Investing merely on the basis of past return can land you in trouble even in debt funds, a supposedly safe asset class, suggests Sarbajeet K Sen.
The Franklin Templeton debt fund debacle may have a positive long-term fallout as the Securities and Exchange Board of India (Sebi) has further tightened the regulatory framework for such funds.
Thus far, fund houses informed their investors of the risk in their current debt fund portfolios via the risk-o-meter.
Through a circular dated June 7, Sebi has introduced the Potential Risk Class (PRC) matrix, which will inform the investor about the maximum risk a fund manager can take in a debt fund she plans to invest in.
Lacunae in earlier framework
Sebi's October 6, 2017, circular on 'categorisation and rationalisation of mutual fund schemes' had specified how different debt fund schemes were to be categorised.
This framework had a couple of loopholes.
The maximum duration risk that individual securities in a portfolio could take was defined only for two categories -- liquid funds and money market funds.
For all the other categories, the limit on duration risk was defined only in terms of the weighted average of all the securities in the portfolio.
"This led to issues like ultra-short-duration funds, which are allowed an average portfolio Macaulay Duration (MD) between three and six months, holding individual securities of as many as five-seven-year maturity," says Joydeep Sen, corporate trainer (debt markets) and author.
On the credit side, how much credit risk individual securities could take was defined only in the case of corporate bond funds and credit risk funds.
"For the rest of the categories, the credit risk that individual securities could take was left to the discretion of fund houses," says Sen.
What Sebi has done
Fund houses will now have to classify their debt funds using the PRC matrix.
This will be a 3x3 box with nine cells. The horizontal axis will indicate the maximum credit risk while the vertical axis will indicate the maximum duration risk a fund can take.
Credit risk will be measured by credit risk value (CRV) and duration risk by MD.
On the interest rate side, an important restriction has been imposed.
For a fund in Class 1 (MD < = one year), the maximum residual maturity of each instrument can be three years.
For a Class II scheme (MD < = 3 years), the maximum residual maturity of each instrument can be seven years.
A Class III scheme can invest in instruments of any maturity.
What do these changes imply?
The PRC matrix will increase transparency.
"The fund manager will have to state upfront the maximum risk she will take. It will be a part of the fundamental attribute of the scheme that cannot be easily changed," says Sandeep Bagla, chief executive officer, TRUST Mutual Fund.
An additional check has been imposed on debt funds.
"All funds will have to be classified as A, B, C signifying underlying credit risk, while duration will be stated in terms of years. This will make it simple to evaluate and assess the risk and compare funds," says Arun Kumar, head of research, FundsIndia.com.
Since the regulator has made the matrix a fundamental attribute of the scheme, a change on this front means the fund house will have to approach Sebi, give notice, and allow investors an exit window during which it will not charge them an exit load.
Taking extra risk to earn extra returns will become harder.
Further, running a barbell strategy will also become difficult.
Under such a strategy, if the average MD a fund was allowed (according to its classification) was three years, the fund manager would hold some securities of very low duration and some of very high duration.
It would meet the regulatory requirement to have an average MD equal to three years.
But the longer-duration bonds would make such funds more volatile than they were supposed to be.
Returns may not necessarily be impacted.
"Returns come from credit risk and interest-rate risk. Exposure to securities will be taken in line with the explicitly disclosed risk parameters. There will be no material change in returns due to this move," says Bagla.
What should you do?
You will have more information now.
Once these norms come into effect from December 1, use both the risk-o-meter and PRC matrix in conjunction to understand the current risk of the portfolio and the maximum possible risk a fund can take, and then choose a fund.
As recent experience has shown, investing merely on the basis of past return can land you in trouble even in debt funds, a supposedly safe asset class.