Managing risk aka IIFL,ESSEL and DHFL crisis

Whenever a crisis especially in the financial sector looms large or is indicated- what do you do?

Do you simply retract all your steps and go back to ground zero and start again on the drawing board.

At least this is what I observed in the recent IIFL, DHFL AND ESSEL debt crisis.

Most of the investors did not even have any Investments in the affected funds, still, the moment they heard Liquid funds are not safe - they pressed the crash landing button?

Why was that?

Did they even for a moment realise before investing that their fixed income schemes would be risk free.

Would anyone pay a higher premium over the normal rate of return if there wasn't any risk.

Isn't there a risk even in FCNR deposits- that of exchange rate. Or the fact that if they are forced to liquidate their deposit even a day earlier than 365 days- they get no interest.

Risk and return are two sides of the same coin whichever walk of life you move.

The same job that we do on board, carries lot less remuneration on land. Do we stop sailing? We just take risk mitigating factors .

So what steps should we have taken before investing in debt funds ?

Before that we must ask what the risks were.

The first risk was that of interest rate. Any rise in interest rates could have led to the returns falling.

And second risk was that of liquidity itself. Which means that the underlying papers could not have been sold.

In the same series third risk happened to be that of the default by the debt issuing company itself which finally happened.

But how could somebody not see such a big default happening?

To answer this I must tell you the story about a famous neighborhood Lala who was in the business of collecting money and paying interest on it and also lending money to the weaker section and charging interest on that.

Despite being well educated my father and grandfather followed his scheme and deposited weekly installments to get a return to the tune of 18% in 1970s. To cut the story short both the money and the Lala just vanished.

Add to this various chit funds and committees which are regularly defaulting in repayment of their debts.

So does that mean that we stop investing in the fixed income assets and stick to bank fds , Post Office schemes or other supposedly safe avenues.

No absolutely not.

We must realise that it is the our investment in the fixed income assets which actually form the backbone of the National  infrastructures projects.

In the same way the companies also fulfill the finance needs from these fixed income assets like the above 3 companies went to the mutual fund industry to get money.

It is not everyday that the companies are defaulting on their payments. But at the same time we cannot jeopardize our hard earned money by taking chance with even one such incident.

So what would I do?

I would most certainly go for a big AMC which has been in the business of managing debt instruments for long time. 

Then again we keep reading articles mentioning that the size of the fund does not guarantee safety or returns either.

Well it doesn't but when we put our money in a fund of the size of about 15000 crores then most certain its exposure to any single company would not exceed 2to3 percent. And this would certainly protect its downside in case of any such default.

If you will see carefully you will not miss the fact that two of the largest AMC are not there in the list of affected mutual funds.

So it automatically follows after selecting an old big and reputed AMC the second thing that I will select is a debt fund of reasonably large size.

The third selection criteria which I will apply to my entire portfolio is...

I will opt for overnight funds liquid funds or Ultra short term funds. The underlying securities or debt papers of such funds have a very short maturity which in essence means that the the borrower has promised to pay the money at his earliest which is within 6-12 months.

So by following these three steps I would reasonably secure myself.

After following such a course of action if I am still faced with a company defaulting then my entire risk would not probably exceed 2 to 4 percent which means that for an investment of 1 crore I would stand to lose a maximum of 2 to 4 lacs.

Apart from the fixed income plans we had also seen prices in the equity sector on account of PNB earlier last year. But even with that a good fund house like HDFC did not suffer more than 2.3 % on the NAV.

But unlike the debt papers, the fund manager went into bye buy additional PNB at the lower rates and benefited once the market and the PNB stock moved up.

So the mantra should be- don't avoid risk.

Manage it.