Why credit investing is best left to specialist private credit funds than mutual funds
Why do we approach professionals in any field? The answer obviously is to rely on their superior experience and domain expertise and be guided by their learned advice in relation to the matter at hand. This is perhaps the same reason why investors have flocked to mutual funds over the past few years: to rely on the experience of seasoned fund managers to manage their wealth and put their money to work in the most efficient manner. AMFI records indicate that the mutual fund industry witnessed a manifold increase in its AUM over the past four years: from INR 14.90 lakh crore in June 2016 to INR 27.28 lakh crore in July 2020, representing a surge of as much as 183% during the interim period.
Over the years, the catchy “mutual funds sahi hai” (‘mutual funds are a right decision’) campaign has also helped in anchoring the message with lay investors that when it comes to investing one’s savings prudently, it makes sense to entrust it with the relevant subject matter experts. The mutual fund industry recorded as many as 9.15 crore folios as of June 30, 2020 (as against 4.89 crore in June 2016; a 1.87x jump), 89.91% of which were retail folios (i.e., investors with ticket sizes of less than INR 200,000), 9.25% were folios of high net worth individuals (i.e., investors with ticket size of over INR 200,000), and the remaining 0.85% were institutional folios. Rise in financial awareness, higher disposable incomes, and the sheer attractiveness of Indian capital markets has also led to more and more lay investors participating in mutual fund investments, as further evidenced by the rise in systemic investment plans (whereby an investor invests a certain fixed sum in mutual funds each month) from INR 3,320 crore in June 2016 to as much as INR 7,830 crore in July 2020.
Also, with India’s capital markets regulator SEBI permitting ‘direct plans’ in mutual funds (wherein an investor can purchase units of the fund directly from the fund house eliminating the intermediary advisor/broker) from January 2013, the lay investor’s accessibility to mutual fund investments skyrocketed significantly, with as much 40% of the total market share now being contributed by direct plans. Along with India’s rising capital market indices, the number of investors who began investing in mutual funds based on their own understanding of the sectoral outlook, macroeconomic cues and fund performance also began to witness a steady increase.
Retail investors in India have equated mutual funds mostly with equity investments, a fact which is quite evident from even a cursory analysis of the AUM numbers. While the Fixed Income segment contributes approximately 53% of overall industry AUM (approximately INR 14.50 lakh crore), this portion is largely subscribed by the institutional investor segment and only 29% of the Fixed Income AUM (approximately INR 4.21 lakh crore) is subscribed by retail investors. In contrast, the Equity AUM – which is 47% of the aggregate industry AUM (INR 12.82 lakh crore) receives as much as 76% participation from non-institutional investors, representing approximately INR 9.60 lakh crore.
While credit investing – which has an overall AUM size of INR 29,000 crore – constitutes only a small segment of the overall AUM INR 14.50 lakh crore of debt mutual funds, this has come under intense media and investor scrutiny in recent times, especially in the aftermath of the recent episode concerning the debt funds managed by a mega fund house in India. The sheer size of investor wealth involved alone – at its peak, as much as 4.5% of the industry’s Fixed Income AUM was invested in the six credit funds managed by the fund house – highlighted a long-running structural flaw vis-à-vis credit investing by mutual funds. The said fund house used to specialize in credit investing and is regarded as a significant contributory in helping to create a market for debt instruments, especially those with credit ratings lower than AA. The fund house, while remaining within its investment strategy as disclosed in the respective fund documents, perhaps took this specialization a tad too far by investing a portion of the AUM of multiple debt funds into low rated paper in order to enhance overall portfolio yield. With liquidity in the credit markets beginning to contract over the recent years triggered by the IL&FS crisis in September 2018, and multiple COVID-19 induced lockdowns bringing the credit markets to a state of near freeze, the fund house kept receiving redemption requests (as the schemes were open-ended in nature) and when matters reached a boiling point, the fund house had no option but to shutter the said funds leaving all investors high-and-dry.
This episode raised some pertinent questions as to where the real underlying ‘problem’ lay: (i) were the credit calls taken by the fund manager of questionable quality, or (ii) was the strategy itself inappropriate for an open-ended fund model, or (iii) was it the ‘black swan’ event itself (of the pandemic striking in full force thereby forcing a risk-off attitude among investors leading to mass redemptions) to be blamed here?
The pandemic certainly impacted risk perceptions of investors the world over making them significantly risk averse. Also, with the series of corporate-governance related incidents in the Indian financial services sector over the past two years being fresh in investor minds, the pandemic-induced lockdown was perhaps the figurative last straw which triggered the deluge of redemption requests. Were the credit calls taken by the fund house of questionable quality? Unlikely so, especially considering their vast experience in this sector, together with their unmatched credentials as market creators for a new class of investments. The key underlying issue is perhaps much more fundamental: is credit investing a strategy appropriate for open-ended funds?
To answer this question better, let us understand how a typical mutual fund house approaches credit investing. A medium sized fund house typically employs around 10 fund managers who tend to be equally split between equity and debt funds. Therefore, in a 5-member debt fund management team, one can expect (at best) a single fund manager being responsible for overseeing credit investments. Given that the industry has been witnessing unprecedented levels of inflow in recent times (buoyed by increasing levels retail participation), the sheer volume of capital that needs to be deployed by the credit fund manager within short periods of time each month can at times be disproportionate to the time/staffing resources that the fund house may have at hand. As they say, too much of a good thing – and in this case, the good thing being steady flow of capital from retail investors chasing outsized returns via credit investments – can be bad.
Also, given the pressure to deploy significant amounts of capital while outdoing others in YTM, credit fund managers often adopt a safer and top-down approach while evaluating investment opportunities, choosing to park funds in issuance by large corporate groups based on promoter integrity/track record; rather than considering deployments in smaller companies, which will result in only lower quantities of deployment. While investing in smaller companies, credit ratings issued by rating agencies often play a greater role in decision making and are often the ‘first check’ while evaluating potential investments, given the comparatively limited amount of information that is often available on these companies. Finally,a good section of the modern retail investors (especially those investing via direct plans than regular plans) are more of a D-I-Y class whose key sources of information include ‘friendly’ recommendations on social media groups and past returns of a fund/category, versus informed advice from learned sources such as investment advisors or brokers, and tend to react impulsively to information, often triggering a deluge of redemption requests at the first sign of strain. And for an open-ended fund dealing in credit investments in lower rated paper (which are largely illiquid in nature), such redemption requests can pose a serious challenge and when continued beyond a point, could even be the death knell for the fund.
Several of the deficiencies involved while making credit investments within the mutual fund structure are avoided in the alternative investment fund (AIF) structures, which by their very nature, remain a better medium for credit investing. Firstly, AIF structures are mostly close ended in nature and depending on their strategy, can have fund tenures ranging anywhere from three years to as long as over ten years. This close ended nature of AIFs helps in ensuring that their operations are better asset-liability matched, and also insulate the fund management house from redemption risk, which can lead to the unfortunate and untimely undoing of the fund. Secondly, unlike mutual funds, the AIF Regulations prescribe a relatively much higher entry threshold of INR 1 crore for investor participation, thereby restricting the availability of this asset class to a limited class of mature investors who are better positioned to accept/absorb the risks involved in investing in this asset class. Additionally, the AIF structure also provides the investment manager a higher degree of flexibility while structuring the portfolio to suit risk/return appetites of investors, unlike the relatively strait-jacketed approach that mutual funds must follow. Given the wider retail participation in mutual funds, SEBI has tightly defined parameters across fund categories which leave very little room for fund managers to bring in any form of differentiation. Thirdly, specialist AIFs generally tend to have better resources – both in terms of time as well as manpower – for making credit investments. Unlike mutual funds, an AIF investment manager is not under any time pressure to put money to work on a regular basis, and therefore is able to spend a meaningful amount of time in conducting a more comprehensive and detailed due diligence, covering financial, commercial, legal and integrity checks, competition analysis, etc., which perhaps leads to a more informed credit decision. Finally, the SEBI AIF Regulations require the investment manager to demonstrate skin-in-the-game by mandatorily investing its own capital into the AIF along with other investors, thereby ensuring a closer alignment of interests as compared to mutual funds.
All said and done, the high-yield bond fund (credit mutual fund) industry is worth USD 2.5 trillion globally (~INR 188 lakh crore) and with an AUM size of INR 29,000 crore in India, our industry is just about getting started. Indian investors have always been overly focused on the equity asset class, and pure play credit funds came into being in India around 2008 in the aftermath of the global financial crisis. While the recent turmoil experienced by the industry and subsequent loss of investor confidence may have set us back by a few months, we expect this to gradually return over the medium term as the ecosystem matures, and this asset class has the potential to significantly grow in an investor’s portfolio.
By Deepak Malik and Cyril Paul