‘Promoter put’ skews risk pricing at mutual funds

YV Reddy, the former RBI Governor had, in an interview to DNA last week, said that central banks providing clear guidance on policy had led to underpricing of risk.

This thought, while interesting, should not come as a surprise.

It can also be argued that market behaviour was rational. The relative underpricing of risk stemmed from the faith that markets had in central banks delivering the goods.
A rational, and possibly similar mispricing of risk behaviour can be seen in the Indian mutual fund industry, especially the fixed-income category of funds which contribute bulk of the industry’s size.

For the past several months many mutual funds have been grappling with potential (and possibly actual) credit defaults.  The most prominent of these have been due to funds’ exposure to the real estate industry.

We’ve also had instances from other industries, for example, pharma major Wockhardt and crumbling retailer Subhiksha.

These instances have been widely reported and debated in the media. So investors being well aware of the potential credit losses, could be expected to avoid funds which have such exposures.

On the contrary, the opposite seems to have happened.

Most fund houses that faced such issues have been promoted by leading business groups of the country.

These promoters have stepped in and protected the funds (and hence investors in those funds) from any credit losses.

While such business decisions may seem in the interest of investors, it leads to moral hazard and pernicious behaviour of investors who tend to completely eschew prudent risk assessment, while taking investment decisions.

These investors take comfort from the implicit — let’s call it the ‘Promoter Put’ — signal given out by fund houses.

HDFC Mutual Fund, which possibly moved out the biggest chunk of such assets from the fund to the asset management company, has seen a healthy rise in inflows since.
The ‘Promoter Put’ at work can also be seen at other large funds that resorted to such measures to protect investors from credit losses.

Fund managers who took the right risks but do not have the umbrella of the ‘Promoter Put’ seem to have suffered the worst. Normally, such a fund should witness a healthy rise in funds under management at the expense of those whose judgements were less than exemplary.

However, no such thing has happened. In fact, larger the fund house and greater the reputation of the group to protect, the greater seemed to be the implicit ‘Promoter Put’.
Much as the ‘Greenspan Put’* turned out to be pernicious, investors should realise that taking investment decisions based on the implicit ‘Promoter Put’ could lead to harmful consequences.

Investment decisions are best taken on the basis of proper risk evaluation and assessment of the portfolio and the fund manager.

Even the fund management industry would be better placed if they realise that proper risk assessment is the way forward and should therefore prime investors on return expectations accordingly.

Mutual Funds are risk products and investor understanding of these products needs to account for it. Investors seem to want the best of the good times but none of the bad.
It’s is an unhealthy situation that needs to be reversed at the earliest.

* Former US Federal Reserve chairman Alan Greenspan bolstered falling stockmarkets by consistently reducing interest rates. The market’s feeling that the Fed will always bail out created an artificially high appetite for risk and a  global liquidity machine,  which together spawned the bubble that has now burst. The term ‘Greenspan Put’ was coined in 1998 when the Fed cut rates after the hedge fund Long Term Capital Management collapsed.