Making sense of assured--returns schemes

Mutual fund schemes with `assured returns' have been the source of much controversy. We have seen episodes like Canbank Mutual Fund where it was not possible for the MF to meet its obligations -- fulfilling its promises required a payout of Rs.11 billion while the assets of the scheme were Rs.5.9 billion. Strictly speaking, in the spirit of limited liability companies, the shareholders of Canbank MF should have walked away from the fund, allowing it to default on its obligations; this is perfectly in keeping with a concept of shareholders having limited liability.

SEBI viewed this as a basic question in investor confidence -- if Canbank MF was allowed to default on its obligations, then investors in India would have been more circumspect about promises made by other financial instruments in the future. In this sense, a default by Canbank MF would impose negative externalities upon all sales of financial products in the future. Ultimately, the shareholders (Canara Bank) were forced to bring up Rs.5.3 billion to enable the promises made by Canbank MF to be met. SEBI has similarly used all means at its command to ensure that several other funds live up to their promises, thus bringing about massive payments to Indian unitholders.

Thanks to this policy regime, assured returns schemes have become the exclusive province of a few MFs who are willing to make such promises, such as UTI. Other private and foreign MFs have owners who find it inconceivable that their liabilities could potentially exceed the funds they invested in the equity of the MF. This has led to criticisms of the "unequal playing field" where MFs with owners who wish to limit their liabilities are disadvantaged as compared with MFs with owners who do not.

A special complication in this situation is that the entities involved in selling assured return products are ultimately backed by the Indian government. It is hard to imagine UTI ever being allowed to default on its obligations. If matters at UTI did come to such a pass, we can expect tremendous political pressure upon government to cobble together a bailout. In this sense, an entity like UTI is "too big to fail" (TBTF). If UTI is TBTF, the guarantees that it makes can generate claims upon the taxpayers of India. This is surely an unfair subsidy to UTI which is not being made available to other MFs, and this is surely an inappropriate liability for the government of India to be adopting.

Yet, to look at this picture from a totally different perspective, there is no absolutely question that investors in India like assured returns products. The financial market volatility of the last decade has generated a large pool of investors who are unwilling to take down--side risk. It is much, much, much easier to sell assured returns products than it is to sell products which make no assurances.

How do we make sense of this situation? On the one hand, there is little doubt that Indian savers like to buy assured returns schemes, in which case it is the job of the financial sector to offer them. On the other hand, there is little doubt that the principle of limited liability should not be suspended for the MF industry, and that implicit State subsidies for some players are inappropriate.

To disentangle these issues, we have to start by asking: how much is the risk involved in a given product? If the rate of return for five--year government paper is 12%, then it is not a problem if 76% returns are promised over a five--year horizon for an instrument which purely invests in government paper. If a MF makes such a promise, it is hedged when it has invested in the 12% five--year government paper. If, on the other hand, a MF promises 100% over a five--year horizon when five--year riskless interest rates are at 12%, then there is a risk that these hoped--for returns might not materialise.

This is the core issue: what is the risk to the MF in an assured--returns scheme? There is a problem of prudential regulation here. A MF which makes extravagrant promises about returns -- based on hopes about future price movements -- is exactly as much of a problem as NBFCs which promise 20% riskless returns. In both cases, prudential regulation should require that whoever makes promises should have "adequate" capital backing these promises. This requires risk measurement on an instrument to instrument basis.

In this sense, SEBI's policy on assured returns schemes, i.e. that of employing all means at its command to ensure that the principle of limited liability is violated in order to meet promises, is incomplete. This policy violates the basic principle of limited liability. It does not satisfactorily deal with situations like UTI -- where SEBI has not verified the adequacy of the "development reserve fund" as against potential liabilities -- or other funds where SEBI does not verify that shareholders have adequate capital to cope with potential liabilities.

A powerful insight into assured--returns products is obtained by noticing that there is an option embedded in the product. When a fund sells a product where the unitholder receives all the upside potential, but his downside is capped at a fixed level: (a) the unitholder is getting a put option and (b) the fund is short--selling this put option. In order to hedge itself, the fund needs to buy a put option, the price of which should really figure in every NAV calculation.

In a truly safe situation, such as the fund which promises 76% over five years when the interest rate is 12%, this put option is worth nothing and the assured returns are hence unimportant. In other situations, the option--character becomes important.

Assured returns schemes thus consist of MFs selling put options without hedging away that risk. This should make them exactly as uncomfortable as short selling put options on NSE's upcoming options market. In terms of prudential regulation, regulators should be exactly as uncomfortable with a large short position on a put option market (which would require initial margin) as with a MF which assures returns (which has paid no initial margin).

Are market participants in India clever enough to recognise the option--character of assured returns schemes? Consider SBI Magnum Triple: the NAV is Rs.185, and while most schemes trade at a discount to NAV, it trades at around Rs.265. This reflects a put option, which the unitholder has (an assurance of Rs.300 in nine months) in addition to having a portfolio worth Rs.185. The market valuation of Rs.265 clearly incorporates the value of the option. Regulators should require that the NAV calculation incorporates the value of bundled options.

In summary, assured returns schemes should exist because India's investors want them. The question that policymakers face is of how they should be produced in a safe way. The risk of assuring returns should be hedged by purchasing put options on a secondary market. If the policy establishment puts its act together, index options can be a reality in India by December 1998. Once this is done, it would become possible to sensibly have assured returns schemes.

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