Financial Engineering – We’ve all heard of this term. But what’s it all about? And why is it so new? Financial Engineering is term used for the past 2-3 decades at best. While real engineering has been around for 2-3 centuries …. Since the steam engine at least.
Engineering is about taking some components and fixing them together into a machine that can do much more than what the components could achieve individually. So, the whole is actually much greater than the sum of the parts.
Financial engineering also seeks to take individual parts / functions of financial instruments / financial institutions and structure them into something better. However, unlike in real engineering – in finance, the whole can never be greater than the sum of the parts. Because when it comes to finance, 10+10 will always equal 20.
However, when doing financial engineering, people sometimes get carried away and try to make 10+10 equal to 25. The way they actually do it though is ….. 10 + 10 = 25 – 5. However, the -5 is hidden somewhere where people cannot see it. That, my friends is modern day financial engineering.
So why am I discussing financial engineering today? I’m discussing it in the context of Mutual Funds. More specifically, I am going to talk about Debt Mutual Funds which invest in corporate bonds.
Mutual Funds started out by enabling investors to pool their money and invest in a diversified basket of stocks. That basket was managed by a qualified professional, called the Fund Manager.
But at some point, someone thought – wait why can’t we have a Mutual Fund that invests in Corporate Bonds? And so began the Debt fund – a fund which would be a safer investment than the equity fund and provide better returns to investors than a bank fixed deposit. 10+10=25 ??? Maybe so. Let’s see.
A Bank, borrows money from depositors at 6% (in case of FDs) and 3% (Savings balances) and lends it to Businesses at say 8%. It’s a centuries old well established model of financial intermediation. That’s a huge profit margin, right?
So a financial engineer thought up – Why not have depositors directly lend to corporates through the Bond Markets, by way of a Mutual Fund, at say 7%? The corporates would prefer this as they would save 1% interest and the depositors would get a higher interest of 7%. To top it off, it would be a liquid product like a savings account, rather than having a fixed tenure like an FD. So depositors would ideally be getting a 7% return against the 3% savings account return.
See how, you can make 10+10 = 25? That’s financial engineering. Its brilliant, isn’t it? Too good to be true. So, where’s the ‘-5’ in this?
That, my friends is where risk management comes into picture. In order to earn the extra ‘5’ … or in our case, to go from the 3% return to 7% return, this financial engineer has skipped or leapfrogged several risk management comforts that a Bank provides. Let me talk about the most important ones below.
Equity Cushion:
For every 10 rupees of loan that a bank gives, it needs to maintain 1 rupee of equity capital. What that means is that in case of any loss on the loan portfolio (by way of borrowers not repaying on the corporate bonds), the bank will be the first one to take the loss till its entire equity capital is wiped out, before any depositor takes a single rupee of loss. In case of a debt mutual fund, that equity cushion is absent. All losses are borne by the investors themselves.
What this means is that investing 100 rupees in a Mutual fund is not akin to putting 100 rupees in the bank. It is actually equivalent to putting 90 rupees in a bank account and investing 10 rupees in the stock of that same bank. That is the ‘-5’ that nobody told you about.
Liquidity / Asset Liability Management:
If a bank lends a 5 year loan to someone, they simultaneously try to raise a 5 year fixed deposit to fund it. On the other hand, if they provide an overdraft or short term loan of say 90 days, they try to finance it through short tenure fixed deposits or savings account balances. This is called Asset Liability matching. By doing this, they try to ensure that they will have adequate funds to repay their deposits, when they fall due.
In debt Mutual funds (except FMPs), there is an ‘Asset Liability Mismatch’ by design. While the Mutual fund allows depositors to withdraw money at anytime they want, the bonds that they have invested in have a fixed tenure (which may be several years in the future). So, they don’t necessarily have the funds available to repay investors when they seek redemption. Now, you may say that they can sell these bonds in the market. That is true, but the markets for corporate bonds themselves are quite illiquid (in India, at least) and it is often difficult to meet abnormally high redemptions.
Regulatory Support:
Abnormally high redemptions, brings me to another question. Can there be a bank run on a mutual fund? Yes, there can. When there is fear in the market that a Mutual Fund will be unable to fund its redemptions, all investors en masse try to get their funds out – similar to a bank run. But the big difference is, that in case of bank, the RBI or govt. step in to ensure that the bank has adequate liquidity and such a bank run is avoided.
However, in case of Mutual funds such regulatory support is missing and the fund simply has to say, ‘No, I don’t have the money’ when it gets very high redemption pressure.
We have recently seen this play out in case of a very large bankruptcy of Yes Bank and on the other hand, the troubles faced by Debt schemes of Franklin Templeton. Look at it this way – Your money in a bank as troubled as Yes Bank with huge losses and NPAs is still safer than in a corporate debt scheme of Franklin Templeton – which is not even remotely in as much trouble as Yes Bank.
Interest Rate sensitivity:
This is the big unknown for retail investors. Most people are not even aware that an increase in interest rates in the market leads to drop in NAV of their debt funds and vice versa. In case of banks, this risk is also absorbed by the bank’s equity. However, in case of debt MFs, this risk falls squarely on the investor.
The Verdict
So, is a Bank FD better than a Debt Mutual Fund? Not quite. What I’m saying is that the two are not directly comparable.
When a debt mutual fund offers a higher return than an FD, it does so by taking away several layers of safety, which would otherwise exist in bank deposits. So, the next time your financial advisor tells you to invest in a debt Mutual Fund rather than a bank deposit, because it offers a higher return, be sure to understand that it comes with higher risk as well.
A debt mutual fund as opposed to a bank FD requires the investor to be a smarter person. You need to educate yourself about the risks involved in various types of debt mutual funds before taking the decision whether or not to invest in them. But that’s true for investing in general. As you keep investing in more complex products, you need to keep adding to your own knowledge and skill levels.
Sounds of Silence 
Reblogged this on Spruhal Invests.