Fenil's Library

Many a times on clear nights, when I look up at the stars, I can’t help but wonder if there is intelligent life out there — or are they just like us?

Come to think of it, we remain long-term investors only till the markets keep rising. Everyone knows that equity investments provide the best return over the long term. Yet, it’s hardly been over a year since the downturn, and retail investors have long deserted the equity markets.

I used to kid myself that by referring to the virtues of prudent asset allocation and patience I was giving sound advice. Looks like investors are treating these concepts more as sound and less as advice. What else can explain the current mad rush for guaranteed return products?

There is no reiterating that in the world of capital markets there can be no guarantee. Yes, an investment in bank fixed deposits or bonds from the Reserve Bank of India or the National Bank for Agriculture and Rural Development, etc yield an assured return. However, there is an integral difference between the way a bank pays you interest and the way in which a mutual fund (MF) or an insurance company does.

When you place a deposit with the bank, the bank onward-lends this deposit to another person or business for a higher return than what it pays you and pockets the difference. The difference between the borrowing and lending rates of the bank is called the spread.

On the other hand, when you invest your money with a mutual fund or an insurance company, unlike in the case of the bank, the money is never onward-lent at a higher rate to anyone —- instead it gets invested in the capital market in a mix of equity, bonds, debentures, government securities and the like. Therefore, unlike the bank which has a clearly defined spread, the return from an MF or an insurance company would solely depend upon the profitability/ success of its aforementioned investments.

Now, you will appreciate that the return from investing in equity or bonds can never be certain — not when you invest and not when an MF or insurance company invests on your behalf. No one, just no one, is an exception to this rule and there is no better example of this than the currently unfolding crisis where once hallowed investing institutions have collapsed and shut down.

It’s not as if these lessons are new to our markets. In the early days, when MFs first started, there were a few (especially the public sector ones) who flouted this rule and went on to assure returns. The consequence was no different — most of them are no longer in business. UTI itself ran into trouble with seven of its guaranteed return schemes where finally investors were given an option to either convert to 6.60% tax-free bonds or to exit by accepting cash.

The Securities and Exchange Board of India (Sebi) stepped in and took the correct step of basically barring MFs from assuring any return on any scheme. Over time, MFs came out with an innovation called fixed maturity plans (FMPs), which were essentially like fixed deposits from mutual funds. Since the return and tenure of the instruments comprising the portfolio of the FMP was known beforehand, MFs started indicating the expected return. Sebi preferred to look the other way, perhaps because it was only an indicative yield and not a guarantee — till the inevitable happened. There were rumours of defaults of some of the instruments that the FMPs had invested in, leading panic-stricken investors to withdraw their funds even at a loss of capital, let alone any return. This has compelled Sebi to disallow even an indication of yield. So, there is no guaranteed return and no indicative return on the FMPs. Return, if any, is left to market forces and the fund manager’s expertise. Kudos to the regulator for finally getting it right.

One would think insurance companies who had the luxury of learning from their mutual fund counterparts would take a page or two from the unfolding of the above events.

But a bit of background first.

The premium that you pay the insurance company is segregated into mortality premium (for insuring life) and investment premium (the part that is invested on your behalf). And just like in the case of a mutual fund, the insurance company too invests the investment premium in the capital market in a mix of equity and fixed income instruments. To that extent, there is really no difference between an MF and an insurance company —- but wait! There is a significant difference. Insurance companies aren’t answerable to the Sebi. The regulator in their case is the Insurance Regulatory and Development Authority (Irda). And given that almost every insurance company worth its unit linked insurance plan is busy guaranteeing return in all kinds of creative ways, the Irda clearly has no problem with this practice. This is in spite of the fact that our capital market history is replete with both consumers (investors) and producers repeatedly burning their hands, trying to do something that is fundamentally impossible and even downright foolish.

A senior executive of a leading insurance company told me his company had its bases covered since the rate it was effectively guaranteeing (4%) was well within its capacity and hence, no problem was likely going ahead.

I am afraid I don’t share this foresight. Once you enter the waters of guaranteed returns, you are basically swimming with the sharks. What can and will happen is that each new offering will try and push the envelope further in order to go one-up over competition. Like in any other industry, there are the established players even in this one, not to forget those who are trying to gain market share. If a return guarantee is indeed going to be what is required to seduce the investors, there is no saying how far the seduction can be carried. And like the saying goes, those who ignore history are condemned to repeat it.

I think it is time insurance companies own up and collectively discontinue a practice that does not augur well for the industry at large. Even a single failure can undo years of good work.

Only time will tell how it pans out from here. Meanwhile, investors would do well to stick to bank deposits and bonds for their fixed income requirements, turn to mutual funds to participate in the capital markets and make use of insurance companies for the almost forgotten purpose - to get insured.