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 (Illustration: Jayachandran/Mint)
(Illustration: Jayachandran/Mint)

The changing face of risk in Indian household savings

  • From the risk of fraud, the discussion is moving to poor investment decisions and disclosure
  • The focus of investment decisions should be both on the return and risk features of an instrument

The bad bonds of India and the resulting uproar when they were found in provident fund portfolios has changed the face of risk faced by the Indian household. From the risk of fraud, the discussion is moving to poor investment decisions and disclosure.

The opening up of capital markets in the early ’90s made investing in stocks accessible to more investors but at the same time exposed them to the risks of an archaic trading and settlement mechanism that was prone to being manipulated. The modus operandi for a good stock market scam was standard. Find a cheap source of fund and channel it into the stock markets to inflate prices and drive up the index. In 1991, Harshad Mehta found this source of funds by exploiting a loophole in the inter-bank funding process. The price of ACC Ltd, a favourite stock, went up from 200 to 9,000 a share in a period of three years, an absolute return of 4,400%! The bubble burst when State Bank of India, some other banks and PSUs discovered the leak and Mehta’s source of funds were cut off. The Sensex lost 2,000 points in nine months and wiped off the investment capital of many small investors. But it didn’t take the markets long to forget the lessons learnt and it allowed Ketan Parekh to hold sway in the tech bubble era of 1998-2001. Parekh used promoter and co-operative bank funds to inflate the price of his preferred technology stocks. Again, the retail investors joined the party just when it was winding up and they ended up paying as they were caught in the cross-hairs of the bulls and the bears.

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(Graphic: Santosh Sharma/Mint)

The scams, however, led to regulatory and institutional reforms which overhauled the trading, clearing and settlement, and price discovery systems of the stock markets and made it a more efficient platform for making equity investments.

While the Satyam Computers scam played out in the stock markets, it was not strictly a stock market scam. A darling of the tech stock boom in the stock markets, Satyam Computers went belly-up in 2009 with the promoter accepting that the books of the company had been misstated and revenues and profits fraudulently inflated. The price of the stock sank to as low as 11.50 in January 2009 from a high of 542 in May 2008, and many investors found their entire portfolio wiped out. While for the investors it was a wake-up call on the importance of managing the stock and sector-specific risks in a portfolio with diversification, the crisis also saw a slew of reforms in corporate governance to make the role of independent directors more effective and to fix the liability for auditors.

Investors lost money in the more familiar deposits and the chit fund markets that were riddled with scams. The Sahara group had convinced 30 million investors that it was in their interest to hand over their money to its loss-making and low net worth companies. And the Sharada group promised 14 million chit fund investors returns as high as 50% in some cases, and paid agents a commission of 25% to bring them in. The opaque nature of these products meant investors made investment decisions with very little or no information. With no information about how the funds mobilised were to be utilised, no assets provided as security, no credit rating and no liquidity, these were nothing but ponzi schemes where inflows from subsequent investors were used to meet obligations to earlier investors. Inflows dried up when capital market regulator Securities and Exchange Board of India (Sebi) forbid the groups from accepting fresh funds till it got the required approvals from the regulators. The schemes collapsed and buried the savings of the investors.

Cut to 2018 and a rash of bad bonds from the IL&FS group, Essel group and others began showing up in debt portfolios of mutual funds, unit-linked insurance plans (Ulips) and pension funds. At best, it can be assigned to incompetence and poor choices made by the fund managers and, at worst, it is a case of people in fiduciary roles wilfully failing in their responsibility. Sanjay Sinha, founder, Citrus Advisors, an investment advisory firm, ascribes this to an attempt to harvest higher returns. “In a highly competitive mutual fund industry, the differential return is what sets one fund apart from another. Very few investors go to the second level of analysing the attendant risks that come with the higher returns. There is incentive to go up the risk curve to deliver higher returns at the cost of the ability of that debt instrument to stand the test of confidence when markets are stressed," he said.

The close scrutiny that the issue is getting trains the spotlight on practices that are against investors’ interests that need to be curbed.

“An over-regulated industry is not desirable. However, it is important that the industry adheres to the spirit of the existing regulations and not just in letter. That helps resolve issues of trust, if any," said V. Ramesh, managing director, MF Utilities India.

Sinha sees a possible change in the way rating agencies are compensated. “The fees of rating agencies should be paid by the user rather than the issuer. There will be better alignment of interest in that case," he said. Stricter norms for instruments, such as loan against shares, may also be in the offing.

Setting realistic return expectations for investors is one way to ease the pressure on producers to constantly look for ways to outperform. Investors should question the higher return from a product compared to its peers and determine if they are comfortable with the source of the additional return. The focus of investment decisions should be both on the return and risk features of an investment to ensure that investors know what they are signing up for. 

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