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A lesson in risk

FMP problems arising from Essel group affairs underscore the oldest principle of investing - risk and returns are two sides of the same coin


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The education of the Indian debt fund investor continues. The financial misfortunes of first IL&FS and then the promoters of the Zee/Essel group have ensured that Indian mutual fund investors will appreciate the deep connection between returns and risk more than they have been doing in the past. Currently, yet another lesson in this education is being conducted.

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Unfortunately, many (maybe most) investors are used to ignoring 'Mutual funds are subject to market risk,' just as smokers are used to ignoring warnings about the health risks. That was never a great idea. While a variety of debt funds have been impacted earlier, there's now trouble in Fixed Maturity Plans (FMPs) too. Somehow, investors in FMPs felt that they might be immune to these problems due to the unique nature of these funds, but that has turned out to be not the case.

FMPs are generally used by companies and large investors as an alternative to bank fixed deposits. Loosely speaking, these funds do have more of a resemblance to FDs than they have to other mutual funds. These are closed-end funds, meaning that one can only enter them when they are launched and exit them when their pre-stated term is over. As far as their returns over this fixed period go, FMPs tend to be predictable. Earlier, till January 2009, fund companies used to offer an 'indicative return' for FMPs. This has been outlawed now, but I'm sure that oral indications are still offered as part of the sales process.

Unlike other types of mutual funds, FMPs are run in such a way that this indicative return actually had some meaning. FMPs invest in debt instruments with the intent of holding them to maturity. This means that regardless of any ups and downs in the market value of the investments, the final earnings should be predictable. That is, if all goes well, as has generally done so till now.

This 'if' is now a big if. A number of FMPs have are now coming due that are holding debt that has been given to corporate entities of the Zee/Essel promoters. This debt is backed, as collateral, the promoters' holding in listed group companies. This debt cannot be redeemed at this point as the promoters do not have the money to repay it. As a result, these FMPs will not be redeemed in full right now. Investors will get most of their money back, but the part of the NAV backed by the Zee/Essel debt will not be paid back. In theory, the funds could sell of the shares they hold as collateral.

However, back in January, when a small (Rs 200 crore) worth of shares were sold, the stock dropped by about 30 per cent. Subsequently, the group's promoter Subhash Chandra negotiated with the lenders and got a reprieve till September 30. The funds are said to have collectively agreed that any attempt to sell the collateral by anyone would destroy its value for everyone. One hopes that eventually, investors would get paid in full.

At this point of time, this is the sensible course of action. However, there are lessons here all round. For the funds, it's an indicator that they should stay clear of this quasi-banking like activity. For investors, this episode is an indicator that 'market-linked' means risk. The risk may be a little more or a little less, but in investing, there's never any disconnection between risk and returns. If you want FD-like security, then go to a bank. If you want the higher return of an FMP, then take the higher risk too.

In a way, these little blow-ups that we are having in debt funds are a big positive. It keeps both fund managers and investors grounded in reality. As we've seen around the world since 2007, nothing is worse than kicking the can down the road and pretending that a given asset class has less risk than it actually has.

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