The mutual fund industry has been the talk of
the town in the past 3 days, courtesy the winding up of 6 mutual fund schemes
of the Franklin Templeton Fund🥺😭. The size of the mutual fund industry
(measured as asset under management) has grown at a CAGR of almost 20% in the
last 17 years🤩😮 and an individual investors' reliance on them
is very high, especially the ones who lack knowledge of direct investment in
stock markets. Amidst all the chaos in the industry, lets understand the mutual
fund industry, briefly evaluate the problem and how the RBI stepped into ease
the financial contagion effect of one mutual fund on the other in Post #5 of the
Quarantine series.😎🥳
Q1. How big is the mutual fund industry?
A1. The size of the mutual fund industry is
defined by the assets under management (AUM)🧐🤔❓. In simple
terms it means the total market value of all the financial assets which a mutual
fund is holding in various instruments (equities, debt, exchange traded funds).
The total AUM of the mutual fund industry as
on March 31, 2020 stood at around Rs 27 lakh crs, which is 13.6% of India’s
nominal GDP. *It is important to note that the top 10 mutual fund houses (out
of 45) account for 83% of the total AUM, indicating the concentration of the
investment in a few mutual fund houses*. One of the top 10 includes Franklin
Templeton, which has recently been in news about winding up of 6 of its
schemes.
Q2. What is the composition of the investment
made by mutual funds houses?
A2. Out of the total funds deployed by the
mutual fund house, 53% is invested in debt oriented or income schemes (fixed
income securities) while 39% is invested in equity or balanced schemes and the
balance in exchange traded funds.
Within the debt schemes, 45% of the investment
is in corporate bonds (30% in corporate bonds and 15% in bonds of public sector
entities), 17% is in commercial paper while 10% in certificate of deposits ( it
is issued by scheduled commercial banks and other financial institutions and is
similar to a fixed deposit). The mutual funds also invest their money in
government securities issued by the Central government and state governments
and this accounts for almost 9% of the total funds deployed in debt securities.
Q3. So what is the problem with the Franklin
Templeton Mutual fund and what led to the winding up of its scheme?🤔😭
A3. The Franklin Templeton Mutual Fund has a
total AUM of Rs 1.16 lakh crs (4.3% of total AUM of the industry) and ranks 9th
in the list of total mutual fund AMCs. The problem which occurred here is that
the mutual fund house announced winding up of 6 of its debt funds, whose
combined AUM is around Rs 28,000 crs. This amount is 25% of the total AUM size
of Franklin Templeton.
In simple words, *winding up* means these
funds will cease to exist after all the assets it has have been sold-off. And
till that time it happens, there will be no purchase (including SIP
installments, Switches & STP) or redemption or SWP installments allowed
from these funds.
*So the point to note is that the mutual fund
house has decided to wind up not because the company in which they had invested
has defaulted (not repaid money) but it is because they had high redemption
requests from investors and were not able to meet the same.*
However, it is also important to note that
despite winding up of schemes, the mutual fund house will continue to hold
these investments and they can sell the investments at the right price or
maturity date. This is the time, the funds earned by the MF will be
redistributed with the investor.🕺🕺
Q4. The problem of COVID-19 and why the
decision to wind up these schemes?
A4. The stock markets have tumbled as an
aftermath of the outbreak of the unprecedented COVID-19 and investors have moved
towards safe-haven assets instead. On account of this the corporate bond market
has also become illiquid as there are no enough buyers for these corporate
bonds, especially the “lower rated bonds”.
By lower rated, I don’t mean below investment
grade, but I mean bonds having ratings of “A category and below”. *To draw an
analogy here, these bonds are not the stalwarts/toppers of the class but are
the average performers*. Lower the rating of the bond means they are more risky
vis-à-vis higher rated instruments and as Finance 101 explains “Higher the
risk, higher is the reward” for these instruments.
As per the SEBI, they have provided a detailed
classification as to which instruments should a mutual fund house be investing
money into. If we draw comparison of SEBI’s classification and Franklin
Templeton’s winded up mutual funds:
· 3 out of the 6 funds were into
instruments having tenure of less than 1 year,
· 1 was across different durations
· 1 was for 3-4 years duration
· last one is a credit risk fund which
specifies that 65% of the investment will be in below highest rated
instruments.
Apart from the last credit risk fund, SEBI
only defined the duration and not the rating category of the investment scheme.
It is important to note here that the mutual fund house invested almost 50% of
the money received into instruments which were of the “A rated category” (in
simple words, good average students). In short, these 6 schemes invested in
short term and below best rated category.
In a normal scenario, the mutual fund house
could have managed the redemption requests by either selling the instruments in
which investment was made or borrowed money from the banks.
*But the problem in Templeton’s case was that
there was not only high redemption pressure but also lack of demand for low
rated bonds, which meant they would have to sell at a lower price and even
incur losses. These losses would have to borne by the investors itself and
hence the MF house decided to wind up those schemes.*
Q5. So how has the RBI come up into picture
today?
A5. The RBI has announced Rs 50,000 crs (1.8%
of total AUM and around 4% of debt AUM) special liquidity facility for the
mutual funds in the wake of redemption pressures related to some debt mutual
funds.
*In simple words it means that the RBI shall
conduct repo operations (money lent to the commercial banks) for a period of 90
days at the repo rate (i.e 4.4% at present)*. The funds availed by the banks
can in turn be lent to mutual funds against the collateral of investment grade
bonds, CPs, debentures and CDs.
*The “catch” is in the term “investment grade”
because the question is whether the banks will lend money against a collateral
which is investment grade but has a rating of "A category and below”
(good average students) ?
This is where the bank’s risk appetite will
come into picture because it is less risky for them to lend money against a
collateral of AAA rating as against an “A rating category” (note: it’s not
always the case as there have been AAA cases which have also defaulted)
*In short, the RBI has intervened via an
instrument which is similar to a targeted repo operation but with a shorter
duration (90 days) as against its previous instrument of TLTRO 1.0 and 2.0
which were for 3 years.
To conclude, the impact of COVID-19 has been
widespread across the financial markets and the RBI has been swift to respond
to the onerous challenge coming up from different frontiers of the financial
markets. Let’s see which more “panic attacks” we have in store in the finance
section going ahead.😃
Regards,
Sushant
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