Why Franklin-type fiasco will keep repeating

Franklin Templeton India Mutual Fund last week suddenly announced it was winding up six debt schemes that held more than Rs 27,000 crore. These are Low Duration Fund, Dynamic Accrual Fund, Credit Risk Fund, Short Term Income Plan, Ultra Short Bond Fund, and Income Opportunities Fund. 

 
Franklin will neither accept fresh subscriptions, nor allow exit. It will liquidate the portfolio as and when the debt papers mature, or earlier if it can sell. Whatever it collects, it will return to investors. How much will that be? No one knows. Investors are trapped. Those who had put in money in other mutual fund (MF) schemes are deeply worried. What went wrong? Is there a systemic flaw? Is there a role for the regulator here? Can this happen again? What should you do to avoid such accidents?

1. What went wrong? When coronavirus struck, Franklin faced redemptions. If redemptions match inflows, there is no issue. Even if they fall short, it is not an issue up to a point — funds are allowed to temporarily borrow to meet redemptions. Franklin too has been borrowing but redemptions were greater. So, it had to shutter the funds. Why couldn’t it sell its investments to raise money? Because its investments were illiquid. Franklin’s fixed-income desk has been trying to take extra risks (structured, complex deals and poor-quality paper) even in schemes that were supposed to be safe (like liquid schemes) to goose up its returns so that it could attract more money to manage.

2. Is there a systemic flaw? Yes, if you ask me, and, no, if you ask the mutual fund ecosystem, comprising fund companies, fund managers, distributors, advisors, and the regulator. The popular narrative of this group — broadcast by the media — is that the problem is mainly external (the havoc wrought by Covid-19) and partly internal (extra risk taken by Franklin). I am sure the fund does not accept the second. These arguments are specious. I argue that the problem is both with the fund industry and the product categories.

The fixed-income division, not just of Franklin but various mutual funds, has been trying to swing for the fences. MFs have been involved in all the major scandals over the past 18 months — Infrastructure Leasing & Financial Services, Zee/Essel, Dewan Housing Finance Ltd (DHFL), and YES Bank. Some time ago, Franklin wrote off 100 per cent of its investment in a Vodafone paper. It had the highest exposure to the telco, at Rs 2,074 crore out of a total Rs 4,500 crore, which Vodafone owed the fund industry as a whole.

I had first exposed in Moneylife how Wadhawan Global Capital (WGCL), the personal holding company of DHFL promoters, raised Rs 2,125 crore through zero-coupon bonds from Aditya Birla MF and Franklin. Franklin had also lent to Rana Kapoor’s holding company YES Capital, which held 3.27 per cent of Kapoor’s YES Bank stake, again through zero-coupon bonds. IDBI Mutual Fund put this highly risky product in its liquid fund, while Franklin India Debt Fund has put 8.27 per cent of its assets in these bonds. In all these cases, MFs acted as reckless lenders and not as prudent investors. Clearly, how debt funds are being run is a systemic issue.  

3. Is there a role for the regulator here? Yes. It can do two things. One, it needs to fix the accountability of credit-rating companies and fund companies by enforcing clauses that claw back the fees of all cases that blow up. Funds abdicate their responsibility to raters who have no accountability to them! This is perverse. Raters must be made accountable for ratings that blow up without warning.

Secondly, if Franklin is asked to put back into the fund the fees it has extracted from these six schemes, it (and all other fund houses) will certainly straighten up and take a close look at the rackets that its debt guys (supposed to be risk-averse people) are up to. It will regulate itself well. Two, the regulator needs to redo debt fund classification. While equity has 10 categories, debt has 16. We don’t need so many. Several, such as credit-risk funds and long-term debt funds, should not be sold to retail investors at all, but only to institutions.

4. Can this happen again? Yes, of course, it can, bec­a­use the regulator has never touched the heart of the pr­oblem: The fund industry’s income is a percentage of funds it collects. This incentive makes asset-gather­i­ng its main objective, not its fiduciary role as a trustee of other people’s money. If their fees were somehow li­n­k­e­d to returns and/or certain outcomes, there would be a ch­ange in their behaviour. But the Securities and Ex­ch­ange Board of India (Sebi) is not even thinking of this.

5. What should investors do to avoid such accidents? Take a look at the funds named in the first para. I can bet even finance professionals can’t tell where such funds invest and their related risks. Debt investment is the specialised domain of a small group of finance professionals. Many investors I know don’t even understand that debt schemes are mislabelled as fixed-income schemes, which give investors the impression that they are similar to fixed deposits. In reality, many debt schemes have huge hidden risks.

The principle here is simple: Capital protection is paramount. Take your chances in equity, never in debt. So, say no to fixed-maturity plans, credit risk, and dynamic debt. You need only liquid schemes as a substitute for a savings account to park your money and, maybe short-term schemes. Of course, there is one more important step. You need to figure out which liquid and short-term debt scheme is okay. This is impossible for the average investor. Option two is to find an advisor you can trust. As you can see, even my bare-bones solution is not simple. That’s how hard Sebi and the fund ecosystem have made it for you.
The writer is the editor of www.moneylife.in
Twitter: @Moneylifers


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