MFs to write-off 75 % Locked-in Yes Bank Shares: Will it hurt index funds?

Here is how AMFI's decision to write-off 75% locked-in shares of Yes Bank (from March 16th 2020) will affect index funds

Published: March 21, 2020 at 9:45 am

On March 13th 2020, the finance ministry while notifying the Yes Bank Limited Reconstruction Scheme added a three-year lock-in period of 75% of Yes Bank Shares from the date of notification. The association of mutual funds of India have decided to set the value of these locked-in shares to zero. A look at how this would impact index mutual funds.

AMFI does not want to use the price of the 25% free-to-be-traded shares for the locked-in 75%.  With no precedence to follow, it has decided to set the value of the 75% to zero (full write-down) for the entire lock-in period. This is the Yes Bank Valuation note by Motilal Oswal MF

This is not segregation or a side-pocket but a temporary write-down. The Nifty has approximately 0.17% exposure to Yes Bank. This means about 0.12% of this exposure or about 6.7 lakh shares would have a value of zero effective March 16th, 2020.

At the end of the three-year period, the proceeds would be handed over proportionally to unitholders invested in the fund as on March 16th.

Will this affect actively managed mutual funds?  Since their portfolios do not follow an index, there is no way to answer this question. It is reasonable to conclude that this development is irrelevant to active fund returns.

Will it affect index funds? The answer is, it will affect the returns of Nifty index fund investors who held units as on March 16th. By setting 75% of Yes Bank shares in their portfolios to zero just two days before it exits the Index (maintained by NSE) and assuming the remaining 25% is sold off in time, AMCs have ensured the tracking error of the fund will not be affected much.

This does not mean much for an investor who, for example, started investment on say, 1st Jan 2020. On March 16th 2023, the remaining Yes Bank shares will be available for sale. The AMC would sell it and distribute proceeds to this investors proportional to units held. This sale would be done outside the portfolio held at that time.

So if the investor computes her return from 1st Jan 2020 to March 16th 2023 (assuming the pay off happens the same day) it would be a bit different (more or high) than the Nifty return. Of course, it would only be a small difference but that is accidental because the exposure to Yes Bank in the Nifty is small currently. Had it been higher, the difference would have been significant.

Note this difference in return can also be thought of as a day to day deviation in the index fund (for such investors) and the index. It does not matter if the AMC treats the 75% exposure to Yes Bank as valued at zero or valued at market price. The eventual difference would be the same.

We have repeatedly stated here that tracking error is of no use while evaluating passive funds. For example, the tracking error of an ETF is reported using its NAV. This will always be lower than the corresponding index fund because an ETF will always have lower expenses.

However, the ETF NAV is irrelevant to the investor as they buy and sell at market price which can significantly vary as we saw a few days ago: Why SBI ETF Nifty 50 Price changed only by 0.2% when Nifty fell 7.6%

Tracking errors are only for the fund management to measure their ability to track the index. By setting 75% of Yes Bank holdings to zero, they have ensured the tracking error is not affected.

This does not mean returns will not be affected. For an investor, the true measure of tracking error is a comparison of fund returns and index returns. This will get affected for investors who hold Nifty index fund units as on March 16th 2020. Also read ETFs vs Index Funds: Stop assuming lower expenses equals higher returns!

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