How opaque portfolios, misuse of mandate and misrepresentation, shortchanged investors of Fixed Maturity Plans and created a crisis. Sucheta Dalal explains
When the whirlwind of global financial turmoil hit the Indian shores in late September, it wasn’t Indian banks that were rocked. Barring, of course, ICICI Bank which became the target of speculative short-selling. None of the Indian insurance companies, investment banks or broking firms had large holes in their books like the most famous names on Wall Street. Instead, from what is known so far, trouble brewed in one odd corner of the financial marketplace – the bland-sounding fixed maturity plans (FMPs) of mutual funds.
As the stock market went into a free fall in September and October, major US financial institutions went bankrupt and a severe crisis of confidence erupted, some savvy FMP investors worried about their investment and demanded their money back. This put fund companies in serious trouble. The pressure was so strong that KV Kamath, managing director of ICICI Bank, warned on 2nd November that mutual funds and non-banking finance companies (NBFCs) with an exposure of Rs630,000 crore could crumble. When asked if mutual funds and NBFCs needed a bailout rather than banks, he said: “Exactly. There is no need for a bailout package for the Indian banking system but the bailout package could be required for mutual funds and NBFCs… We have a situation where the two have a corpus of debt or money lent out at around Rs630,000 crore. The number I have, roughly on mutual funds’ debt side is around Rs250,000 crore and NBFCs, non-deposit taking is Rs380,000 crore.” What he did not mention was that funds, through the FMPs, NBFC and the real estate sector were all locked in a downward spiral.
For years, FMPs have been a useful product for mutual funds and their corporate ‘clients’. They allowed fund companies to channel surplus money from companies and high net worth individuals to the corporate sector when in need of quick money. Some were for short durations (like 15 days) while others were for 13 months or more. Every financial advisor and mutual fund company furiously hawked FMPs as the ideal vehicle for retail investors which offered the safety of fixed deposits with lower taxes. At the end of September 2008, the corpus under FMPs was Rs67,276 crore accounting for nearly 16% of total assets under management of mutual funds amounting to Rs 4,26,669 crore. What went wrong with FMPs? Several things, mainly a combination of dubious market practices and regulatory failure.
FMPs were supposed to invest their corpus in a pre-determined basket of rated and unrated securities allowing them to project indicative returns (and risks) to investors at the time of investment. But, as happens during a long bull run, market practices embraced higher risks and ran far ahead of rules set by the regulator. Some of these practices, which are being discovered every day, were as follows:
Many FMPs were lured by new opportunities that spring up in long bull markets: funding the subscription of initial public offerings (IPOs), funding promoters’ holding in their listed stocks and funding real estate companies. These investments, made through non-banking finance companies, rested on shaky grounds after the stock market indices dropped more than 50% from their January 2008 peak and the real estate bubble was quickly losing air. When redemption pressures hit Indian mutual funds forcing them to borrow funds at steep interest rates, they ran to the authorities for liquidity.
At one time, investment banks and finance companies were floating 15-day paper for IPO funding. Credit rating agencies were happy to boost their income by rating this short-term paper (usually top grading) which was quickly placed with mutual funds. This allowed NBFCs to create excitement in the primary market by holding out the promise of quick and hefty profits.
FMPs did not have simple mark-to-market rules, although their investments included very short maturity investments as well as structured derivative instruments. So funds were hit with a liquidity crisis because they allowed institutional investors to exit at high net asset values (NAV) based on the yield at maturity.
As per SEBI guidelines, a scheme is allowed to invest up to 15% of its net assets in debt instruments issued by a single issuer. However, this 15% restriction can be raised to 20% of net assets of the scheme with the prior approval of the Board of Trustees and Board of the AMC. So, theoretically, a fund can have its entire money in just five instruments, which makes for a huge concentration.
The bigger issue is that this investment restriction does not apply to money market instruments through which a fund can have its entire money parked in just one instrument of one company! This is exactly the case with Templeton Fixed Horizon Fund 15 Months – Growth, which has invested 97.7% of its net assets in a single instrument of a single company - Reliance Capital. This is legal, but is it sensible? It allows an entire mutual fund scheme to become a fund-raising instrument for a single company, while investors are clueless about the risk involved. It negates the very concept of a mutual fund reducing risk by distributing investments in a basket of selected securities.
FMPs offered ‘indicative returns’ – a euphemism for ‘assured returns’ -- which the regulator frowns upon. But it did not interfere with FMPs probably on the assumption that each scheme had secure back-to-back investment in a basket of fixed-return investments. The Securities and Exchange Board of India (SEBI) apparently never inspected specific schemes or found out if this was, indeed, true.
Most FMPs vary in maturities between three and 13 months. Since FMPs are short-term funds, they ought to invest in short-dated instruments. But, in their quest for higher yields, fund managers bought long-term securities (maturity of one year or more).
So, when the financial tornado hit India and savvy investors started to redeem FMPs despite a steep exit load, it exposed the can of worms. As redemption pressure mounted in September and October, FMP investors found themselves short-changed. The ‘indicative returns’ turned out to be myths and most funds imposed restrictions on redemption. In many cases, the actual investment was either completely different from the indicative portfolio or the AAA-rated paper of finance and realty companies was looking a lot less secure. In many cases, investors can’t even make sense of the underlying securities. Many are Pass Through Certificates (PTCs) which, they are told, are guaranteed by banks or their issuers.
Almost every FMP has exposure to an industry sector that is badly hit by the global financial turmoil or has invested in a shaky or opaque paper that investors know little about. Some have even invested in unrated debt paper which was never a part of the indicative portfolio.
The biggest problem is that many FMPs have a direct and indirect exposure to stock markets, finance companies, realty and to hybrid, securitised paper representing unknown pools of mortgage-backed receivables. HDFC Mutual Fund’s 370-day FMP June 2008, for instance, has 12.27% invested in Corporate Loan Security SR I 2006. It is a privately-placed debenture. It is difficult to figure out what this is. It also has 16.47% in Corporate Loan Trust 2008 and another 16.67% in Loan Receivable Trust A1 7. All FMP portfolios have such kinds of securities. These are not very easy to decipher and track and even a single bad investment (any NBFC or a real estate company can default) will cause a sharp drop in returns. For instance, an 11% ‘indicative’ return will drop to around 4%.
Investor complaints being directed to the media suggest that many FMPs attracted investment by indicating one basket of securities and actually invested in an entirely different set of riskier securities. Does this amount to misrepresentation, diversion of funds or outright fraud? SEBI has apparently not gotten around to examining that as yet.
The Economic Times reported that an investor who put money into HSBC’s Fixed Term Series 52 FD (total scheme was worth Rs275 crore) in March 2008, discovered that its actual investment was vastly different from the indicated portfolio. HSBC’s response to the newspaper was: “an indicative portfolio is always broad-based.” This means that there was absolutely no sanctity to the indicative portfolio or the indicative returns. Shouldn’t the regulator have noticed this and fixed it with proper regulation before it blew up into a problem? Instead, SEBI is still studying the issue while savvy investors are taking their money out of FMPs even if it means paying a big exit load and taking a hit on expected returns. It is residual investors who will bear the brunt of FMP mischief. SEBI now plans to plug early exits from FMPs and to make secondary market listing mandatory for them. That is for the future; at present, the horses have already bolted.
Rajiv Malhotra is another aggrieved FMP investor fighting a long battle with ABN Amro over redemption of Rs1 crore invested in FMPs that had offered a 11.5% yield and redemption in two days (as per SEBI rules). First, ABN Mutual barred exit and unilaterally reduced redemption to Rs1 lakh per day. Consequently, it has waived the exit load during a pre-defined exit option period, but calls that a ‘service gesture’. That is only part of the problem. The main issue is that actual investments were very different from the indicative basket of companies. For instance, Thomson Press was never in their original universe of companies but was subsequently included. He was told that the maximum exposure to AA-rated paper will be just 10%; in fact, it was 27%. When Malhotra asked for portfolio details, he was shown some Corporate Debt Trust (CDT) series as the underlying investments. On questioning the fund, he was told by an official that the CDTs are guaranteed by banks like Axis and Standard Chartered. Malhotra recorded that conversation. However, the head of client services (whose emails are copied to us) denies that the banks have guaranteed the CDTs. Malhotra charges that this amounts to cheating and misleading the public and his real return is less than half of what was indicated to him. Clearly, he has a point and, in fact, he is lucky not to take a hit on his original investment too. Thanks to a combination of the finance minister’s swagger about global confidence in India’s capital market, the regulators’ slumber and soaring stock indices, malpractices by funds were never anticipated or investigated.
Despite all the publicity attached to the instrument and the fact that they garnered over Rs132,000 crore (September-end data) or a quarter of all mutual fund assets under management, the regulator did not feel the need to re-examine mutual fund regulation. Had it done so, it would have noticed all the ills we have described above.
On 12th November, the media reported that SEBI was planning to make it tougher to exit from FMPs offered by mutual fund companies. It is also undertaking a ‘structural review’ of mutual funds and intends to curb exposure by FMPs to a single sector. As far as retail investors are concerned, the move comes long after the horse has bolted and FMPs have far bigger problems than early exits or exposure to a single sector.
The warning signs were available for anybody to see. As far back as February 2007, at an interaction of the prime minister with senior journalists, I had pointed out that the government must take a close look at mutual fund regulation, if it was exhorting retail investors to take the mutual fund route to equity investment as a policy. In February 2008, I had emailed prime minister Manmohan Singh’s office about how “short-term paper (even 15-day paper), with a high credit rating is apparently used by mutual funds to divert debt funds to illegally invest in equity.” I had pointed out that “debt funds (we now know they were short-duration FMPs) subscribe to 15-day paper issued by finance companies which have obtained a high credit rating and the entire money is used to apply to initial public offerings.” Clearly, such paper is risky. Any delay in the allotment and refund process could lead to trouble; but, in a ferocious bull market, any worry about “mindlessly sanitised financial paper” would have been dismissed by the mandarins in Delhi. In fact, right until early October, the finance minister continued to exude enormous confidence about India’s economy and the capital markets, apparently oblivious to the coming storm.
Who should have rung the alarm bell? The community of financial advisors ought to have known what is going on. But they probably believed that fund houses had acted in good faith and invested in line with their indicative portfolio and returns. The distributors’ community ought to have known what was happening. But mutual funds and distributors are in a close nexus. What better proof of this than the Bajaj Capital story. On 11th November, The Economic Times reported an internal communication from Bajaj Capital, India’s largest mutual fund distributor, advising its clients to exit nine specific FMPs (whose portfolios were considered weak) and switch to safer ones. It also suggested a ‘cautious hold’ on another and categorised a couple of others as safe investments. The nine that it recommended exit from were: Kotak FMP 12M Series 3, HDFC 15M March 2007, HDFC FMP 370(2), HDFC FMP 26M Aug 2006, DSPML (now DSP Blackrock) 15M Series 1, Birla FTP Series AT, Kotak 15M Series 5, ABN Amro (now Fortis) Series 10 Plan F and Series 11 Plan B. But this late attack of conscience was also short-lived. The very next day, Bajaj Capital, apparently, cracked under pressure from the fund community and withdrew/disowned the ‘communication’ and its assessment. It said that it has not examined the portfolios of these FMPs and offered no comment regarding their safety.
How they handle the FMP imbroglio would be a good test for the regulators, the fund industry, the distributors and also the retail investors. Tough new regulations must be matched by investors asking tough questions regarding the quality of advice they got from fund distributors and financial advisors.
Tax Benefits for Whom?
Mutual funds (MFs), as an investment vehicle, are meant for retail investors. The government, especially finance minister P Chidambaram, does not miss any opportunity to ask individuals to invest through MFs and has also made the returns from equity MFs tax-free. Returns on FMPs are taxed as per capital gain which allows for indexation benefits. This gives products like FMPs a major advantage over bank fixed deposits. Bank interest rate is fully taxed (subject to minor tax concessions) while some FMPs with indexation benefit were giving a post-tax yield of 8% or more (at a time when bank deposits yielded 6%-7% pre-tax). Who took advantage of this? Not the retail investor, because MFs were not even selling FMPs to them, leading one of our readers to complain (see MoneyLIFE 5 June 2008). The fund industry has been conveniently using this tax loophole to build a business of managing over Rs60,000 crore of assets. The tax incentives were meant to encourage retail investment in the market. Instead, it is banks and corporate treasuries who are reaping the benefit, usually at the cost of retail investors. SEBI needs to separate the retail plans from the institutional funds. After all, the government has been pushing retail investors to MFs without checking whether the interests of funds are aligned with those of retail investors. Only when retail and institutional funds are separated, along with different tax treatment for both, will MFs focus on growing the retail market.