In the recent times with the failures of payment on account of interest/principal on their bonds, debentures and other debt instruments issued by the large corporations i.e DHFL, Yes Bank, IL & FS, Reliance Home Finance Limited, Reliance Infrastructure Limited etc., resulting in the significant decline in NAVs of the Debt Mutual Funds, investors of Debt funds have a question in their mind whether their money in debt funds are safe and it had led to significant withdrawal of funds from debt funds since March, 2020.
Recently, CFO of a well- known company on the investor call also stated we don’t trust debt funds after the Franklin Templeton Episode, so shall we not invest in Debt Mutual Funds or there are common mistake which result in erosion of wealth which may be avoided.
Meaning of Debt Mutual Funds:
Investing in a debt instrument is similar to lending an advance to the issuing entity. Debt mutual funds are an investment pool wherein they acquire debt instruments of various corporations or they lend to the large corporations to earn the regular interest income and capital appreciation on their investment making decisions on the expected movement of rate of interest in the upcoming futures. Likewise any other mutual funds, AMCs are not the owners of the investments and the real owners are the people to whom units of these debt mutual funds have either been allotted or they have purchased from the open market.
7 Common Mistakes committed by investors while investing in Debt Funds
1. Decision making based on rankings of past returns: In the emerging time of technology, investors have also tried to become smarter and they do check the rankings of mutual funds on various online platforms while investing in the funds and choose the highest rated funds available on the E-Platform. This is the first mistake people do in Investing, rankings of the mutual funds are generally based on the past performance (return) of the mutual funds and don’t account for the asset portfolio, sector allocation, ratings of the debt instruments, average maturity etc. held by the scheme. Why, I say, it’s the first mistake because offer documents of every scheme itself state “past returns are not indicative of future performance”, along with that these rankings do change quarterly/half-yearly/yearly as the returns of the schemes get changed, however, we cannot change our debt portfolio at such frequent intervals due to several factors Exit Load, Taxation, etc.
2. Unawareness of Key Ratios: In the above stated para we have discussed why we shouldn’t look at those rankings which are based on past returns but the question arises what should be looked at, here is the list of key ratios which should be considered while choosing any debt fund:
i. Yield to Maturity: Yield to maturity is an indicative ratio which denotes the expected yield of the portfolio of the scheme, if the same is held till the maturity of the portfolio. Example: If YTM of the scheme is 6% and the average maturity of the scheme is 2 years then it is expected that the scheme will deliver the 6% return at the end of the period of 2 years, other factors remain the constant. It is a much reliable indicator of return than the historic returns and the rankings based on historic returns.
ii. Assets under Management: Assets under the management (AUM) indicates the amount of assets held by the AMC under the said scheme against which the units have been issued by the AMC to the investors. Large AUM size assists the scheme to maintain the liquidity and do not result in a significant fall in the NAV of the scheme, if, large redemptions come on a particular day.
iii. Maturity of the Portfolio: Tenor of the portfolio shall be examined in depth before investing, longer tenor will carry the higher rate of return along with the higher risk of Marked to Market and Credit Default Risk. Contingency funds or funds required in short term, temporarily parked in debt funds shall have to be invested in the schemes which have short maturity while the funds which are invested with long term horizon shall be invested in schemes which have a longer tenor, ignoring this critical point may result in the dissatisfactory performance of the investment.
iv. Expense Ratio: The expense ratio is the indicator of the total amount of expenses charged by AMCs towards managing the portfolio of the scheme for the period. The higher the expense ratio lower will be the return to the investor, SEBI has mandated for AMCs to disclose the expense ratio on periodic intervals for the information of investors along with putting maximum capping for charging the expenses by the AMCs so that investors are not excessively overcharged by AMCs. One may refer to the link and read about the regulations on the expense ratio available on the SEBI website. https://www.sebi.gov.in/legal/circulars/oct-2018/total-expense-ratio-ter-and-performance-disclosure-for-mutual-funds_40766.html
3. Overlooking Track Record of the Portfolio Manager: The Track record of the manager, is the most critical aspect to be known before investing in any kind of mutual fund scheme. Mutual Fund is the pool of the investment which is always managed by the people and it is the fund manager who decides where to deploy the funds, how to minimize the risk and maximize the return for the unitholders of the scheme. Since the fund manager is going to take the scheme/mandate forward, it becomes very critical to choose the fund manager who has the investment strategy similar to our investment strategy and understand his investment style. Name of the fund manager of each scheme is always mentioned on the fact sheet of any scheme, so one should carefully examine a) since when he is managing the scheme b) what kind of strategy he chooses for investment c) performance of other schemes managed by him etc before investing, better to research before rather than regretting after investing.
4. Not evaluating the portfolio of the scheme: As we know, the mutual fund is the pool of investment, so it generates the return from it’s underlying assets i.e Portfolio, it may consists Debentures, Bonds, Corporate Deposits, Cash and Cash Equivalents, Commercial Papers, Treasury Bills etc. So, the safety of the investment and return on the investment will depend on the kind of securities lying in the portfolio of the scheme, safety of any instrument is generally based on the credit assigned to it by the credit rating agencies AAA, A1+ is the highest rated instrument which depicts the sound financial position of the issuer of the instrument (although in the past they have also failed, it’s an unavoidable risk which we play). So, while choosing the scheme we should be more inclined towards the portfolio which consists more AAA, A1+ papers in their portfolio.
5. Ignoring the Diversification: Diversification is the concept wherein an investor diversifies the risk of investment by acquiring more instruments to avoid the unpleasant experience arising out of the unforeseeable future. It is recommended by almost every financial advisor, diversification may reduce your return but it may save you from erosion of your capital. That’s why investors choose mutual funds because the investor is entitled to all the assets in proportionate. Sometimes, mutual fund schemes also do not follow this golden rule of investment and they heavily take exposure in one company or sector resulting in the inadequacy of the diversification. As an investor, we should never choose those schemes which are heavily exposed to one corporation or one sector unless the thematic fund has been chosen for investment. DHFL pramerica mutual fund was worst hit by the default made by DHFL in honoring it’s obligations. SEBI has taken very welcome steps in the past by fixing the maximum exposure limit in a corporation and sector as well for AMCs but far to go in this direction.
6. Lack of patience and anxiety: Wealth creation is more a game of patience than the intelligence and numbers, a person who has control over the nerve may be far ahead than the person who lacks on it. People generally, chose to invest in debt funds when the interest rates, g-sec yields are falling as they are getting poor returns on their term deposits which have resulted in the higher NAV of the Debt funds arising due to the Marked to Market gains depicting astonishing past returns of the debt funds as compared to Term Deposits without analyzing/realizing these are notional returns and will vanish as soon as the cycle of falling interest reverses and starts rising. In the past one year, short term maturity debt funds have shown astonishing returns in the range of 8-12% due to this reason only and those wouldn’t be able to deliver the same in the upcoming time. In the same way, people sell their holdings in the rising interest rate scenario, due to the effect of negative marked to market on the NAV which is also temporarily and soon should be normalized, if held till maturity of the instruments.
7. Review of the scheme on return rather than the portfolio of the scheme: Last but not the least once a scheme has been chosen investors start reviewing the scheme based on their return ignoring the above- stated principles. The scheme should always be evaluated considering the principles based on which it was selected as long as it meets our investment criteria and money paramount is taken care by the scheme portfolio we shouldn’t consider it to switch/replace. As in the long run if the set of principles are correct then the good return will also follow.
Disclaimer: The Content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. All Content in the article is the information of a general nature and does not address the circumstances of any particular individual or entity. Please evaluate and discuss with your financial advisor before making any investment decisions.
Authored By- CA Kanj Goel – Kanj3101@gmail.com