INSUBCONTINENT EXCLUSIVE:
By Dhirendra KumarCredit rating agencies appear to be in the business of supplying what could be called scapegoat services, while mutual
funds think that as long as they have a scapegoat on standby, the job of bond fund management is done.
Over the past few months, a
particular type of mutual fund is in turmoil, with investors developing a strong fear of potential losses where they expect none
These are liquid funds, which are useful for one narrow purpose only, which is to keep money for very short periods of time with a very high
Essentially, liquid funds are substitutes for keeping money in the bank but have slightly higher returns
This substitution is generally too much trouble for those of us who keep a few thousand to a few lakh of rupees in the bank, but matter a
lot to larger businesses.
Investors expect — and have been led to expect— that there will be no negative surprises in these funds and
each day’s NAV will be more or less as predicted by prevailing interest rates
The problem is that in the recent past, there have been some cases where debt issued by a particular company has suddenly turned toxic, with
ILFS being the latest and biggest case
Invariably, there were liquid funds that lost value and investors panicked
There are probably regulatory changes being considered to improve the structure of liquid funds and that’s one part of it.
A different,
and fundamental problem is the one I referred to in the beginning, which is the interaction between credit rating and fund management
Before reading further, you should open YouTube and search for ‘Big short credit rating’
The first search result will be an excerpt from the movie ‘The Big Short’ where one of the investment manager teams in the movie are
meeting a Standard Poor official
This short excerpt will refresh your memory about how credit rating actually works.
For fund managers, credit ratings play a central role as
a qualifier of investment-worthy debt
Add to this the fact that investors in liquid funds expect a zero rate of any investment blowing up
These two facts combine to create an impossible situation
To understand why, read this thought experiment that Nassim Nicholas Taleb conducts in his book ‘Skin in the Game’:
First case, one
hundred persons go to a Casino to gamble a certain set amount
Some may lose, some may win, and we can infer at the end of the day what the “edge” is, that is, calculate the returns simply by
counting the money left with the people who return
… Now assume that gambler number 28 goes bust
Will gambler number 29 be affected No
You can safely calculate, from your sample that about 1% of the gamblers will go bust
And if you keep playing and playing, you will be expected have about the same ratio, 1% of gamblers go bust over that time window
Now compare to the second case in the thought experiment
One person goes to the Casino ahundred days in a row, starting with a set amount
No matter how good he is, you can safely calculate that he has a 100% probability of eventually going bust.
This credit rating activity,
even if (a big if) it is conducted sincerely and competently, cannot but produce an occasional blow-up
It’s based on averages and trends and as Taleb says elsewhere, “Do not cross a river that is on average four feet deep.”
This brings
us to fund management’s role
Finally, it’s AMCs and their fund managers who are responsible to the investors
Whatever happens, the buck stops with them
Instead of ending with following SEBI’s rules and credit ratings, fund management has to start from there
Their responsibility towards their investors is to deal with whatever the real world throws up — that’s what they are paid for
If the credit rating agencies are less than perfect (to put it politely), then that’s part of that real world and funds must deal with
it.
(The author is CEO, Value Research)
