A lot happened in last couple of months in financial markets. And the mutual fund industry was also in the thick of action for variety of reasons. Both in equity and debt segments. When a common investor talks about mutual fund, most probably, they are talking (and thinking) of equity mutual funds. Many would be surprised to know that equity funds comprise less than a third of total MF AUM. Yet it has the largest “recall”.
Two probable reasons for the popularity of equity funds could be:
a) the secular bull run that started in 2014 (and ended abruptly in Mar 2020 ?) and
b) the incessant marketing campaign of “MF Sahi Hai” by the regulator and AMCs in print and electronic media.
The debt mutual funds, which are about a third of MF industry were also in the thick of news for all the wrong reasons. Many MFs had spate of writedowns over last 1 year. So much so that the expected annual returns were lost in a day and some more in a few schemes. Then Franklin Templeton MF did the unthinkable and shut down 6 of its under-performing debt schemes without any warning. Mar’20 was something of a watershed month. Equity markets fell more than 25% and with it many years of equity fund returns turned zero and negative. Some debt funds also saw negative returns in Mar. To say, mutual fund investors are a shaken lot would be an understatement.
The third largest category in MF space is Liquid Funds. This is about a fifth of the total MF AUM, which is still substantial at 5 lakh crore. Yet we hardly hear about this category. Maybe nothing much happens here. Or maybe this is the most “taken for granted” category. Perhaps this space is so commoditized that it is difficult to separate merit against also-rans? Today, we will look at this unglamorous category and try to shortlist good funds by alternate methods. As per SEBI classification, Liquid Funds are those that have investments in debt and money market securities with maturity of 91 days or less. This is a simple breakdown of fund categories by their investment time horizon:
As we know, risk and returns are inversely proportional. For my liquid investments, I would like to invest in a fund that has the least risk. NOT in the one that has best returns. The objective of investing in liquid fund is not capital appreciation but capital preservation. Search for “best-performing” liquid fund is futile and can prove counter-productive. Why? The whole idea of investing in liquid fund is – one should be able to withdraw money at will, without any loss of capital. The little return we get from liquid fund is bonus and should not be the primary focus. In my opinion, the correct metric for a liquid fund should be the absence of risk. Since that is possible only in an ideal world and not in the world we live in, I will settle for a fund with least risk or acceptable levels of risk. Rather than looking at returns, let us try to find better metrics to shortlist and evaluate liquid funds.
There are 40 AMCs in India and 39 of them have a Liquid Fund. The exception being Shriram Mutual Fund that offers only hybrid and equity funds. Top 10 AMCs account for more than 80% of AUM. Bottom 20 have less than 4% of AUM. For this analysis, I have considered data from top dozen or so AMCs, covering more than 85% of AUM.
Metric 1 – Diversification: Unlike in equity funds, diversification is beneficial in a debt/liquid fund. Because the risks are also spread as much. More number of securities means any single instance of delay or default will have lesser impact on the overall portfolio. Let us look at historical data:
Birla, HDFC and ICICI MF had consistently large number of securities in their portfolio. At the opposite end of spectrum is Mirae, IDFC and Franklin (at the very bottom).
Metric 2 – Single Security Exposure: In case an underlying security delays payment or defaults or goes bust, how much of an impact can that have on the portfolio? Let us look at the portfolio holding with maximum exposure to any single security. Since treasury bills have zero credit risk, we will exclude it from the dataset:
This chart looks little muddled as it has too much data. Let me try to clean it up and present in a more readable format:
Axis, Birla, HDFC, ICICI, Nippon and SBI are the AMCs that have lower median holding. IDFC and Franklin had historically higher exposure. What can we infer – one would be better off being in the first group rather in the second group.
Metric 3 – Risk Free Investments: Since govt. securities carry no credit risk and we are not too concerned with returns, would a liquid fund not be better off just investing in those? Let us look at historical exposure to Treasury bills of these funds:
Notice the consistently high exposure to T-Bills for funds like Axis, HDFC, ICICI and SBI. Also notice their absence in Franklin and Mirae in Mar and Apr. Let me compress the data and re-present in another format:
Funds like SBI had consistently high exposure. ICICI and HDFC are not far behind. On the other hand, IDFC and Franklin have deep swings – from high exposure to almost zero. Again, one would be better off being in the first group than in the second group.
In the three parameters above, HDFC and ICICI liquid funds have been in consistent top ranks. Let us see how did they fare in the extreme volatility seen in Mar’20. Liquid funds witnessed more than 1.1L crore or about 25% AUM outflow in Mar’20. Part of the outflow could be attributed to advance tax payment by corporate and individuals. And then there was this never seen before volatility in equity and debt market simultaneously. The other reason for outflows could be attributed to flight to safety. There was such mad rush that overnight funds were inundated with inflows and liquid funds saw negative returns for couple of days. Of course, things settled when RBI announced rate cut in last week of Mar. This is the month on month % change of AUM of liquid funds. Notice HDFC held its forte even in Mar and had decent inflows in Apr.
A trend observed across asset class, time and geography is that money chases performance. Above average and consistent money managers are always presented with more money to manage. HDFC Liquid fund has more than 20% of market share. The next two – SBI and ICICI are far behind at 13% and 11% respectively. The impact of fund size on the performance of fund is a hotly debated topic. One does find many conclusive evidences – both for and against. But in debt fund space especially, size does matter. It is imperative to invest with the top quartile of the fund universe.
By shortlisting funds on these parameters are we sacrificing on gains? Let us compare annualized returns of shortlisted funds against benchmark:
The different between benchmark and shortlisted funds is negligible. This little difference could be attributed to expense ratio of the fund. So, by choosing a fund with better risk management, we are NOT losing on returns but gaining peace of mind. Can their performance and risk management style change tomorrow? Certainly possible. What should an investor do? Keep their eyes and ears open. More important, keep an open mind. Because the investment landscape is ever changing. One has to keep pace with it.
Investors are better off by just parking their excess money in safe options till the time they find better investing opportunities elsewhere. Liquid funds are one of those options. It can easily absorb even large amounts of capital without much impact cost. There is absolutely no reason taking extra risk on the debt portion of your investment as well. Because there is NO potential upside to it. As simple as that.