Portfolio

Myth of ‘guaranteed’ returns

Aarati Krishnan | Updated on March 09, 2018 Published on August 03, 2013

The promise of fixed returns from a broker means practically nothing, unless you know where the returns are going to come from.

In recent years we have been rather complacent about our financial markets. Whatever else may be wrong with our economy or government, we thought, our financial markets, with their state-of-the-art trading systems and hyper-active regulators, were surely immune to crisis.



No-man’s land



But the trading halt and suspended contracts at National Spot Exchange (NSEL) this week have turned this notion on its head. This controversy brings to light how an entire exchange (which recorded a Rs 3 lakh crore turnover last fiscal) was functioning in a no-man’s land, with neither the Forward Markets Commission nor any other regulator taking active responsibility for it. Given that some of these contracts were on obscure commodities without a clear benchmark price, brokers and speculators made merry by roping in high net-worth investors and offering them ‘assured returns’ from punting on such commodities as raw wool and castor-seed. While the going was good, investors made their money. But when regulators belatedly took note, the exchange was thrown into a payments crisis and called a halt to trading. This has reportedly left many affluent investors, who had taken positions on the exchange via their brokers, in the lurch.



While this episode should lead to some soul-searching for the regulators, what about the lessons for investors? There are many.



Lure of fixed returns



The first is that Indian investors, who are the soul of conservatism when it comes to financial products such as equities or bonds, seem to throw caution to the winds whenever anyone mentions a ‘guaranteed’ return. It was the ‘assured’ returns of 15 per cent (annually) that led affluent investors to lend money to traders in the NSEL for punting on obscure commodities that they neither tracked nor understood.



It was also very similar ‘guaranteed’ returns that prompted others to park money in the Sahara real estate firms’ convertible bonds. It was similar projections that prompted investors to flock to plantation schemes and emu farms without asking too many questions. Investors avoid equity and mutual fund products like plague because they offer only market-linked returns, which they know are subject to fluctuations. SEBI too bars equity and mutual fund players from offering any assured return even on fairly predictable products such as Fixed Maturity Plans.



But the same investors seem to assume that any product that holds out ‘fixed’ returns, even by way of verbal assurances, is automatically risk-free.



Guarantee checklist



It is time investors realised that the regulated but market-linked products are much safer than ‘assured return’ products that function in a regulatory vacuum. After all, the promise of fixed returns from a broker, fund-raiser or middleman means practically nothing, unless you know where the returns are going to come from.



So the questions investors need to ask of every such scheme is: How is this scheme hoping to make money? Is there really a legitimate market capable of generating a fixed 15-20 per cent return on a sustainable basis? If so, why haven’t professional investors such as Rakesh Jhunjhunwala or your mutual fund caught on to it already? If the scheme to trade in wool, build a resort or grow emus doesn’t live up to its potential, does the guarantor have a back-up plan to deliver the assured returns? If he says he has, do his financials support it? And if he reneges on his promise, who is the regulator you can complain to? As long as these questions are unanswered, any ‘guarantee’ isn’t worth the paper it is printed on.



Exchange troubles



Of course, the NSEL saga also exposes the fragility of another business that everyone thought was a sure money-spinner — the business of operating a stock exchange. When MCX launched its Initial Public Offer in early 2012 in flat markets, it was over-subscribed by 50 times, because the business of running a stock exchange seemed so overwhelmingly attractive then.



Exchanges had a natural monopoly as traders usually flocked to the exchange that offers the most liquidity. It was seen as fast growing and highly profitable too. MCX’ revenues had grown at 46 per cent annually in the three years preceding the IPO. Its operating profit margins, like its peers NSE and BSE, stood at above 60 per cent. But recent events have shown that the exchange business has several imponderables too. Traded volume, the only metric that seems to decide the worth of an exchange, can vanish pretty quickly in adversity, taking valuations with it. A negative turn in the market, a new tax (for instance, Commodities Transaction Tax) or a run-in with the regulator can demolish volumes, trim profit margins and sharply level market valuations that hinge on them. The battering witnessed by the stocks of MCX and Financial Technologies in the last few days is proof enough of this.



>aarati.k@thehindu.co.in











Published on August 03, 2013
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