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Mutual Funds - Tried-and-tested mutual funds score over alternate funds

30 Oct 2019

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It’s been a bad year for alternate investments. Investors who have held these for the last seven to 10 years have got little or no returns on their investments. Whether it is real estate funds, credit-oriented funds or PE funds, most alternate investment funds (AIFs) have faltered. Looking back at the way these investments have played out, it is clear that investors got swayed by fancy brochures, back testing and eulogies of the fund manager, not to mention the “different" and exotic nature of the instrument which they believed would return them 15%-plus per annum, without really understanding the risks involved.

Most investors believed that these were secured instruments, with little risk. After all, why would it be difficult to sell flats in a residential complex. Fund managers also touted the security, guarantees and other covenants they had in place to “secure" the funds’ investments. However, what played out was very different. Real estate developers could not sell flats for various reasons, which hit the receivables and with the Indian economy struggling, companies found it difficult to pay off or refinance debt. This led to write-offs in investments made by these funds.

The liquidity crisis which has crippled the lending industry looks to be getting widespread and I do believe equity-linked debentures (ELD) are next in line to be hit. This is because most ELDs issued by non-banking finance companies (NBFCs) use the funds raised not to invest in markets but to lend to finance construction or give loans to promoters. Clearly, these companies may not have access to cheaper bank financing. If you have invested in AIFs or ELDs, you may want to study the offer document carefully to, firstly, understand the risks to decide if you want to remain invested. If not, check if there is a premature exit option, and exit even if it means paying a penalty (which could be in the range of 3-5%). AIFs and ELDs have many issues, which make them unsuitable for individual investors, the biggest being transparency and accessibility.

Firstly, the end use of funds is not always clear, especially in the case of ELDs. The offer documents only cover the specs of the product with other standard disclosures. In case an instrument like ELD is secured, the cover provided is very low—one time the value. Even for loans against shares, a cover of 2.5 times is provided. The security provided in most cases in pari passu, which means an equal right on the security. One offer document that I read, mentioned a pari passu mortgage, which means the investor will only get back his funds once the mortgaged property has been sold by the financial institution it has been mortgaged to. Such covers given as security along with receivables won’t really help in case of a problem.

AIFs and ELDs are, typically, not listed and their valuations are difficult to compare with other products or a benchmark. Less transparency means higher risk for investors. One is better off investing in transparent products like mutual funds, which are more regulated, have lower costs and are liquid. While mutual funds too have made some serious errors, action from the regulator has been swift and investor friendly.

Other issues

Funds may be new and untested and investors fall for the “exclusive" tag on these. What surprises me is that investors who are not willing to commit for long term in equities invest in these funds driven by high fixed return expectations or dazzled by brand names, especially if there’s an overseas parent.

These funds may not actually provide the diversification which they are sold for. Most investors have real estate-heavy portfolios and it makes no sense to then invest in a real estate fund or Reit. Similarly, ELDs would only end up increasing concentration risk, since money will be invested in one NBFC’s debentures.

Alternate products are meant for sophisticated investors or ultra HNIs who understand the product and the risks associated. For retail investors, I would recommend sticking to tried and tested mutual funds, which are well-regulated, liquid, transparent and provide commensurate risk-adjusted returns.

Source: Live Mint BACK

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