions in these stocks and as a result, cannot participate in arbitrage trades in these. So, the arbitrage available in these stocks can only be exploited by domestic prop books and domestic mutual funds. Further, these stocks in the FII restricted list provide better spreads than the rest of the market.

Thus, the more the number of stocks in the restricted list, the better the opportunity for domestic arbitrage funds.

In a nutshell

  • It is extremely difficult to forecast the returns of arbitrage funds as the returns are impacted by a host of factors:
    1. Size of the industry
    2. Interest rates
    3. Sentiments in equity markets
    4. Currency hedging cost and borrowing costs of FIIs
    5. Stocks in the FII restricted list
  • Any sudden change in any of these factors can impact the returns of this category in a positive or a negative manner
  • Returns from arbitrage funds will never be as linear as a liquid fund
  • Returns will generally be a combination of few good and not-so-good months
  • Advisable time frame: Greater than 1 year


Parting thoughts on the a
rbitrage funds vs debt funds debate

Large out performance over liquid funds on a post tax basis should not be expected from arbitrage funds because if that happens even in one month, more money will come into this category which, in turn, will put pressure on the spreads. Sample this – at the end of August 2016 liquid fund category size stood at approximately Rs 3 lakh cr compared to Rs 32,000 cr in arbitrage category. Now you can imagine what will happen if even a small part of liquid funds move to the arbitrage category.

So my sense is that returns for both these categories will remain very close to each other even on a post tax basis (most often with arbitrage funds having slightly higher returns  over a 1 year period predominantly due to their tax advantage). 

Hence you can continue with either liquid or arbitrage funds or a combination of both based on your comfort and understanding. Since the periods of investing is more than 1 year, even ultra short term funds can be considered (which will provide slightly higher returns over liquid funds).

And if you are wondering about me, given my inability to evaluate the underlying return drivers for an arbitrage fund, I shall continue with my simple liquid fund or ultra short term fund 🙂

As always happy investing folks 🙂

Disclaimer: No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments.

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Figuring out a simple do-it-yourself framework for short term investing

(3 minute read)

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We have spent some reasonable time analyzing and understanding debt mutual funds

Part 1 – A primer for investing in debt mutual funds (Link)
Part 2 – 8 factor framework for analyzing any debt mutual fund (Link)
Part 3 – The ultimate guide to liquid funds (Link )
Part 4 –
Here’s a quick way to select Ultra Short Term Funds (Link )
Part 5 – Making sense of Short Term Debt Mutual Funds (Link)
Part 6 – Credit funds – Don’t count your returns before they hatch (Link)
Part 7 – Here’s why I don’t invest in credit funds (Link)

Now comes the most important question..

All this is fine. But how do I put all this into action?

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Before we jump into the action plan, let’s decide on the the scenarios under which we plan to use debt funds.

I personally use it under 2 scenarios:

  1. Relatively short time frame + Goal is extremely critical (i.e cannot be postponed eg education fees, marriage etc) and no back up funding plan if there is a shortfall + Safety of money is priority i.e no losses whatsoever
  2. Part of asset allocation

Taking into account the above scenarios, let us put in place a simple investment framework for our short term investments (less than 5 years)


  1. 1 day to 6 months – Liquid Funds
    • Eg Axis Liquid Fund, Kotak Liquid
  2. 6 months to 2 years – Ultra Short Term Funds
    • Eg IDFC Ultra Short Term Fund, Reliance Money Manager Fund
  3. >2 years – Short term funds
    • Eg – Axis Short Term, IDFC SSIF – Short Term Plan
  4. Avoid credit risk: No credit funds
  5. Minimize interest rate risk:
    • No Income funds (funds with high modified duration)
    • No Dynamic funds (funds which adjust their modified duration to take advantage of interest rate movement)

The basic idea is to keep my debt fund portion,

  • As simple and basic as possible
  • Minimize risk to a large extent
  • Spend minimal time and effort in tracking

All risks and the chase for returns will happen in my equity portion where I also intend to focus majority of my time and efforts.

So given the context, we have put in place a reasonably good framework for short term investments. 

But then Albert Einstein suddenly reminds us..

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Now, the next step is to play the devil’s advocate and question

  • Arbitrage funds don’t get taxed post 1 year. Aren’t they better than debt funds on a post-tax basis for investments more than 1 year? 
  • Can’t we use some portion of equities for non-critical goals in the 3-5 year range to improve returns? 

Honestly, I don’t have immediate answers. So in the coming weeks, we shall find out the answers to both these questions and see if we can improve upon our existing framework.

Till then happy investing 🙂

Disclaimer: No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments.

Here’s why I don’t invest in credit funds

In our earlier post here we figured out that:

In credit funds, the real issue is not about credit risk , it’s about liquidity risk !!

155H.jpg
Long term investors have to focus on the trade off  between – Expected returns vs Risk

There are two fund management organizations – IDFC MF and Axis MF, who have also communicated their views on credit funds. Let’s read them and see if we can get some additional perspectives.

You can read IDFC fund manager Suyash Choudhary’s thoughts on Credit risk here

Photo_Suyash_Choud_2554466e.jpg

  1. The Macro Reason to Reassess Credit Risk – Link
  2. Managing risks in investment – Credit vs Duration  – Link


Highlights from the note

  1. Long term investors have to focus on both expected return as well as risk when investing
  2. Since this trade-off can always change with changing triggers, the focus should be on expected return versus manageability of risks taken.
  3. Credit risk and duration risk are both legitimate means to earn ‘excess’ returns over fixed deposits
  4. Duration Risk:
    • Duration risk works via a daily mark-to-market channel and hence offers more short term volatility in return profile (although the longer term profile may actually be much more stable)
  5. Credit Risk:
    • Credit risk is binary in natureeither manifests or it doesn’t. This is especially true in a market like ours where there is hardly any secondary market price discovery for lower rated credit assets. Thus change in credit quality doesn’t get dynamically reflected in price changes
  6. The difference really lies in the ability to respond in terms of curtailment of risk if the view changes on evolving developments
  7. Duration risk can be managed on an ongoing basis since it is backed by a robust secondary market where one can buy and sell.
  8. Credit risk cannot be managed on an ongoing basis which makes the ongoing management of the risk difficult.
  9. Also, the relative choice (of how much of credit risk and duration risk to take) has to take into account the macro environment which either creates a tailwind or a headwind to each type of risk
      

You can read Axis fund manager Sivakumar’s thoughts on Credit risk here

Sivakumar_jpg_2431109f.jpg

  1. Credit Issues in Fixed Income Portfolios – Link
  2. Credit Quality – Link
  3. Video – Link

Highlights from the note

  1. Effect of credit default is lumpy and is not captured in daily mark to market. Thus the risk is not captured completely until a downgrade / default event
  2. Apart from the credit risk concerns, the other reason that credit portfolios face a significant risk is the lack of liquidity in the secondary market in lower-rated instruments. This presents a contagion risk for the markets since in case there is a need for any investor to liquidate its portfolio over a short notice, it will be exceedingly difficult to do so.
  3. Understand the credit profile of the fund before investing
  4. Concentrated portfolio increases impact of credit event (i.e downgrades & defaults) – Affects a large part of concentrated portfolio
  5. Not launched credit fund + Conservative approach to credit + Disciplined portfolios with tightly defined limits for most of our funds – >75% AAA – <2% per issuer AA- and below + Relatively liquid portfolios

Parting thoughts:

The above views from these two fund managers, confirm our concerns on credit funds especially on the “liquidity” risk.

Given the above arguments and if you agree with me on the liquidity concerns underlying credit funds then:

Stick to funds with high credit quality

As earlier stated, I personally tend to avoid credit risk in my debt fund portfolios.

I also derive far more comfort on the credit quality when it comes to Axis and IDFC debt funds because they share similar views as mine with regards to credit funds. And the best part is these guys communicate regularly, which also helps us understand their investment strategy. This is precisely the reason why you would have seen me include their funds in our debt selection here

That being said, the above notes from the two fund houses were provided purely with the intent of improving our understanding and by no means do I have any connection with them. While I may have a personal preference towards these two, there are obviously other major fund houses, which also have several funds with high credit quality and you are free to choose whichever suits you the best.

As always happy investing..Cheers 🙂

Disclaimer: No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments

Credit funds – Don’t count your returns before they hatch

If you have been following my debt fund related posts, you would have noticed that I generally tend to avoid credit risk in debt fund portfolios. In today’s post we will explore the thought process that goes behind my decision to avoid credit risk.

If you are new to the blog, you can go through my earlier post here to get an understanding of credit risk in debt MF portfolios.

What is a credit fund?
Credit funds are basically debt mutual funds which lend a major proportion of our money to relatively riskier corporate companies and in turn earn higher interest rates for us. So when you look at the fund portfolios, you will see a relatively larger proportion of debt papers which are rated below AA. (Credit rating is an indication of the underlying company’s health and its ability to repay its debt. The lower the rating, the lower are its chances to repay its debt on time.)

Eg  Franklin India Dynamic Accrual Fund

Higher proportion of “below AA” rated papers..

Credit Strategy
Source: Morningstar

which helps in providing higher interest rates..

Credit Strategy - YTM

See that.. a whopping 10.87% compared to a current YTM of ~7.5-8% for most of the short term funds which invest in high quality papers (i.e predominantly AAA rated papers). These funds generally have Yield to Maturity (i.e interest rate return) which are 1 to 2% above short term funds which invest only in high credit quality papers.

Credit funds generally invest in short maturity papers between 1-3 years and the modified duration is mostly around 1-2 years. Thereby the “interest rate” risk taken to improve returns is kept at moderate levels and these funds primarily depend on the “credit risk” taken to generate additional returns.

The basic idea behind credit funds is that – by deploying their own analysis to these lower rated papers, the fund management research team  would be able to identify certain companies which have much better health (than evaluated by credit rating agencies) or is expected to improve and hence the company’s ability to repay its debt is much better than perceived. This allows the fund to benefit from higher interest rate paid by these companies provided the fund manager’s evaluation is correct and the underlying companies to which they have lent repay their debt and interest on time.

Certain fund houses also take sufficient collaterals (in the form of covenants, shares, real estate securities etc) to offset the losses if there is a default from the issuer. Some have inbuilt agreements for priority in repayments to ensure that they exit when they see any small sign of distress.

Credit funds generally come under different names such as accrual funds, corporate bond funds, credit opportunities funds, income opportunities etc. If you need to know the subtle difference refer here. Given so many confusing names used to refer to various credit fund schemes, the best way for us will be to check for the credit quality of the underlying portfolio and decide 😦

The chances of us getting attracted to credit funds is very high given 2 reasons:

  • Higher past returns compared to short term funds in the recent past
    credit opp returnsSource: Valueresearch
  • Expense ratios are higher and hence more incentive for advisors to sell these funds to usExpense ratios compared to short term funds are higher by atleast 0.5 to 0.8%.

Now the key is to understand the underlying risk behind the higher returns..For that we need to find the answer to a simple question.

What happens when some of the underlying borrowers get downgraded in terms of credit rating or worst case, default and do not repay the interest and borrowed amount?

For the purpose of understanding, let us hypothetically assume that, a credit fund has lent our money out to 20 corporate borrowers equally and has 5% equal exposure to each debt security. Now assume that the financial health of one particular company to which the fund has lent starts deteriorating and hence its chances of paying back its borrowing and servicing interest reduce. Usually the credit rating agencies evaluate this scenario and reduce the rating provided to the company. This is technically called a credit rating downgrade. To understand better, you can check the actual Amtek  Auto downgrade credit rating reports here and here.

This leads to an immediate price drop for the debt security of the company. Logic being lower rated papers will need to have a higher interest rate given the reduced rating and higher risk. But as the underlying interest payment for a debt security is prefixed, the prices of the debt security will have to adjust (in this case, decline to a certain extent) to match with the higher interest currently demanded by the new investor.

This is an impact on a paper which was downgraded from AA- to C. Below chart data is only for illustration purpose.

Ratings Downgrade Pricing impact

Source: Axis Mutual Fund Presentation (Link to presentation), CRISIL/ICRA.

Now while the exact decline in prices would be dependent primarily on the nature and severity of downgrade, going by past history, we will assume that approximately 30-50% of the debt security price will get eroded under a credit downgrade situation. This will mean that there will be a negative price impact of -1.5% to -2.5% in the fund (30% to 50% decline on a 5% allocation). Worst case if it is a default then the entire 100% of the security holding will have to be written off i.e 5% decline for the fund.

This risk is called credit risk and as seen above is very simple to understand. At the first look, it seems like an “ok” kind of risk to take provided we ensure that the fund is adequately diversified among many borrowers and the additional returns (which we get more often than not) are high enough to compensate for the risk taken. Credit downgrades and defaults are not very frequent. And even assuming the fund manager gets 2 calls wrong and has 2.5% exposure each, the overall downside may be around 1.5% to 2.5% on the NAV. But if everything goes right we end up making around 1-2% extra returns.

All fine till now. But unfortunately, there is another risk which we have forgotten to take into account. Liquidity risk. What the heck is that??. In simple words, it means that there are not enough buyers, so even if there is a price being theoretically quoted, finding a buyer at the quoted price is not easy (think of real estate).

This is precisely, in my opinion, the biggest issue when it comes to credit funds. Indian bond markets are still underdeveloped and most of the lower rated papers are extremely illiquid which means they are extremely difficult to sell in bad times.

Let’s listen to what the great investor Mr Howard Marks has to say about liquidity..

“Usually, just as a holder’s desire to sell an asset increases (because he has become afraid to hold it), his ability to sell it decreases (because everyone else has also become afraid to hold it). Thus (a) things tend to be liquid when you don’t need liquidity, and (b) just when you need liquidity most, it tends not to be there.”

If you have some time, do read his entire writing here . Trust me. It will be well worth your time.

Think of it this way. On one side you have the lender (that is us who have invested in the fund) who can take out money anytime and on the other side the fund has invested in a few illiquid debt securities which cannot be immediately sold off in the market. Now if due to some reason (generally a credit downgrade or default event) a lot us panic and decide to take our money from the fund you can imagine the plight of the fund. The fund may get stuck with the downgraded paper and be forced to sell its more liquid holdings as there is a rush to redeem units. And as the pace of redemptions increase, both its security selection and its portfolio concentration can go completely out of whack leaving the existing investors with a far more riskier portfolio for no fault of theirs. And there lies the crux of the entire problem!!

Let’s get back to our earlier example where the fund has lost 1.5% due to 30% decline in one debt paper which was earlier 5% of the overall portfolio (now the same paper would be ~3.5% of the portfolio). Generally, the biggest investors in debt mutual funds are the corporates. They have large treasury teams who are in charge of the investments and keep monitoring every fund day in and day out. Now they realise that 1.5% knock is fine, but if the paper defaults then it will lead to an additional loss of the remaining 3.5% in the debt paper. So they decide to take their money off. Now every other corporate and savvy investors do a similar sort of calculation and decide to pull off the money before the situation worsens. So suddenly there is a large amount of people removing their money from the mutual fund (called redemption pressure). Now the fund manager unfortunately is not able to sell off the downgraded debt security as its difficult to find a buyer even even at its so-called market value. So the fund manager has no choice but to sell the high quality debt papers which are liquid. Now assume the redemptions are large and almost 50% of the fund money is taken out (I am exaggerating but you get the point). Now all this while the dumb me who is also the investor in the fund remains blissfully unaware of all this happening and see my fund’s portfolio after a month. I am shocked to see that now I am stuck with not 3.5% of the original downgraded highly risky paper in my portfolio but rather 7% of the same security in the portfolio as the 50% of the liquid higher rated debt securities of the fund is already sold. And my existing fund portfolio looks a whole lot different with most of the high rated and liquid securities being sold off. Oh shit how unfair.

Relax. The fund house obviously realizes this and tries to address this by two ways

  1. Side Gate – The fund simply doesn’t allow anyone to take their entire money out. It puts a restriction on the amount an investor can redeem from the fund. Now if that sounds ridiculous and completely unfair. Read here to see what happened to two credit funds managed by JP Morgan when one of its debt security Amtek Auto got downgraded. And remember my rant about the corporates being the smarter and more resourceful guys. Go on check this link.
    Recently the market regulator SEBI obviously concerned by the proceedings, post this event, has put in a new rule that, even in case of a systemic liquidity crisis, no redemption requests of up to Rs.2 lakh can be subject to restrictions. For redemption requests above Rs.2 lakh, AMCs will redeem the first Rs.2 lakh without restriction while the remaining money can be subject to any restriction imposed by the AMC. Further, restrictions on redemptions can be imposed only for a specified period of time that cannot exceed 10 working days in any given 90-day period.


  2. Side pocket – The fund simply isolates the affected portion as a separate fund with a seperate NAV. So except for the affected portion you are free to redeem the remaining portion if they want. The proportion of investor money (in the scheme) linked to stressed assets gets locked until the fund recovers dues from a stressed company.

Out of these two options, “side pockets” seem like a better option as explained here. The argument goes like this – the side pocket concept would provide the required liquidity to the investor and ensures that their entire money is not stuck. Further it also ensures that the early sellers in the fund do not benefit at the cost of the remaining investors.

Now the only flipside is the subtle unintended consequences. A fund manager who knows that the side pocket option is not available will be forced to be much more prudent and aware of the risks he is taking. If the option of a side pocket exists, then the fund manager may venture out to take unwarranted higher risks to provide higher returns as anyway they can use a “side pocket” if something goes wrong.

For once, the regulator SEBI also seems to share my concerns and post the recent JP Morgan – Amtek Auto debacle has warned against the future usage of side pockets by Indian mutual funds (see here)

So adding to the problems, the funds from now on cannot use the side pocket option in future and the side gate option also has several new restrictions imposed by SEBI. This means the credit funds will find it more difficult to handle redemption pressures if at all it arises. And since the side pocket option is not there, investors will want to exit as fast as possible fearing possible “redemption freeze” scenario which ironically will only exacerbate the redemption frenzy. Phew.

Assuming you survived the post till here, the simple summary is that more than the credit risk it is actually the liquidity risk which is the real problem in credit funds.

Since these credit events are not very frequent, the bigger risk is that we may tend to under appreciate the very nature of risk!!

Now my thought process has always remained very simple. From heart I am an equity guy. All my chase for returns happens in equities. Debt funds personally has always been about safety. A few percentage plus or minus in debt returns, really doesn’t make a huge difference to me.

My primary usage of debt fund is a parking space for near term needs and as a part of my asset allocation strategy (i.e changing the mix of equity and debt based on valuations). So typically I will be needing this debt money desperately to buy equities when there is a crisis and equity markets have crashed (now whether I am able to pull it off in reality is a different issue). The last thing I want is for my debt fund to say that “Sorry boss, we have stopped redemptions due to a liquidity crisis”. Credit funds given their inherent structure have a high probability of getting screwed up in these scenarios. So my simple laymanistic reasoning being – why take so much tension for debt returns. As it is equities give me enough of it, but at least the long term payoff is worth the pain 🙂

As always, investing is a very personal thing and you are free to invest in credit funds but please ensure that you are not buying only because of the past returns and make sure you really understand the underlying risks (especially the liquidity risk).

Happy Investing 🙂

Making sense of Short Term Debt Mutual Funds

This is the 5th post in the debt mutual fund investing series. You can find all the earlier posts here:

Part 1 – A primer for investing in debt mutual funds (Link)
Part 2 – 8 factor framework for analyzing any debt mutual fund (Link)
Part 3 – The ultimate guide to liquid funds (Link )
Part 4 –
Here’s a quick way to select Ultra Short Term Funds (Link )

Short Term Funds:

Short Term funds generally invest in debt securities with maturities ranging between 1 to 3 years. In other words the money is lent to different companies, banks, NBFCs ,government etc for 1 to 3 years. Since the tenure of lending is slightly higher for Short term funds compared to Ultra Short Term Funds and Liquid funds, most often we get marginally higher returns (which will be reflected in a slightly higher YTM)

I use this category of funds when my  investment horizon is more than 2 years and safety of capital is the priority. Think of this more like a decent alternative to Fixed Deposits.

These funds can take two risks to generate additional returns

  1. Interest rate risk
    The funds take a moderate interest rate risk to improve returns and mostly have a modified duration ranging between 1 to 3 years. So there is a possibility of higher returns if interest rates decline and vice versa. Most of them keep varying their modified duration within the range based on their interest rate view i.e will reduce the modified duration if the fund manager expects interest rates to go up and increase the modified duration if he expects the interest rates to go down. Some short term funds are more conservative and move the modified duration between 1-2 years while slightly aggressive ones move between 1-3 years modified duration.
  2. Credit Risk:
    In addition to the moderate interest risk , within the category, there are funds which additionally take credit risk as a strategy and those which avoid credit risk. Personally, I don’t like to take credit risk in my debt portfolios. I take risks via my equity portion and I am not too comfortable taking credit risk in my debt portion where “return of capital” is the priority over “return on capital”. Hence I first check for these funds which take credit risk and remove them from my list. But for investors who clearly understand credit risk and are willing to take the risk to generate additional returns, they can consider those funds which take credit risk (which is reflected in a higher YTM).

How to choose a Short Term fund ?

If you have gone through the earlier post on choosing Ultra Short Term funds (Link ), then you will be familiar with our simple approach – find funds with reasonable size, minimal credit risk, moderate interest rate risk and proven fund management teams.

As in the previous post we will be using the excel report from MOSL Research called Most MF Daily Score Card. You can download it here. (You need to create a login. No worries, it is free only)

There are a total of 58 Funds classified as Short Term funds.

Step 1: Knock off all schemes less than 1000 cr: 26 funds get knocked off and we are left with 32 funds.

Step 2: To check for credit quality – Knock off all schemes with % of AAA+ Sovereign + Call & Cash < 80%
Another 10 funds get knocked off and we are left with 22 funds

Step 3: Knock off funds with modified duration greater than 3 year
You can keep your own cut off here. I end up removing another 4 funds and I am left with 18 funds.

Step 4: Sort it according to 3Y returns and observe the max and min returns

Range of return outcomes:
3Y = 9.0% to 10.3%

Putting that in perspective, for every 1 lakh you invest in Short Term Funds the difference between the lowest and highest return fund in our final list in the last 3 years works out to be ~Rs 4,700. As expected the outcome ranges are pretty narrow and even if you end up with the lowest return fund it is definitely not catastrophic!!

So once we have arrived at this stage – we shall remind ourselves of the “paradox of choice” and instead of getting into analysis-paralysis our aim will be to find a “good enough” fund !!

Step 5: Stick to major AMC’s with reasonable track record and good debt fund management teams

I generally prefer funds from IDFC, ICICI, HDFC, Reliance, Axis, Birla Sun Life. Of course, that being my preference, you are free to pick any fund within these 18 schemes. Some schemes that I like are 1)IDFC SSIF – Short Term, 2)Birla SunLife Short Term Fund, 3)Axis Short Term Fund and 4)Kotak Bond Short Term Plan.

Short Term FundsSource: Morningstar, Value Research

In our next post, let us analyse the pros and cons of taking up credit risk to improve returns in debt fund portfolios.

Happy investing folks🙂

Disclaimer: No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments

Investing Chitra Katha – Understanding the impact of modified duration on debt fund returns

Hi everyone. This is a new series I am attempting, where the idea is to simplify investing topics in the form of pictures.

In case, you want the detailed explanation on the topic you can always refer to our older post here

If you like this and would like to see similar simplified posts or have any suggestions, do let me know via your comments.

Happy investing 🙂

Disclaimer: No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments

Here’s a quick way to select Ultra Short Term Funds

In our last post, we figured out the basics of liquids funds and how to select an appropriate liquid fund (Link). Today let us move on to our next category – Ultra Short Term Funds.

Ultra Short Term Funds:

Ultra Short Term Funds (UST) are very similar to Liquid Funds in terms of their conservative nature. UST funds invest predominantly in debt securities which have a maturity of more than 91 days and less than 1 year. Due to the slightly higher maturity of underlying securities in UST funds compared to a liquid fund (which invests in debt securities which mature in less than 91 days) UST funds may have marginally higher returns over liquid funds. Logic being when you lend for a longer time frame you will require a higher interest rate from the borrower. This will be visible in the YTM (Yield to maturity) of the fund.

Typically we can use this fund for short term investment horizons of more than 3 months. (I use it up to to 2 years)

As always, by applying our simple framework (Link) we will primarily need to check for

  1. Interest rate risk that UST funds take to improve returns:
    The funds mostly have a modified duration ranging between 0.3 to 1 year (There are also few funds which are classified under UST and have modified duration as high as 1.8 years). Since we look at this category for short term and want only marginal levels of interest rate risk to improve returns, let us stick to funds which have modified duration less than 1 year. 
  2. Credit Risk:
    Typically since this category is meant for short term investments, most of the funds maintain a high credit quality in their portfolios i.e they have a high percentage of Sovereign (govt. bonds) and AAA and equivalent rated bonds (AA bonds can also be included unless you are ultra conservative). But that being said, there will always be some funds which invest a portion in lower quality debt securities (below AA rated) to have a higher YTM and hence show higher returns. Hence we must check for these funds which take credit risk. I personally don’t want credit risk when I invest in UST category as it is meant for short term and “return of capital” is the priority over “return on capital”. But for investors who clearly understand credit risk and are willing to take the risk to generate additional returns, they can consider those funds with higher YTM.
  3. Expense ratio:
    The expense ratio is generally around 0.10 to 0.60% for the category for direct plans. The lower the better.

How to select the right UST fund ?

Honestly there is nothing  such as the “one right” fund. What may be right for me might not work for you. So I shall take you through my logic of selecting the funds. Instead of focusing on the funds that I choose I would request you to check if the logic appeals to you. Once you are fine with the logic, you can either go with ones I choose or tweak around to figure out your own funds.

One of the biggest issues I face with the mutual fund industry is the mammoth no of choices it offers when it comes to choosing funds. While rationally, it looks like a great situation to be in, as you have large no of choices and hence can make better decisions. But unfortunately the truth is that more no of choices actually cause decision paralysis. If interested you can read about this interesting phenomenon called “Paradox of choice” here. Most of us (of course that includes me) will get into this decision-making paralysis. Hence the key is to remember that our selection process intends to find a “good enough” fund and not the no 1 fund (and the hard truth is no one can predict the no 1 fund of the future..why ?? well that is one of my favorite topics and I reserve it for another day)

So lets get to business..

The screener options in value research and morningstar do not provide Modified duration and hence to manually collate data for each and every fund is a nightmare. Finally I have found a reasonable hack to get through this.

Motilal Oswal Research publishes an excel report called Most Mutual Fund Daily. You can download it here . We will be using this for our selection process. While the sheet does have some problem as not all the cells are getting filled up and there is also a slight mismatch between some of its data and value research. However this is the closest I could get to a decent screener and hence kindly adjust with this at this juncture.

There are a total of 61 Funds classified as UST funds.

Step 1: Knock off all schemes less than 1000 cr. Since debt mutual funds are an Institutional dominated segment (i.e mostly it is the corporates who park their surplus cash in debt funds) I would prefer a larger sized scheme which will be able to handle  the impact of sudden redemption (selling) pressures if any. 27 funds get knocked off and we are left with 34 funds.

Step 2: To check for credit quality – Knock off all schemes with % of AAA+ Sovereign + Call & Cash < 80%
Another 11 funds get knocked off and we are left with 23 funds

Step 3: Knock off funds with Modified duration greater than 1 year
You can keep your own cut off here. I end up removing another 3 funds and I am left with 20 funds.

Step 4: Sort it according to 1Y, 2Y, 3Y returns and observe the max and min returns

Range of return outcomes:
1Y  = 7.6% to 9.0% 
2Y = 8.1% to 9.1%
3Y = 8.5% to 9.6%

Putting that in perspective, for every 1 lakh you invest in UST the difference between the lowest and highest return fund in our final list in the last 1 year works out to be Rs 1,400 (for 2 years it is Rs 2,172). So the most important thing to notice is that the outcome ranges are pretty narrow and even if you end up with the lowest return fund it is definitely not catastrophic!!

Takeaway – once you have arrived at this stage – remember the “paradox of choice” and we are only looking for a “good enough” fund !!

Step 5: Stick to major AMC’s with reasonable track record and good debt fund management teams

I prefer funds from IDFC, ICICI, HDFC, Reliance, Axis, Birla Sun Life. In fact I have a bias towards IDFC as they are the only fund house where the fund manager regularly communicates (you can find them here) and hence as investors it is easy for us to understand what is happening in their funds. I sincerely wish other AMCs follow suit (Axis does a decent job but still not upto IDFC).

Now technically you are free to pick any fund within these 20 schemes. I would prefer IDFC Ultra Short Term Fund – Direct Plan and Reliance Money Manager – Direct Plan (Reliance has a nice app which allows me to easily invest in their direct scheme. Check the details here . Again just to clarify, I have no connection with neither IDFC or Reliance AMC and you are free to pick any fund of your choice)

UST Funds

In effect what we are essentially trying to do is to reduce credit risk, emphasize reasonable size, take moderate interest rate risk and stick to good fund managers!!

I hope you found this useful. In our next post, let us cover short term debt funds and how to select a “good enough” short term fund.

Happy investing folks 🙂

(P.S – In case you have a better screener source, method or suggestion, feel free to add it in the comments section. As always, I would love to be wrong and hope to keep learning from my mistakes. Looking forward to learn from all of you)

Disclaimer: No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments