We would like to start this note by quoting Warren Buffet:
"Bad things aren't obvious when times are good"; "After all, you only find out who is swimming naked when the tide goes out."
The drive to increase retail investor participation since 2012 has seen tremendous success, rewarding both, the investors and the industry. Investors eagerly entered the equity markets via the SIP mode, and have turned out to be steadfast participants, not scared away by bad news that may impact the markets. Surplus money parked in banks in the form of savings bank accounts and fixed deposits also started finding its way into debt mutual funds, and the Demonetization drive in 2016 proved to be another opportunity for the industry to drive home the advantages of investing into a debt fund vis-a-vis fixed deposits.
Good times don't last though, and since September last year our debt fund investors have been on a roller coaster ride with some companies that were held in their mutual fund portfolios being downgraded because the companies were not able to meet their repayment obligations; as a result, the valuation of the funds has been taking a hit. What is scary is that even liquid funds, which are at the lower end of the risk-return matrix, have been severely impacted, shaking the confidence of investors who looked at debt mutual funds to park their idle money. The bad news has been coming without respite, and we are now getting used to hearing about downgrades of one or the other company's papers that are a part of mutual fund portfolios, triggering the mark down of the NAVs of the respective funds.
The Value of Independent Research
Research analysts like us have been on our toes, updating investors on their exposure to the troubled papers via the different debt and hybrid funds in the industry. However, this analysis has led to an interesting observation: that a handful of the fund houses have managed to stay unaffected, because they stayed away from these corporates. This made us delve deeper into the risk management processes at these places, and try to understand what helped these funds stay away from these companies, despite their papers carrying the highest-grade ratings. One of the fund houses that came to our notice was Canara Robeco Mutual Fund, a joint collaboration between Canara Bank and Robeco.
For those who may not be aware, Robeco is a 90-year-old international asset management firm started in Netherlands. It is currently fully owned by ORIX Europe, a subsidiary of ORIX Corporation, a Japanese business conglomerate that started operating in 1964. The company's website declares:
"Robeco is an international asset manager offering an extensive range of active investments, from equities to bonds. Research lies at the heart of everything we do, with a 'pioneering but cautious' approach that has been in our DNA since our foundation in Rotterdam in 1929. We believe strongly in sustainability investing, quantitative techniques and constant innovation."
"Every investment strategy should be research-driven", is what their First Director, Wim Rauwenhoff said; since then, their philosophy has been to make investment decisions based on thorough research and sound risk management, assuming a long-term view. For them, "Risk management is essential, which is why we say we will always believe in long-term, sustainable capital growth." The fact that the Indian arm has adopted Robeco's global standards across portfolio management and risk management can safely be concluded as one of the reasons for the fund house staying untouched in the recent debt mark fiasco.
Understanding Canara Robeco's Risk Management Process
We caught up with Avnish Jain, the veteran Fund Manager who heads the Fixed Income space at Canara Robeco Mutual Fund to understand how he has emerged unscathed while some of his peers are finding it difficult to stay afloat on a daily basis.
Jain starts the conversation by stating the obvious: Debt fund investments are subject to risk but how they are managed will finally decide if our investors are still better off investing into these funds rather than following their parents' footsteps of keeping their savings with banks.
He then takes us through the three major risks that can adversely impact investor portfolios, while explaining the processes they follow religiously in mitigating these risks.
Interest Rate Risk
Interest risk arises out of modified duration of the debt portfolio. Higher the duration, higher is the risk and vice versa.
Credit risk arises when an instrument that is a part of a debt mutual fund portfolio defaults, leading to loss of interest or principal.
Liquidity risk is the risk that investors will not be able to withdraw their invested amount when they require the surplus.
Management of Interest Rate Risk
Interest rate risk is actively managed through changes in portfolio duration to take advantage of interest rate movements. The debt team tracks global and local macro-economic parameters (like inflation, growth, commodity prices and trade numbers), government fiscal policy, and RBI's monetary and liquidity stance to formulate medium-to-long term interest rate views. A fund's duration is then appropriately increased or decreased, depending on the category of the fund; for example, for a short duration fund the increase/decrease in duration is likely to be lower as compared to a dynamic bond fund.
Management of Credit Risk
A weighted model using a number of factors is used to decide the issuers that the fund would lend to, and the limits to be given thereof. This forms a part of the elaborate credit risk control framework followed by the fund house. Some of the broad parameters are:
1. Quality of the management / structure of corporate governance
2. Financial performance of the company (in terms of solvency, profitability and liquidity ratios)
3. Capital expenditure plans and funding sources
4. Long term strategy of the company
5. Expected future performance of the sector and relative company performance
6. The risks associated with the sector, i.e., cyclical industry, dependence on borrowings, extent of global linkages, etc.
7. Type of security
This stringent process helps them stay away from the risk premium or alpha offered by low quality papers. Here Jain re-emphasizes that, despite staying away from low credit quality papers, they further try to reduce the other risks such as concentration risk, as much as possible, by putting limits to the exposure towards issuers, sectors, security type, etc.
Management of Liquidity Risk
The worst thing that can happen to an investor is to find out that their funds are not allowing redemption when they actually want the surplus to meet their needs. According to Jain, there are 2 types of liquidity risks: Asset Liquidity Risk and Funding Liquidity Risk. The former refers to a situation where trades cannot happen at the quoted market prices, while the latter happens when the redemption requirements can only be met by distress sales of fund assets, thereby adversely impacting the value of the portfolio. Here, the point to be noted is that the funding risk will only arise if there is asset liquidity risk.
To avoid such a scenario, the fund management team ensures that a part of the portfolio is invested in cash or near liquid papers (for money market funds). In case of low to higher duration products, the fund manager ensures that good part of the portfolio is invested in highly liquid government bonds/corporate bonds.
This is followed by extensive portfolio performance analysis and stress tests based on historical stressful events (like the Lehman crisis) and the fund's own hypothetical scenarios (a global trade war). The stress tests actually help them to understand the weak points in a portfolio and rectify them, if required.
"All these limits and controls are embedded in our order management system, which ensures that the rules are consistently applied, and these are checked prior to order confirmation. This prevents regulatory breaches of any kind."
We believe this case study aptly highlights why, when investing, it is important to consider risk-adjusted returns, and not only returns. Fund houses like Canara Robeco, which have taken a cautious approach while investing into fixed income, have always struggled to make it to the top of the charts from a pure returns point of view. However, during such times of turbulence, these funds stand out as examples of the importance of risk management even in a traditionally low-risk asset class. Investors are taking note of them and are realising that there are no asset classes that come with a risk-free tag.
As for our investors, we have started recommending Canara Robeco funds for investments of less than a year, that is, their Liquid, Ultra Short Term and Low Duration Funds. Recommendations of all the debt fund categories of over this duration as per the risk return matrix are subject to the results of our quantitative model results, and so we would like to wait for this year's model output to take any view on the rest of their funds. Also, considering the volatility in the debt market, we are generally advising our investors to stay at the shorter end of the curve; in this space, they can safely take exposure into funds from Canara Robeco Mutual Fund.
Finally, we would like to conclude with a quote from Robeco's philosophy that best explains the peaceful smile that the fund management team have been able to put up in the last few months:
"Successful pioneers are also cautious. The key to combining both these elements is rigorous research, building on our first director's belief that 'every investment strategy should be research-driven'. To achieve this, we draw fully on our talented investment managers, researchers, analysts and specialists to find the best ideas. Working through a process, we 'crash test' strategies to identify - and solve - problems. Put simply, if we can't prove it, we don't launch it."
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