5 Unknown Mutual Fund Risks !

We all used to discuss the regular risks associated with mutual fund investment. But recently due to one company’s stock and debenture, the mutual fund industry experienced few unknown Mutual Fund risks. Let us see what they are and how to be careful.

Caution

The trouble started with an auto ancillary industry company called Amtek Auto. One month back the stock price was around Rs.170 and it is now at around Rs.28. A fall of around 80% within a month. The reasons are as below.

  • The company has under loss and June quarter results reported a loss of more than Rs.150 Cr.
  • The company is finding it difficult to pay the interest on loans of around Rs.7, 800 Cr. Per quarter they need around Rs.200 Cr. to pay as an interest towards this loan, i.e. around 25% of its sales.
  • CARE rating suspending the company for rating stating the reason as a company not provided the information.
  • The stock has been taken off from Future and Options segment of the market.

Which Mutual Fund Companies hold Amtek Auto?

Five of India’s Top mutual fund companies holding the stock in their portfolio under the different fund categories. They are HDFC MF, Kotak MF, UTI MF, ICICI Prudential MF, and IDFC MF. Basically, the major chunk is from Arbitrage Funds of these MF companies. The total holdings of these mutual fund companies is around Rs.100 Cr. When we consider the AUM of funds, then this may seem less. But the question is why fund managers silent on company’s financial health and why they hold?

The detailed holding is explained in the Business Standard’s article of dated September 1, 2015.

This is the history about the company and equity holding of mutual fund companies. Now let us concentrate to this post. Recently JP Morgan Mutual Fund Company has been in the news because of Amtek Auto.

Two JP Morgan Mutual Fund’s debt schemes, Short Term Income Fund’s and JP Morgan India Treasury Fund together hold around the combined exposure of Rs 200 crore in Amtek Auto’s debt papers. When the debentures of this company were issued in earlier this year, then CARE rated this as AA- (double A negative). Both these funds holding around 10.25% of Amtek Auto debenture.

Why NAV falls due to fall in credit rating? As per Live Mint When a bond’s credit rating drops, its price, too, gets marked down as an adjustment, according to the formula that debt funds are mandated to use to value underlying securities. In other words, this is a mark to market loss. Amtek Auto has not yet defaulted on the principal payment to JP Morgan AMC.”.

Due to fall in bond price and panic of defaulting, the redemption started in these two funds.  The result is NAV of two of its debt mutual funds, JP Morgan Short Term Income Fund and JP Morgan India Treasury Fund fell by -3.38% and – 1.73% on August  27th, 2015.

To limit this sudden redemption and further fall of NAV, JP Morgan restricted the redemption  from each of the two schemes to 1% of the total number of units outstanding on any business day. Means 1% of units in each scheme will be available for redemption, on a first-come-first-served basis.

But instead of default by Amtek Auto, the company may tell JP Morgan to roll over the debentures. Then the issue may calm down as of now. However, this is not a long-term or permanent solution. At the same time, if the Amtek Auto defaults, then you may see another such fall in NAVs of both funds. This means a permanent loss of equal to the % of holdings by these two funds in Amtek Auto Debenture. So the EXIT is the best option.

Now let us understand what risks this whole scenario brings to us

5 Unknown Mutual Fund Risks

  1. Liquidity Risk-When we say Mutual Fund investment, we always used to hear that it is a liquid asset. But what if because of such situations you are not able to liquidate your holdings? JP Morgan Mutual Fund restricted the redemption from each of the two schemes to 1% of the total number of units outstanding on any business day. It is as if the situation where banks restrict money withdrawal from an ATM during a banking crisis. According to rule, for any mutual fund company to take such decisions, the board of directors and trustee of a company must agree to it. Also, it must inform to SEBI for such action. But I feel there is no such process followed. Once there is an approval from all these three (board of directors, Trustee and SEBI), then only mutual fund company can impose such rule. In this case, no such rules followed. Is it to protect investors money or collapse of their own fund?
  2. Biased Risk-It sounds strange to you, but if you go with this news item of Times Of India, it allowed 3 large companies to exit from the schemes but not allowed for other 5 biggest companies. So the mutual fund company biased towards few companies to liquidate and come out of troubled funds. But what about the retail investors? Will they get such special treatments?
  3. Dynamic nature of Credit Rating Risk-See the ratings of the debenture when it was launched to the current status. CARE rated it an AA- (double A negative). CRISIL AA (+ve or -ve) means “Instruments with this rating are considered to have high degree of safety regarding timely servicing of financial obligations. Such instruments carry very low credit risk.” But now rating agency suspended it’s rating. So what retail investors can learn? Never be in the wrong belief that ratings remain constant. They are dynamic in nature and risk is always there.
  4. Fund Manager’s Risk-Look at these two funds. One is short term fund and another is ultra short term debt fund. We invest in such funds to avoid any volatility. We consider them as safe funds due to their holding nature of high-rated securities. In such a situation, why the Fund Manager hold Amtek Auto? Doesn’t he know the finances of the company? Who will bear the cost for his fault? Initially, the fund was invested around 15% in AA rated securities as were mandated. But later it increased the exposure to 30%. This is purely against the mandate provided during the launch of the fund. Usually, fund managers indulge in such track to create good returns against the peers or index. The result is devastating.
  5. Regulatory Risk-We all say with proud that mutual fund is the well-regulated industry. If so, then why SEBI not pushed the alarm button to the JP Morgan Mutual Fund when it increased its holding in low-rated bonds to more than the mandated holding? Now forget about that too, why SEBI not acting when without any such rules, JM Mutual Fund restricted the redemption limit? Also, why SEBI closed its eyes when JP Morgan Mutual Fund allowed redemption only to few big investors but forget retail investors?

What can we learn from this episode?

Check your fund holdings. It is hard for retail investors to understand the debt holdings. But not that much difficult also. If your debt funds holding any such low rated funds, then it is better to switch off. Because you have enough volatility from equity portfolio. Otherwise, if your fund holding such low rated bonds, then selects a fund which is low modified duration fund.

40 Responses

  1. I read your article and found it very knowledgable. There are certain queries in my mind regarding SIP method of investing in mutual funds. I want to invest but there are so many mutual funds in market and choosing the best looks complicated. Hope you can help me on this issue.
    My profile goes as follows.
    Age 28 yrs
    Occupation – merchant navy
    Yearly salary – 18-20 lac
    I am looking for long term investment plans. One for 10 years investment and other for 15 yrs solely for wealth creation not for tax evasion. As my earning are tax free. Hope you can guide me on this.
    Also if you can advise any learning website or classes to enhance investor knowledge. Lastly pls advise if you or anyone in your knowledge provide paid financial advice.

  2. HI, prsanth, great work. You know my insurance agent asked to invest in mutual funds. He SAID it would be very beneficial for me but he didn’t told me about the risks involved. Thanks to let me knowing.

  3. Hi, I have spent 50,000 rupees on Kingfisher airlines sometime back and I got around 4,000 shares. As per current market value it is around 5,000 rupees. Is there any way it can grow in near future. or Is it ready for lockout or bankrupt. Please advise.

  4. Sir,
    I am 22 yrs old , just now started investing in SIP for mindset for long term more than 15+years. Please suggest me whether my portfolio is good

    axis long term equity regularplan growth RS 1500 per month

    motilal oswal multicap 35 fund reg growth RS 1500 p.m

    motilal oswal midcap 30 reg growth RS 1500 p.m

    PLS suggest is this okay ,if not suggest me the fund where i want to switch

    thank u for ur time sir, waiting for ur reply:)

      1. Yes sir, I hv choosen axis for tax minded bz I put lumpsum in that when ever I get money and for exhausting 80c, motilal I hv no idea, as my advisor choosen these fund, pls suggest me the fund if I want to quit motilal

          1. okay sir thn ill switch to franklin prima plus and relaince small cap,thank u sir for ur valuable time to answer me

  5. Sir,
    I want to invest RS 3000 in SIP for long term. Please suggest me where and how much I should invest in your view. Please specify the mf name.
    Regards

  6. Mr.Basu,
    I am 41 years and plan to retire at 55. My savings till date are not adequate enough to sustain in future. But my salary present is enough to make an investment(savings) of 1 lac per month.Can you give some investment tips to secure my retirement in any form.

      1. Sorry but Do you offer any paid Financial planning services for customers online.
        I wanted some financial advises for my investments

  7. FANTASTIC! AWESOME and a very useful article. People (even Chartered Accountants and other finance professionals ) don’t thoroughly research these things as they rely on SEBI and trustee of the company to follow the rules. If a large Multi-national AMC like JP Morgan act in such reckless way with complete disregard of law, then what we can say about new and smaller AMCs? I will never invest in JP Morgan MF -that’s for sure.

    Shame on the Fund Manager – Namdev Chougule of JPMorgan India Short Term Income Fund and JPMorgan India Treasury Fund.

  8. Can Ulips be considered as safer option as compared to Mutual Funds in such circumstances?

    Since there is a lock-in period of 5 years and hence fund managers of Ulip are not aggressive / risk takers as compared to mutual funds.

    1. Ritesh-Where the ULIP fund manager invest? They have to invest in equity and debt based on the option you chosen right? In fact in ULIPs it is hard to go deep inside the fund details than MF. There is no such rule or guarantee that ULIP fund manager will not take risk because of 5 year lock-in. What if the madness to beat his peers or index made him to run behind low rated papers or stocks?

  9. I have invested in Kotak Equity Arbitrage fund and ICICI Equity Arbitrage fund. Is there any risk for these funds as far as Amtek Auto is concerned?
    I have read that if an arbitrage fund buys the stock in the cash market, it will sell an equal quantity in the futures market to make a profit from the mis-pricing. Fund managers say that these funds will not be impacted by the fall in Amtek Auto stock price as this position would be fully hedged in the derivatives market. Is it true or should I switch these funds into Liquid Fund? Please reply and thanks for your informative article.

      1. Requirement : To get tax free return post 1 year compared to Liquid or Debt or Glit fund or Fixed deposits. As these arbitrage fund are in the name of Partnership Firm, where rate of income tax is 30%. Also Arbitrage fund are of low risk fund. My investment span is 1.5-2 years. Expected return should be around 8%-9%. Thanks for your Kind attention.

  10. Great article but why do such information come out only when there is some turbulence in the market.
    Today you go through any financial blogs every one suggest mutual funds with SIP as the only viable investment option, and ask people even to cancel some insurance policy to opt for MFs instead.
    Ofcourse there is risk with every investment, who knows India can even become like Greece one day if something terribly goes wrong.
    That doesnt mean that we can keep cash at home right.
    Appreciate your concerns on informing various risks even with debt MFs, especially you have exposed SEBI who is always in favour of big players

  11. does it means, its better to invest in index funds and bluechip instead of mutual funds??.
    Pls clarify, because i just recently started investing in mutual funds.

    1. Abhishek-The above issue is related to debt funds. When you say equity then there is market risk. We invest in debt funds to avoid volatility. Hence, avoiding them and entering into equity without knowing the time horizon and risks is disastrous. The solution is to learn before investing.

  12. U can add here METAL FORGE’s Recent history….previous name of this company was Ahmednagar Forging….many fund houses hold that shares in their holdings….

  13. Basu,

    As usual, a very useful article. People (even educated and savy ppl) blindly buy mutual funds instead of index funds/etf/bluechips, in search of superior returns.

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