liquidity risk in mutual funds

In the former chapter, we delved into the Franklin debt fund saga. Investors have now grasped that investing in a debt fund should not be subjected to useless parameters such as past returns or current fund ranking. The market has frequently demonstrated that this method of selecting funds is in vain.

The evaluation of any investment must be based on risk metrics. Before getting involved in a debt or equity fund, it is important to understand the associated risks. Nonetheless, thanks to the ‘Mutual funds are subject to market risk’ tagline, most people get an indication that equity funds involve an element of risk.

Unfortunately, many assume that debt funds bear no risk.

If you have gone through the prior chapters, you will be aware of the risks posed by debt funds. Specifically, those include default risk, credit risk and interest rate risk. The recent Franklin episode further highlighted a dormant risk factor – ‘Liquidity Risk‘.

Let us begin this chapter by discussing liquidity risk and then move on to understanding the other types of debt funds.

Liquidity risk from a debt fund perspective can refer to two things:

1. The low liquidity in the Indian bond markets which is the underlying market for debt funds leads to an adverse effect.

2. The lack of availability of funds with the AMCs to service investor’s redemption

These two are closely linked.

The lack of liquidity in the bond market makes it difficult for AMCs to quickly liquidate the papers they hold, resulting in them being obligated to keep the paper until maturity. This effectively means that the money is ‘locked-in’.

The main role of an AMC is to collect money from the investor, then use that capital to generate returns for them before handing it back when they reclaim their units.

The AMC must have sufficient cash reserves to honour requests for redemption by investors. If there is an abundance of such requests, the inability to fund them could cause problems.

Contemplate this: The AMC has invested in debt instruments that can’t be inverted as required due to liquidity issues in the bond market. Simultaneously, they require significant amounts of money to meet redemptions, leaving them susceptible to liquidity crises if there is a high demand for redemptions.

Franklin India encountered this same predicament. On a regular basis, Asset Management Companies (AMCs) have sufficient money to satisfy redemptions since these activities are commonplace for an AMC.

In light of a potential surge in redemption, AMC will be presented with an issue; where could they acquire the extra cash to handle such a situation?

They rely on borrowing.

According to the directives of SEBI, Asset Management Companies (AMCs) may borrow up to 20% of their net assets under management.

Here is the extract on AMC’s borrowing limits –

If an AMC is utilising this lever to acquire funds, it could be a sign of their dwindling cash reserves and the need for additional finance to satisfy customer redemptions.

To determine if the AMC is borrowing, one must consider the monthly portfolio report they release. A positive cash component indicates there is no debt, while a negative amount suggests otherwise.

Take a look at Franklin’s Ultra-short Term fund’s portfolio from Jan 2020 –

Portfolio in Feb 2020 –

Portfolio in March 2020 –

The cash component went into the red in March 2020, indicating that the AMC took out loans and illustrating early symptoms of financial difficulty. Subsequently, Franklin closed this particular fund together with five others on 23rd April 2020 – thus giving a few indication of trouble.

Here’s what needs to be noted-

Do not simply assume that a negative cash rate implies the fund is doomed to fail. Look carefully and make connections to completely comprehend the current situation.

The cash aspect of a portfolio can be an indicator of trouble, which lags behind as the AMC’s details come out with a delay. Nonetheless, it still remains a legitimate suggestion.

You need to stay on top of this if you’re a ‘do it yourself’ investor. It’s your responsibility to analyse the market and form an understanding of what will take place in March when it comes to Franklin. Essentially, this means connecting the dots. Can you guess what might happen there?

It’s difficult to answer these questions, but looking back now, I can make a list of things that I would do differently.

– The initial indication that Franklin was in trouble arrived in the form of the Vodafone incident.

– The portfolios contained papers of a rating lower than AA+; this was always questionable.

– Cash decreased, borrowings increased.

– The market itself was weak, thanks to COVID 19

– The street sentiment was negative.

When these elements are linked up, you may foresee potential issues arising. Even for a proficient investor (or even more so for analysts) it may not be simple to comprehend; however, with more exposure to the financial market, putting together the pieces of the puzzle gets instinctive and one’s judgement inevitably comes from within.