Across the world, risk-adjusted return is considered a crucial metric to assess the performance of mutual funds. There is no doubting its significance—the risk taken by the fund manager in delivering the return is as important as the return itself. The most commonly used metric to assess risk is volatility, or standard deviation, in returns. While this is an apt measure in liquid and mature markets, in India, standard deviation may not always project the right picture of risk because of specific nuances and angularities.
Some situations, from the perspective of debt funds, best express this limitation.
One, mutual fund portfolios in India have started experiencing material credit events only over the past two years, which is why the risk of capital loss on investments in lower-rated credits has started affecting net asset values (NAVs) only recently. On the other hand, accrual of higher yields was reflected in better statistics for funds that took the credit calls. Lack of market depth also meant there were limited checks on whether the return on investments was commensurate with the risk taken.
Two, the Securities and Exchange Board of India’s (Sebi’s) categorization of debt funds largely represents segmentation on the basis of Macaulay duration bands. Except corporate bond funds (where exposure has to be only in the highest rated bonds) and credit risk funds (where at least 65% exposure has to be into below-highest-rated bonds), in all other categories, fund managers have the freedom to use credit-based strategies within the Sebi-defined duration bands. As a result, credit risks across different funds in the same category are not necessarily uniform. For example, within dynamic bond funds, allocation to non-AAA and A1+ paper ranged from 3.58% to 98.05% as of April 2020-end portfolios. Likewise, allocation varied from 5.57% to 100% in medium duration bonds.
Three, the corporate bond market is highly illiquid, especially for lower-rated issuances. In the absence of regular trading and market making, true market-based price discovery on a day-to-day basis is hindered. NAVs also reflect a similar trend, which implies that standard deviation of returns cannot be the only metric to assess risk.
Therefore, for comprehensive portfolio risk analytics, complementing the risk-adjusted performance metric with detailed evaluation of other portfolio attributes such as credit quality, illiquidity and concentration is crucial. Since portfolios represent the current holdings of funds, the analysis is far more forward-looking compared with NAV-linked assessment.
Credit risk measures the probability of a borrower failing to pay interest or repaying the principal on a timely basis. Liquidity refers to the ease with which a fund manager can liquidate holdings when the need arises. This is very pertinent for open-ended mutual funds, which carry an inherent asset-liability mismatch given the daily exits permitted to investors. Concentration risk, or the risk arising out of over-exposure to a single security, issuer or sector, can amplify the impact of both liquidity and credit risks. Additionally, it is also important to look at aspects such as group exposure and exposure to structured credit such as loans against shares.
The current credit quality down-cycle—which began with the IL&FS crisis in September 2018—and the consequent redemption pressure that amplified the problem because of inherent market illiquidity raise questions about suitability of investments in debt funds. The concerns on account of the covid-19 pandemic and the closure of some debt funds last month have only magnified these concerns.
While mutual funds remain the best avenue for debt investments as they provide the benefits of diversification, liquidity and ease of access to the debt markets, it is important for investors to understand that fixed-income investing does not necessarily give fixed returns. Also, recognize that not all of them are risky either: as of April 2020, 92% of investments in mutual funds were in G-secs, cash and cash equivalents, bank fixed deposits and the top-rated AAA or A1+ categories. Further, funds in all debt fund categories other than credit opportunities (37%), medium duration (57%) and dynamic duration (74%) had exposures of at least 85% to these instruments.
The solution is not avoiding debt mutual funds, but being aware of the quality of the underlying portfolio of funds where one is investing, and also monitoring investments on a continuous basis.
While consistency of performance and an impressive track record are important considerations when selecting funds, it is equally important, if not more so, to scrutinize the portfolio-based risks of liquidity, credit rating and concentration. While each of these parameters need to be evaluated separately, one must also remember that they are inter-linked. It’s important to consider both NAV-based and portfolio-based parameters.