Negative returns from liquid funds? Here’s what you should do

Updated: November 13, 2018 6:02:29 PM

The USP of liquid funds is that these give stable returns even when the market is volatile. Individual investors use liquid funds for temporary parking of funds, and corporate treasuries use it for its efficiency over bank deposits.

Though not mandated by law, they have taken a call based on their own judgement.

By Joydeep Sen

The USP of liquid funds is that these give stable returns even when the market is volatile. Individual investors use liquid funds for temporary parking of funds, and corporate treasuries use it for its efficiency over bank deposits. The USP being stability of returns, negative returns from liquid funds is a rarity, occurring once in, five years or 10 years, when something extreme happens.
Black swan events

Over the past couple of months, two unusual events happened. One, an erstwhile AAA-rated supposedly blue-chip, quasi-PSU-owned company defaulted. That the credit rating was downgraded to D was a matter of detail. The other remarkable event is how the few AMCs, with exposure to IL&FS, handled the situation. As per SEBI rules, mutual funds have a long time to write off NPAs. However, a few funds, including liquid funds, have written off the IL&FS exposure completely, i.e., they have done a 100% write-off. Though not mandated by law, they have taken a call based on their own judgement. In the process, depending on the extent of exposure to IL&FS instruments in the portfolio, returns to investors have been impacted adversely.

Impact on investors

While accruals in liquid funds provide for stability in returns, this unusual write-off, depending on the extent of exposure, has taken away, say, one month to one year of accrual. Hence, one month to one year returns look negative in a few liquid funds. This is what is being discussed here: negative returns from a few liquid funds. No be noted, this may not be a permanent loss, depending on the potential recovery from IL&FS.

Lesson learnt

Black swan events are by definition rare and you can’t really prepare for it. The lesson we learn here is the age-old maxim of diversification. Let’s take an example: you have Rs 100 to be invested in liquid funds. You spread it across 10 liquid funds, equally, i.e., Rs 10 in each fund. Let’s say each of them are accruing at 7%, hence your Rs 100 becomes Rs 107 after one year.

Now let’s say one of these funds give negative Rs 1, over one year, due to exposure to one bad paper. In this case, you earn Rs 6.30 from accrual of nine funds and give up Rs 1 to one unfortunate fund. Your net return over one year is Rs 5.30, still decent. Now, instead of 10 funds, if your investment is spread across five funds equally, what is the scenario? The loss from the “bad” fund so to say, is Rs 2 instead of Rs 1, due to higher exposure. The accrual from the remaining four funds is Rs 5.60 and your net earnings is Rs 3.60, less than if it were spread across 10 funds.

Since nobody knows the future, diversification is a simple and proven risk management tool. The fund category, even safer than liquid funds, is overnight fund, which deploys for one day, and roll over, in the system managed by Clearing Corporation of India Ltd (CCIL) called Collateralised Borrowing and Lending Obligation (CBLO), now changed to TREPS.

Conclusion

In the context of IL&FS, it is still not a “gone case” though some AMCs have written it off completely. There is a new management in place put by the government, and the new board has put a revival plan before NCLT. It will take time for revival, but for investors in those funds who have written it off completely, anything that may be realised in future is a bonus.

Currently, these funds have stopped fresh purchases, hence the benefit of a lower NAV, after write-off of IL&FS, is not available to others. Even if they open for subscriptions in future, they may put some mechanism in place, so that only existing investors get the benefit of any future realisation.
Meanwhile, for all your investments, please follow the age-old beaten path of diversification.

(The writer is founder, wiseinvestor.in)

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