‘Diversify savings beyond mutual funds’

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In 2008, at the height of the Global Financial Crisis that emanated in the US, debt mutual funds faced a massive liquidity crisis and had to be bailed out by the Reserve

.

Since then, it has been an endless litany of woes for mutual funds. The crisis in the NBFC industry in 2018, triggered by the collapse of ILFS and subsequent bankruptcy of DHFL, saw many investors exposed to significant losses.

In March 2020, Covid and lockdown induced illiquidity in the corporate bond market to which mutual funds have significant exposure, forced RBI to step in with Targeted Long Term Repo Operations.

Bonds issued by Vodafone faced erosion in their market value though the company did not default-bond prices reflect probability of future default.

Yes Bank’s Rs 8,415-crore Additional Tier1 bond meltdown, again exposed investors to losses. This was followed by SEBI’s new valuation norms for AT1 bonds which led to another round of scare mongering among investors about potential markdowns.

To cap it all, Franklin Templeton froze redemption in several schemes in 2020, creating panic among mutual fund investors.

In the last few months investors in debt mutual funds saw significant erosion in the long and medium duration funds thanks to rising interest rates; bond prices and interest rates move in opposite directions. Even short duration funds have given negative yields after adjusting for inflation. The much touted “target maturity index funds” which are the latest craze with almost every mutual fund jumping into the sector, have led to massive losses for some investors. However, investors who do not panic and hold till maturity, may be able to recoup the losses, and hopefully make some return too. Not many investors have flinched at the losses, reflecting maturity and understanding of the product.

Just when the managers/trustees in charge of the mutual fund houses were breathing a little easy, the industry has again been rocked by the “front running” allegations at a well-known mutual fund. Investors rely upon the honesty of their managers who execute trades on their behalf. When some managers allegedly profit from these trades at the expense of investors, then all trust breaks down. It is not clear yet, if the alleged front running scam is specific to a mutual fund, or there are bad apples across the industry.

It is never a quiet day for mutual funds with frequent scandals, losses and liquidity issues.

Basic rules of investing
Given the endless negative headlines in the industry, investors should perhaps view investing in mutual funds as an asset class. Some basic rules of investing apply here. Do not invest in something you don’t understand. Second, diversify, diversify, diversify. Third of course, do not get carried away by past returns.

On the first rule of understanding the product first, debt mutual funds are much more complex than their equity counterpart. Equity funds invest in the stock market, with returns to a large extent mirroring the markets. Most investors understand volatility in stocks. In debt mutual funds investors expecting “fixed income” returns like bank deposits have been shocked time and again by credit losses in their investment (ILFS in 2018 being a prime example, among many others), liquidity issues (Franklin Templeton’s freeze on redemptions in 2020), and duration-related losses (2022). Investors should try and understand each of these risks(credit/liquidity/duration), before investing in debt mutual funds. Being carried away by prestigious names backing mutual funds like

,

, Kotak, Axis, Templeton etc. can only lead to distress down the line. Unlike a bank where shareholders absorb losses and protect depositors, in debt mutual funds every single Rupee of loss is passed on to investors. A public sector bank racked up NPA’s (bad loans) of 27%, but depositors did not lose a single penny. Had this happened at the bank’s mutual fund, investors would have got back only 73% of their money.

Should mutual funds be treated as an asset class?
Most investors are familiar with various asset classes like equity, fixed income, gold, real estate, private equity, venture capital etc. Of course, crypto, too (“rat poison” anybody?!; that’s a characterization of Bitcoin by Berkshire Hathaway’s legendary CEO Warren Buffet).

Putting all one’s bet on mutual funds is a prescription for disaster, however convenient and tax efficient they may be (some debt mutual fund investors are heading for close to tax-free returns in this financial year thanks to being taxed after indexing for inflation).

In today’s world, floating rate savings bond issued by the government offering a pretax yield of 7.1% though subject to periodical revision, offer an attractive avenue for diversification. Sovereign gold bonds, again issued by the Government, offer a potential hedge against Rupee deprecation and geo political turmoil. Bank deposits too, are slowly making a comeback, with higher interest rates.

Some bad apples in the industry
The mutual fund industry is today a behemoth with Rs 38 lakh crore assets under management. There are some very fine people running mutual fund schemes. However, mutual fund managers are a microcosm of the imperfect world we live in, resulting in some bad apples in the mutual fund industry too.

Therefore, it would be wise to diversify one’s savings beyond mutual funds; and within mutual funds, it would be prudent to diversify one’s investments across multiple schemes spread across fund houses like SBI, ICICI,

, Kotak and HDFC.

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