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Fear & loathing on MF street

As institutional investors withdrew money from mutual funds, the industry went into a tailspin. The blind panic led to the small investors exiting at a loss.

Narayan Krishnamurthyand twitter-logoTanvi Varma | Print Edition: December 11, 2008

When is it a good time to exit a mutual fund? Is it the time that you hear a fund house has hired a priest to conduct a daily puja so that bad omens can be dispelled? Or when another fund demolishes a toilet and moves the research team to this place because a vaastu consultant says it’s the best place? Or when a fund sponsor insists on studying the horoscopes of his dealing room staff? Yes, we knew that the industry was going through one of its worst phases, but have things come to such a pass?

Fund houses might shrug off stories like these, saying they are baseless rumours. But investors are not willing to bet on it. This is why they’ve voted with their feet; the estimated redemptions in debt funds in October 2008 stood at Rs 58,000 crore. The combination of increased redemption, advance tax outflows and the falling value of investments saw a steep fall in the assets under management of the mutual fund industry as a whole. The data released from the Association of Mutual Funds in India (Amfi) shows that there was an 18% drop in the AUM between September and October 2008. The industry lost more than Rs 97,000 crore worth of assets in October.

WHY SIPS WORK
Fund houses have been selling the advantages of SIPs in a rising market. But the real benefit of SIPs comes into play when the market is falling.
 LUMP SUMSIPBENEFITS OF SIP
Entry NAV (Rs)20.5520.55-
Exit NAV (Rs)23.4323.43-
Total investment (Rs)36,00036,000-
Units acquired1,751.801,795.5043.7
Average cost/unit (Rs)20.5520.05-2.43%
Investment value (Rs)41,045.3042,068.801,023.6
Return (%)14.0116.862.49
To know the benefits of SIP over a three-year period, when the market has both rising and falling phases, we took a monthly SIP of Rs 1,000 against a Rs 36,000 one-time investment. The SIP scores over the lump-sum investment.

WHAT REDEMPTION MEANS

TO FUND HOUSES: Churning of funds is part of the business, but large-scale churning can be worrying. However, the fact that the industry has managed payouts of over Rs 90,000 crore in Sept and Oct 2008 indicates its strength.

TO CORPORATE INVESTORS: Exiting to book profits makes good financial sense. However, if the redemption is out of panic, it fuels industry-wide fear and can be detrimental to the market sentiment.

TO RETAIL INVESTORS: Again, profit-booking makes sense. However, if redemption is simply because the herd is selling, remember that the last to get out bears most of the brunt of lower value (NAVs).

It could have been the start of a vicious cycle—heavy redemption pressures, falling AUM leading to loss of confidence, this in turn leading to heavier redemption. Luckily, this seems to have been avoided, and by the end of November, the industry appeared to be turning around. But what caused the panic?

“Investors were exiting for no rhyme or reason. It was as if there was a herd mindset that had overtaken them,” says Dhirendra Kumar, CEO, Value Research. Of course, it makes sense for them to sit tight, but most small investors take their cue from corporate investors, who withdrew large amounts to meet their liquidity needs. Small investors, who believed that the funds could not meet such heavy redemption pressures, preferred to exit at a loss rather than see the value of their investments erode.

But retail investors formed just a drop in the ocean; some 80% of the AUM comes from corporates and institutions. Most of these large investors park their excess cash in short-term debt funds and liquid funds, including FMPs, as part of their routine treasury management. The liquidity crisis meant that these companies had to tap their reserves, leading to massive withdrawal of their investment. Prasanth Prabhakaran, senior vice-president, Kotak Securities, says the redemption from corporate investors and HNIs was “owing to liquidity problems and a flight to safety”. Insiders know all about the corporate group that withdrew Rs 650 crore worth of investment in liquid and liquid-plus funds in three days because it had to pay off a foreign debt.

Dr Ranjit Kumar, 29
Hubli

Has invested in mutual funds since 2006

He started an SIP, investing Rs 2,000 a month. His total investment of Rs 24,000 is worth Rs 17,000 today

"Mutual funds are risky and all the hype about them being investor friendly is only partially true. My experience has been bad and I don't think I will buy these products any more."

Fund houses claimed that they could handle the redemptions, as most of them had lines of credit with banks, which allowed them to borrow up to 20% of the value of the AUM. But the fact is that liquid funds were caught off guard, with little or no cash reserves set aside for instant payouts, since such large-scale redemptions have never been witnessed in the past.

There’s also the fact that fund managers exhibited greed and poor risk analysis. In order to gain extra returns, they started investing money in papers with longer maturities, which were not easy to redeem overnight, as the case should have been. “As the credit situation became worst, even assets that were like cash equivalents became difficult to sell,” says Kumar.

Redemption was not easy from FMPs as well since the money was invested in bonds with a fixed maturity, which meant premature selling in an illiquid market. “It was a case of only some fund houses with strong sponsors being seen as safe,” adds Kumar. Some players say that this is not entirely true since all fund houses faced redemption pressures. Others, however, claim that this is why strong domestic players like ICICI, even with Rs 15,000 crore worth of redemptions, did not suffer as much as foreign players like Mirae.

What has compounded the problem is the bag of illiquid securities worth Rs 40,000-45,000 crore that fund houses hold. These are considered among the most toxic assets in the financial market today and comprise pass-through certificates (PTCs) or securitised instruments against consumer durables and other loans, debentures floated by real estate companies, and securities issued by non-banking finance companies. The funds are finding it impossible to sell the PTCs; in fact, one fund sold these papers back to the issuer. The certificates, with a coupon of 12%, were sold to the issuer—a Mumbai-based NBFC belonging to a large corporate—at 18% of the original value.

The net result has been negative returns from liquid and liquidplus funds. The situation worsened when banks began to have liquidity troubles and started to pull back their money. Thankfully, the Reserve Bank of India (in consultation with Sebi) acted swiftly and the banks were given access to Rs 20,000 crore to meet their liquidity needs and to help the fund houses meet redemption pressures. Despite this, some fund houses, notably Mirae and Lotus, were in trouble; others decided to forestall any problems by putting a cap on redemptions.

Amid this mess, the small investor ended up paying the price. Most investors redeemed in panic, deciding to cut their losses as they feared that the fund houses would go under. Thanks to a high redemption pressure from institutional and large investors, the funds sold their investments at a discount. Debt funds, so far seen as safety nets in volatile and falling equity markets, let the retail investors down. Although funds have stated that there has been no problem on the equity front, there has been a fallout there as well.

Investors are discontinuing SIPs and are reluctant to enter the equity space. In view of the falling demand, new fund offerings have come down in the previous quarter. With banks offering assured returns, the small investor is now making a move towards the safety of fixed deposits. In an ideal world, small investors would have stayed put, and even taken this opportunity to buy, given that prices are low now. But when it comes to money, most of us prefer safety, even if it comes at a high price.

— With inputs from R. Sree Ram and Shruti Kohli

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