Thursday, December 9, 2010

There is no free lunch

Assured return equity plans. ULIP's that guarantee a minimum return. Structured products with guarantee of highest NAV. Capital protection schemes. All kinds of twists are added by sellers of financial products to convince the customer that he can have the cake and eat it too. Everyone wants to make super-profits but does not want to take the risk of losing his money.


Debt instruments offer capital protection. We are of course ignoring counter-party risk here. They are priced at 7 to 9 percent (currently) for durations of one-year plus. By definition anything that offers more in terms of returns comes with higher risk attached.


Equity has given historical long-term returns in the range of 15% plus. Actually, equity is very controversial – depending on which "long term" period you take and the range of years you choose, the returns can vary widely. But let's say for the sake of simplicity that the ten-year returns from 2000 to 2010 is, say, 15%; and if you see three-year blocks in the same period, the returns vary from minus 50 to plus 150 percent. (Please do not rush to confirm data – this is just an example though I think it should be fairly representative).


As a customer what do you want? You want equity-like returns of 15% plus. But you want your capital to be always protected. As a fund manager you know that this is not possible. But the marketing guys are pushing you. The CEO has set the year-end targets for net fund inflows. Competitors are offering products that promise the moon. So you succumb – we all do, ultimately.


UTI's  was one of the earliest  and most famous case of guaranteed returns going awry. It had to be split into two, and wait for divine providence in the form of a market resurgence to breathe some life back into it. In the meanwhile, the people who had invested were not really concerned; the Government of India backed it anyway.


How can a fund manager offer a guaranteed return on any mutual fund or a basket of investments that resembles a mutual fund? Several ULIP's offer this, even if at a low number. Guarantees are only possible when the fund manager invests a portion of his portfolio in debt products. If the minimum guarantee is, say, 6%, the fund manager can just invest most of his corpus in debt and meet his target. That is what he will do. But what is portrayed to the investor is different.  The investor is under the impression that it is predominantly equity that his money is kept in.


What about the Highest NAV guarantee? In this fifteen-year product we will guarantee you the highest NAV of the next ten years, or your original principal back, at the end of the fifteenth year. Capital protection, along with getting the highest NAV! Manna from heaven!


What happens of course, is that as the stock market goes up beyond a point, the fund manager shifts more and more of the money into debt so that at maturity, the promises can be met. He might even hedge himself at various points in time. So finally your returns even out and you pay an additional cost for all this hedging as well as for the fancy name of the scheme. There is of course a small probability that markets might not trade in the bands expected, and then things can go horribly wrong. In this case, if the markets move only in the upward direction, the fund manager is in a bit of trouble.


Then there are complicated structured products. If the index, which is today at 20,000 goes up to 26,000 levels, you get the full benefit, after that you get half of the increase till 30,000; after that, nothing. On the downside, you are limited to going down till 16000, a twenty percent drop. There can be infinite variations of these. There must be complex hedging algorithms at the back end to take care of eventualities with assigned probabilities to each.


From the customer's side, he gets some "assurances" but at what cost? Finally, the fund manager has to invest in the same equity and debt markets, and their fundamental characteristics do not change. For hedging against any eventuality, the fund manager (a) takes a call on the direction of the underlying, and (b) pays a price if the call goes the other way. It is not possible for the fund manager to cover against all eventualities; hence by necessity he concludes that certain events are so improbable, that he can risk not covering against them. How many of us have not taken life cover because we are sure that nothing will happen to us?


As people have experienced across the ages, there is no such thing as an absolute guarantee. Nassim Nicholas Taleb gave it a very catchy name, he called it "The Black Swan". In his rambling style, he told us that there are no guarantees in life. Just because you have not seen a Black Swan in your entire life, does not mean that they do not exist. We all know that of course. But we want to believe – how we desperately want to believe! There are no black swans, there never will be, if I see one it's my eyes that are deceiving me – it's not black, or some sorcerer has colored the feathers, it's not black… human beings have an inherent need to be  comforted with false assurances so that the castles they have built in their dreams do not come crashing down.


Mathematical models give a false sense of security. You pop in some numbers into an options pricing model, which goes by the intimidating  name of Black Sholes and generate some numbers to assess your liability; or aggregate sub-prime loans into a Markowitz model which miraculously get converted into Triple A gilt-equivalents; feed some cricket scores into a black box called Duckworth-Lewis and decide the fate of the World Cup; all the while with a secret fear which you do not acknowledge, that you don't understand what the models do, overridden by a foolish hope born of wanting to believe that nothing will go wrong. The priest who guards the temple in each case assures you that God will answer  your prayers, everything will be fine, he understands how God's mind works, he will tell you what rituals to follow to stave off doom, and charges you for it. Why does high Finance seem very similar to religion? The parallel to religion does not end there. When disaster strikes as it should (make that "as it will"), the whimsical ways of God (six sigma events) are blamed. And placatory rituals are found. Sometimes the old religion is abandoned, only in search of a newer, more complex, model.


No one knows how these models work, and no one wants to. In any case even if they understood it no one has the patience to listen to them explaining it. How many times have you seen cricket commentators explain the logic of what Duckwort-Lewis throws up? Which of us knows what were the assumptions that went into the model in the first place?  Which one of us really wants to know?


If a simple cricket game with its limited variables can be so intimidating, what about the real world. How many variables do an economy move?


As a customer if the Government of India or an institution backed by it offers me a guaranteed product, or the Tatas, or Birlas, I just go for it. If something goes wrong, Big Daddy will pay. I know that there is no free lunch, but my lunch will be paid for by someone else.


The latest case of course being the horrible losses incurred at Aditya Birla Money on the Options Maxima Scheme. The "Short Strangle" strategy based on the premise that markets would be range-bound went horribly wrong. Big Daddy Kumaramangalam had to chip in with a 100 crore infusion from Aditya Birla Nuvo.


Someone finally has to pay for the lunch.

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