If you recall, around four and half years ago, in September 2018, Infrastructure Leasing & Financial Services Limited (IL&FS) , a state-funded infrastructure development and finance company, faced debt crisis, and the Western media termed it India’s Lehman moment.

On September 10, 2018, ICRA downgraded non-convertible debentures of IL&FS Financial Services to ‘BB’ from ‘AA+’. It also downgraded the short-term commercial paper of the company to ‘A4’ from ‘A1+’. Even the securities issued by its other group companies were downgraded to below investment grade, as the company defaulted on its debt obligations.

Certain debt mutual fund schemes that had exposure to IL&FS debt papers became victims of the fallout. Even Liquid Funds were at risk owing to the IL&FS episode.

In October 2018, the government stepped in to take charge of the affairs of the company on account of the mismanagement of the management and board. The Serious Fraud Investigation Office (SFIO) also intervened in the process.

This company, IL&FS, is once again under the spotlight and public scrutiny. The Times of India reported on May 6, 2024, that the company’s management and board after originally reporting a profit of Rs 1,869 crore cumulatively during the five financial years, i.e., from FY14 to FY18, has now estimated a loss of Rs 9,600 crore after the uncovering of the financial irregularities.

Not just IL&FS but even its two subsidiaries, IL&FS Financial Services (I-FIN) and IL&FS Transportation Network (I-TNL), owing to discrepancies in their books, have reported a cumulative net loss from FY14 to FY18. In the case of I-FIN, the cumulative actual net loss is Rs 5,000 crore as against the earlier reported profit of Rs 1,602 crore, while for I-TNL a cumulative net loss of Rs 1,500 crore versus the earlier reported profit of Rs 1,486 crore.

The updated accounts are submitted by IL&FS and its subsidiaries as a response to the National Company Law Appellate Tribunal (NCLAT) order of 2019 and this crucial information is also forwarded to the Ministry of Corporate Affairs (MCA).

It is evident that IL&FS and its subsidiaries were cooking up their books, concealing facts, and falsely presenting a rosy picture. It’s a fraud played upon the investors.

Several reputed audit firms, as a result, are now under scrutiny for overlooking these irregularities, plus their top officials of these three companies, including their directors, are expected to face criminal action.

Do Mutual Funds Own IL&FS in their Portfolio?

Mutual Funds, once burnt twice shy, have fortunately stayed away from IL&FS in the last few years. Many debt funds absorbed the shock and nullified it within a couple of months after the IL&FS debt crisis came to light.

From April 2020, fund houses have either trimmed their exposure or have no exposure to IL&FS in their respective schemes. This decision was perhaps consciously taken by fund managers after being exposed to liquidity and default risk. In other words, certain fund houses deepened their investment process and stayed away and avoided undue credit risk.

[Read: Best Debt Mutual Fund Categories for 2024]

Lesson for Mutual Fund Investors

The IL&FS episode (along with the other episodes about fraud and the debt crisis) should be an eye-opener. Approach mutual funds with your eyes wide open. Look at the portfolio characteristics and other qualitative aspects rather than considering lone returns to select winning mutual funds.

It’s important to stay away from schemes that compromise the portfolio quality for high returns. Historical returns are no indication of future returns.

Don’t ignore default and liquid risk. Fund houses need to have proper due diligence and internal risk assessment policies in place to avoid taking exposure in companies involved in fraud, high levels of debt, and must not rely completely on ratings that rating agencies provide.

Note, that if the portfolio quality isn’t great, the returns could be wobbly and expose you to very high risk. This applies to even debt funds. Stick to funds where the fund manager doesn’t chase returns by taking unjustifiable credit risk. The L&FS episode has been a classic case of what liquidity and credit risk means for investors.

As an investor, keep in mind that for every level of return you seek there is risk. Therefore set your risk-return expectations right when investing in mutual funds.

Want to know how to choose the best mutual funds? Watch this video:

Invest in mutual fund schemes that follow robust investment processes and systems and have risk management mechanisms in place. Also, consider your age, risk appetite, broader investment objective, financial goals, and the time in hand to achieve those envisioned goals.

Be thoughtful and prudent in your investment approach.

Happy Investing!

This article first appeared on PersonalFN here

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