Over the last few months, there have numerous instances where Indian mutual fund managers have been caught on the wrong foot. Even after robust due diligence, fund managers have bought shares in fraud-hit and scam-tainted companies. Even an army of analysts and experts at asset management firms could not detect creative accounting at some companies. There have also been instances where fund-houses have made questionable investments into group firms with money that actually belonged to investors. DNA Money talked to experts to find out what investors should do when MFs make investing mistakes.

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Process, not people

In May this year, Manpasand Beverages’ shares fell 50% after its auditor’s abrupt exit ahead of a board meeting spooked the market. Separately, Price Waterhouse (PW) quit as auditor of construction and infrastructure company Atlanta. In June, Inox Wind’s independent auditor resigning due to time constraints was a scare. Funds were exposed to such stocks. Early this year, when Punjab National Bank was hit by the Nirav Modi-Mehul Choksi scam, MFs faced criticism. The Satyam scandal occurring a decade ago remains etched in our memories. Fund managers are neither geniuses nor do they have superman like powers. They follow investment guidelines and processes.

The safeguard is in the form a bunch of stocks in one portfolio. In a 30-stock portfolio, if a share with 8% weight drops by 50%, the actual impact on the portfolio value is less than 5%. “One of the ideas behind investing in MFs is to diversify risks. Instead of holding direct stock exposure, which may also be concentrated, equity funds help diversify stock, sector and market-cap exposure. Whether it was holding Satyam Computer Services share in 2008 or the more recent (2016) Parag Parikh fund’s holding of Noida Toll Bridge (which was a case of business hit), funds have taken temporary hits and delivered later. As long as a fund is well-diversified and not excessively concentrated, this risk is par for the course,” said Vidya Bala, head of mutual fund research, FundsIndia.

Another safeguard for funds is they avoid illiquid stocks. Usually, funds buy shares in companies that have Rs 5-7 crore daily trading volume. This ensures that when mistakes happen, funds can exit quickly. They are not stuck like many retail investors investing in penny stocks.

“In general, MFs do not hold very illiquid stocks and therefore find ways to exit in case of an issue. This risk is higher in debt funds than equity funds. Take the case of Amtek Auto. Equity funds that held the stock were less hurt while those that got stuck with illiquid debt papers were hurt more. So was the case with JSPL,” Bala added.

Avoid knee-jerk reactions

Our reactions are what causes the problem. The moment, investors hear about some problem in an investment of a MF, there is panic. Investors of diversified equity funds holding fraud-hit companies or those with audit troubles in their portfolio should avoid a knee-jerk reaction to the unearthing of such incidences, said Manish Kothari, director and head of MFs, Paisabazaar.com.

“The share of such companies in their portfolio is too small to make any significant impact on their NAVs. Mutual funds can end up with such stocks in their portfolios, despite the due diligence by fund management, while making stock selection. Hence, these are one-off events, which do not constitute a systemic risk,” he explained.

When a company that is a favourite with investors reveals a fraud, there is no way to foresee and avoid exposure. Even if funds drop in the short term, there is no merit in exiting if your goal remains unmet. This is because excessive selling in a problematic stock often drags it below its real value. This is why such stocks rebound, and also drive the recovery in fund portfolios.

Amar Pandit, founder, HappynessFactory.in said: “We saw this in early 2009 with the Satyam scam where many top fund houses had the company’s stock in several of their funds. The short-term performances of these funds did take a beating in the months following, yet they bounced back. The long-term performance was not affected much. More recently, as the much larger Nirav Modi-PNB debacle hit the news, MFs collectively had a much larger exposure to PNB than they had to Satyam, through their equity and balanced schemes. Yet, at the individual fund level, the exposures were capped on average at less than 2.5%.”

How to protect yourself

Bad investments do happen even after following the rule book. So, what should investors do to ensure the maximum protection? Here are some easy ways.

Firstly, always go for mutual funds with broad investment objectives. Choose funds that invest across sectors and industries. These would typically be 30-60 stock portfolios. Adhil Shetty, CEO, BankBazaar.com said: “The impact of a scam won’t be huge in a MF, as it would be limited to the scheme’s exposure to the stock and the sectors impacted by the news. This ensures that any impact in one sector is counterbalanced by the remaining sectors.”

Secondly, invest your money across different fund management styles and market segments. You should have growth style and value style funds. Do not select multiple funds from the same fund house. “Avoid thematic and sectoral funds unless you understand and are prepared for the risks that come with them,” added Shetty.
Thirdly, find out about the risk management processes at the fund house. There should be a comprehensive checklist of parameters from across the governance, environmental and social aspects of a particular company’s management of its affairs. “A risk management team should be in place. Just having a great investment team is not enough. A good risk management team looks for potential problem areas before they even emerge,” said a fund management professional.

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Lastly, analyse previous instances of investment blunders. “Reports say that ICICI Prudential MF tried to save a group company (ICICI Securities) by investing in its IPO on the very last day. The shares of that IPO are down 38%. Did they follow their investment processes to the tee, or were they forced to bail out the IPO? An emerging fund house thought it could profit from a company that would benefit from value migration, only to discover problems in the company’s accounting. Investors must find out if such events are honest mistakes, or done with other motives,” added the fund management professional.

Source: DNA Money