November 07, 2014

The Trust Deficit

1991-92 was a landmark year for mutual funds in India.  It was a time when the industry was dominated by Unit Trust of India which towered like a colossus over a handful of public sector sponsored fund houses; private sector funds were yet to be a reality.  The cause for celebration was that for the sixth successive year, UTI’s share of gross household savings in financial assets had touched a new high.  What made it even more significant was the jump over the previous year: from a share of 5.8% in 1990-91, UTI’s share in 1991-92 stood at a whopping 13.4%.  In contrast, the share of bank deposits in 1991-92 hit an all-time low of 26.2%.  It seemed as if mutual funds had finally arrived.

Fast forward to 2013-14.  Mutual fund assets have grown over ten times, the industry has many more players, and it is a landscape dominated by the private sector.  Yet, RBI’s preliminary estimates put the share of mutual funds (including UTI MF) to gross household savings in financial assets at a miniscule 1.8%.  In contrast, the share of bank deposits stood at 57.3%, just shy of its all-time high.

So, what happened?

For all that one may find to cheer about the mutual fund industry today, at the heart of the story of its evolution from 1991-92 to today are squandered opportunities and lost trust.  Back then, the industry was on the cusp of something big- an opportunity for mutual funds to become an integral part of every investor’s portfolio.  Twenty plus years later, far from being a reality, it has been reduced to an aspiration that is farther away than before.

The roots of this story can be traced to 1990.  Till 1990, UTI enjoyed tremendous goodwill with its stakeholders.  It was predictable to a fault for both its investment performance and investor servicing: there were virtually no unpleasant surprises.  It wasn’t an easy task reaching such a point.  There were numerous skeptics who liked to point out that, strictly speaking, it wasn’t government owned, and other than in some closed-end, debt oriented schemes, it did not assure any returns.  But bit by bit, UTI worked towards building trust.  It never made brash promises that couldn’t be delivered.  It kept a reserve in case performance wasn’t as expected.  It created well-thought-out, transparent servicing processes that were particularly convenient for small investors.  It invested heavily in technology to enhance the quality of servicing. It deserved the success it enjoyed.

Its goodwill took its first significant knock when investors in its scheme, UGS-2000, launched in 1990, experienced service that was unexpectedly bad.  In quick succession, investors had similar or worse experiences with UGS-5000, and Mastershare Plus.  All of these could be linked to UTI’s engagement of registrars who did not have the ability to cope with UTI’s sales volumes.  But bad as these experiences were, it still had the perceived integrity of its management, and its predictably good investment performance to fall back on.  In 1992, that changed.  Launched in the aftermath of the Harshad Mehta affair, Mastergain 1992 epitomized everything that could go wrong.

Mastergain 1992 (now, UTI Equity Fund) was a sales success, setting a world record for the number of applications received.  But those very numbers made it an investor servicing nightmare.  Eventually, its performance, too, left a lot to be desired.  Most importantly, the manner in which the sales were promoted caused many people to question the integrity of the management.  Many years earlier, UTI had famously claimed, “Trust is our middle name.”  Mastergain 92 was the beginning of a serious trust deficit from which this once-venerable institution never recovered.

This could have been a great opportunity for the fledgling competition but they were mired in their own problems.  Most of these were to do with poor fund management, and assurances of returns that were made, which they seemed unlikely to be able to make good on. In addition, at least one fund house was being questioned as to its role in the Harshad Mehta affair.  By the time the private sector funds started off in 1993, the industry, as a whole, was under a cloud.

Over the next few years, with very few exceptions, it became an uphill task to get investors to subscribe to any scheme.  The only scheme to truly generate mass interest was Morgan Stanley Growth Fund (now, HDFC Large Cap Fund).  Unfortunately for the industry, its investment performance was terrible, and it became the poster child for all that was wrong with the industry.

Through the mid to late 90s, the industry continued to suffer a number of blows.  CRB Mutual Fund was wound up under charges of fraud.  UTI’s reputation took a major dent when the reserves on its flagship scheme, US 64, were wiped out and there loomed the possibility that it might not be able to meet commitments to unitholders in the scheme.  On top of all of this, in the bear phase from 1994-1998 it was hard to find any equity fund that inspired confidence.  It was a period when for most investors, mutual funds became a four-letter word, and it was common to find mutual fund salespeople twiddling their thumbs, because there was nothing that they felt they could do.  Hope eventually came through from two quarters: the launch of debt funds, and the resurgence of equities in the technology-driven bull phase of the late 90s.

As currently categorized by Value Research, the oldest existing open-end debt fund is JM Income Fund, which was launched in Apr 1995.  But it wasn't always a pure-debt fund.  Till the late 90s, it had a slice of equity in its portfolio. The first open end pure-debt fund was Birla Income Plus (now, Birla Sun Life Income Plus).  Launched in Oct 1995, it, too, initially had an allocation to equity in its portfolio, but in mid-1996 changed course to become the first pure-debt fund.  It wouldn’t be an exaggeration to say that this fund gave a new lease of life to the industry.  Through the bleak stock market trough of 1996, this was the only scheme that had sales of any consequence.  Its success lay the foundation for a slew of debt funds being launched by other fund houses through 1997 and 1998.

The year 1999 represented a remarkable period of returns for Indian equity funds.  Never before had such high returns been seen, over such short a period (never since, have they, either).  11 funds saw their NAVs triple in that calendar year alone.  Another 19 saw their NAVs double.  Leading the pack was Kothari Pioneer Infotech Fund (now, Franklin Infotech Fund) whose NAV went up nearly 6 times during that year.  Some people believed that these returns should have been more than enough to bridge the trust gap, and generate enough goodwill to last a long, long time.  In my understanding, most investors didn’t see it that way.

It is widely suggested that there are four characteristics that a trustee should demonstrate so as to engender trust- a. competence in the task entrusted with, b. integrity, c. a disposition to benefit others, and d.predictability.  I avoid generalizations, but I truly believe that for most Indian investors, the foremost consideration in trusting a mutual fund is the predictability.  This is not to say that the other factors don’t count- it’s just that a base level comfort on those factors combined with a high level of predictability is a surefire formula to gain investor trust.  It’s what helps explain the stronger investor preferences towards debt funds, particularly FMPs despite evidence that equity funds have helped in creating wealth over the last 15 years.  It also explains what attracted investors to UTI in its heydays.  When you think of it, UTI never built its reputation on the performance of equity funds.  Those were the weakest link in the chain of trust with its investors, not because of performance, but because of the unpredictability of performance that is in the nature of equities.  Thus, in my opinion, widespread interest in debt funds is the key to increased share of household savings.

Just to be clear: I’m not making a case against equity funds.  There are a number of investors who swear by equity funds, and there are a number of advisors who have helped their clients benefit from these.  The fact is that investing in equity funds requires a certain way of thinking that not many investors or financial advisors possess. The investor or advisors who do are in a small minority.  For the majority to be benefitted from the power of equity markets, there is a need for products or solutions that harness that power with the maximum possible predictability.  An example of that would be asset allocation funds. But that’s a subject I will leave for another day.
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