A recent article by Dhirendra Kumar of Valueresearch ‘Debt funds’ self-inflicted losses’ came as a surprise. The article surprised me for some of the assumptions it made about debt fund as a product, about what investors want and about how fund managers act.
First, the assumption that debt fund is inherently a capital preservation product is not true. It could be a capital preservation product if returns are guaranteed and capital is protected. While fund houses can do so by setting aside reserves to protect capital, no fund house with its limited profitability/reserves has guaranteed capital although they try innovative ways to make them ‘capital-protection oriented’. Debt funds are mostly market-linked products. I say mostly here, because in the case of liquid funds, theoretically the coupon is converted to returns (post expense). Other than this category of funds, debt funds, either because of the duration risk or credit risk, can never be a capital preservation product; at least not unless they are held for the time frame they are recommended for.
A fund that holds any listed bond with a medium to long-term maturity – whether government bond or corporate bond – cannot avoid losses on a day when yields move up sharply. The pain is higher when the instruments have longer residual maturity and lesser when the maturity is low. This is exactly what transpired on the day of Monetary policy as well. Please refer to our article ‘Should you worry about debt fund declines’
While I will certainly not say that a debt fund does all the jobs that an investor wants it to do: we know debt funds provide some hedge to an investor’s portfolio. Just to illustrate, the image below tells you in a year like 2016, debt funds helped curtail the equity falls for investors. Even a 35% debt helped ensure that you were less impacted in a volatile equity market. What they try to do is lessen the shock of equities. They do not state that they will not provide any shocks themselves.
Second, the article makes an implicit assumption that investors come to debt funds for capital preservation and that they cannot handle losses.
An investor who wants capital preservation will stay with his/her savings account or deposit or hold cash. To come into mutual funds thinking that the same preservation is possible but with higher returns is at best delusional. Here, I agree that there is poor awareness and mis-selling by some, making an investor believe that it is possible to get superior returns with no risk.
That said, the fact – as stated by thousands of our own investors – is that people come seeking FD-plus returns or savings bank plus returns when they seek debt funds. Most of them do not understand inflation-beating returns. It is not a benchmark for them to comprehend or compare. And debt funds mostly achieve that, especially on a post-tax basis.
(That debt funds, incidentally provide some hedge against the deep losses when equity markets are down, is an added benefit, that the investors understand, but only after experiencing it. That has been our experience with our customers).
The shock or pain comes to investors where they believed or were made to believe that high returns is possible from long-term debt products, without any downside risks. This typically happens when the investors picks a fund that was not meant to fulfil the job he wanted it to do. We will talk about this a little later.
In other words, the problem arises when investors choose or are made to choose the wrong category of products.
Third, in this specific instance, the article states that fund managers took bet on what the RBI Governor would do. A look at how fund managers have been managing their duration (please read our article on should you worry about debt fund declines) will tell you that directionally, they have been reducing their portfolio maturities, believing that the rate cycle was coming to an end. This is true of dynamic bond funds and long-term gilt funds. That they believed there could be some more cuts was evident because the average duration did not go very low. But that they have steadily cut it suggests that fund managers were taking no sharp bets.
Is the product doing the job it is hired to do?
So, what is the real problem? One can accuse fund houses of upping the complexity of an already complex product, in the name of innovation (read compulsion to garner AUM). But then, is it not the case with all manufacturers? Can there be any less complex products in the insurance or banking industry? Or for that matter, in equity funds – equity savings, balanced advantage, arbitrage, retirement, you name them.
The problem, as I see it, is not in innovating. A product, however well designed would not be successful if it does not do the job for which the investor sought it in the first place (do read the book ‘Competing against luck’ by Clayton Christensen. I am borrowing the learnings from this book).
The quiet burial being given to RGESS is a classic example of poorly designed product that does not really satisfy an investor’s need.
Understanding why an investor sought a product and offering him that product which will fulfil that job for him/her is the key.
- An investor looks for a product to park his money with no time frame in his/her mind – there are liquid funds and ultra short-term funds
- An investor wants a substitute for FD in the medium to long term there are short-term debt funds and income accrual funds.
- An investor does not want to be subject to the vagaries of a changing rate cycle there are dynamic bond funds
- Large investors who want to bet/trade on the rate cycle there are gilt funds
The real problem
Of course, I am far from claiming all is well with what we do. The point I wish to drive here is that funds making losses or fund managers getting one call wrong is not the problem. Those are risks inherent to mutual funds and investors and fund managers learn.
The problem is as follows: At the AMC level, while innovation is welcome, any innovation that does not sufficiently study the problem/job that the product will solve/fulfil for a customer will be a wasted one. Whether the investor wants capital preservation or returns maximisation and what is good for him, is not for any of us – AMCs, experts or distributors – to decide by ourselves. It is for us to observe learn and respond accordingly. The same lies with the distributor. Insufficient understanding or ignoring the real reason of why the customer came to us, is the folly.
A product that does not fulfill that one real need for the customer and the distributor who fails to understand that need and place the right product is the real loser; not the customer.