Behind the UTI mess

The Unit Trust of India lets down its US-64 investors. An analysis of how India's largest mutual fund bungled.

THE country's largest mutual fund manager has managed to push its flagship scheme, Unit Scheme-1964 (US-64), into a black hole yet again. The Unit Trust of India's (UTI) unprecedented decision on July 2 to suspend the sale and repurchase of units for six months effectively meant that two crore investors - after touting this number in its advertisements for three years, the UTI would now have us believe that there are only 40 to 50 lakh investors - have been deprived of liquidity.

That is, they cannot encash their units by selling to the UTI. Every year, starting July, UTI announces sale and repurchase prices (it follows a July-June year). The price for this month in past years has without any logic or rationale been dubbed a 'special price' in a bid to lure fresh investor funds.

For an open-end fund (that is, one in which investors can walk in and buy or sell units), the suspension of move to spend repurchase is unprecedented. The guidelines of the Securities and Exchange Board of India (SEBI), which do not apply to US-64, do allow mutual funds to close the repurchase facility under certain circumstances. But in the case of US-64 it has been closed after inept performance and possible insider trading - grounds which would not come under the SEBI guidelines.

The closing of the liquidity option is galling for small investors - over the last 37 years, millions of retail investors, pensioners and so on have reposed such faith in the UTI that most people refused to see the writing on the wall - and they are the most hurt now.

Even more galling is the fact that out of the Rs. 4,151 crores taken out in April-May 2001 (in itself an unusual event coming just before the dividend announcement), 90 per cent was by the corporate sector. One can concede some smartness on the part of such investors in reading the deterioration in the scheme and possible losses when it switched to NAV-based pricing. The NAV, or net asset value, is the market value of assets divided by the number of units held by investors.

At present the UTI has an archaic system of pricing in which where the sale and repurchase prices are delinked from the NAV. They keep rising incrementally between July and May of the next year to equalise the dividend yield for investors entering at various points of the year. So when the repurchase price is higher than the NAV, as it has been for most years since 1995, every unit bought back by an investor means less value for those who stay on in the scheme.

Since the repurchase price was substantially higher than the NAV in April and May, there was a huge incentive to trade on the basis of inside information. Part of the pull-out may be attributed to restrictions on dividend stripping.

The repurchase price has been higher than the NAV for most of the last six years, but no pullout of the 2001 magnitude happened. But the unprecedented bunching of outflows in April-May 2001 points to the prospect of quite a few corporate investors having been privy to inside information. The inside information in this case could be that the repurchase facility would be closed in July 2001. This explains the rush to the exit. The quantum of exit in these two months alone would have added Rs. 1,300 crores to the value erosion suffered by retail and staying investors.

The government has now announced a probe into this aspect. But this would be effective only if insider/informed trading (pulling out of funds in this case) -driven profits are disgorged and duly restored to the staying investors.

The profit in this case would have to be the difference between the repurchase price - which was around Rs.14.20 a unit to Rs.14.25 a unit - and the NAV which by reasonable estimates may be 25 to 30 per cent less than the face value of Rs.10 a unit.

However, a high degree of scepticism would have to be attached to the issue of whether the probe would be meaningful and whether efforts would be made to disgorge undue profits. This is warranted given the ineptitude of the UTI and the government, especially after the first bail-out in 1998-99.

INTERESTINGLY, this is the first time that the UTI has turned off the repurchase facility in July itself. In 1994-95, it turned off the tap in a staggered manner starting in October and then after a few months completely closed the facility. That was the year when the character of the fund took a turn for the worse.

The UTI and its top brass led by the then Chairman, S.A. Dave, in their greed to mobilise funds and meet 'self-set targets' (usually funds have performance as targets and let the fund mobilisation be a consequence of that) made the scheme attractive for corporate investors by announcing unsustainable dividend rates. They also did not care about the harmful effects of such flows on the interests of small investors.

In the 1998-99 Budget, a three-year tax exemption on dividend had been given to US-64 as part of a bail-out package. This made even dividends at lower rates attractive for investors in the income tax bracket of 20 per cent and above. More so for the corporate sector, and dividend stripping was its favourite activity. In dividend stripping, an investor buys, takes the dividend and then sells. His selling price may be less than his cost. But the difference is a short-term capital loss which can be set off against other capital gains to reduce tax liability.

With the dividend tax exemption, dividend stripping was even more attractive. US-64 was the favourite playground for this game owing to the UTI's opaque operations in this scheme and the pricing system which was waiting to give more money than what the investment was due.

The UTI top brass also made no bones about highlighting how the dividend even at a lower rate was attractive for high tax bracket investors and these flows were encouraged. So even after the first officially admitted crisis in 1998, no lessons were learnt and the UTI was still pursuing hot corporate money.

Now corporate investors and retail investors are vastly different on the basics of investment decisions - investment objective, risk preferences, acceptable post tax rates of return and liquidity. The corporate money that the UTI unabashedly coveted was essentially hot money steaming in and out.

Such volatile flows are difficult to manage at the best of times and even for fund managers with no fetters on their operations. For the UTI, which had the imposed responsibility of doing the government's bidding, such as trying to push up markets in the aftermath of Pokhran-II and other such uncertainties, it was doubly difficult. The task was made more problematic also by its unwillingness to sell the stocks of certain business groups. For instance, in Reliance Industries and Reliance Petroleum, it has been only steady accumulation with nominal sales every now and then. This is true for most of the UTI's stakes in family-owned businesses.

In contrast, it has had no qualms about moving in and out of stocks such as ITC and Hindustan Lever. Of its stakes, only in a few companies was it in a position to book profits. So whenever corporate funds went out, the UTI had limited manoeuvrability in generating cash to meet outflows.

Invariably it had to sell a few bluechip stocks such as Hindustan Liver and ITC, government securities and corporate bonds. This has had an adverse effect on its portfolio quality and investment performance.

The quality of investment performance can be gauged from the fact that the dividend yield (dividend amount divided by the sale price) has been less than what one would have earned in an individual capacity by investing in debt instruments or open-end mutual fund debt schemes including the UTI's UTI Bond Fund.

For 2001-02, the dividend yield is 7.4 per cent. But if you factor in the lower repurchase prices, in the last three years the total returns (dividend plus gain/loss on sale) would be less than what you get from a savings bank account. The latter is equally relevant to staying investors.

Even in absolute terms, this is unacceptable. But this has to be adjusted for risk. US-64 has a 65 per cent exposure to equities. Of all financial assets, equities constitute the highest risk class. So if you adjust for risk, what an investor has got is way below even the inflation rate. This denouement driven by volatile flows has been compounded by shallow markets and strange investment behaviour by the UTI.

The present crisis - the second one in official terms - also has its genesis in investment decisions that would not pass muster. To examine the malaise on the investing side, two instances would suffice and serve as a good proxy on the quality of fund management.

One is the dalliance with Ketan Parekh stocks. This was done in 1999-2000, ostensibly to take exposures in the New Economy (IT, media and telecom) stocks in line with the recommendations of the Deepak Parekh Committee.

The latter, set up to recommend a restructuring package when the first 'official' crisis broke out in 1998-99, had suggested that the UTI should take exposures in New Economy and FMCG (fast moving consumer goods) company stocks. But never would it have imagined that the UTI would go along with an operator of dubious repute and take big exposures in dubious stocks.

The UTI's exposures in top IT stocks such as Infosys, Wipro, Hughes Software, HCL Technologies and NIIT took a backseat to the Ketan Parekh plays. These were stocks such as DSQ Software, Pentamedia Graphics, PentaSoft Technologies, SSI, Satyam Computer, Aftek Infosys, Himachal Futuristic, Shonkh Technologies, Cyberspace Infosys and Global Tele-Systems. The UTI became a convenient dumping ground for a large quantum of these stocks which reduced floating stock in the market and made price manipulation easy.

The extent to which this dangerous dalliance went was clear when even after the Ketan Parekh crisis broke out, the UTI came to the rescue at the Calcutta Stock Exchange. The UTI and Reliance Capital picked up brokers' outstandings of DSQ Software and Himchal Futuristic, among others, in a bail-out.

This was when the shares were on a relentless downtrend (of close to 90 per cent). What the UTI expected to make out of these investments is anybody's guess. UTI had also lent Rs.50 crores to Himchal Futuristic through a debenture issue and the funds were routed to broker bail-outs.

The second instance that shows the indifferent quality of portfolio management was an investment in Reliance Industries made a few years ago. The UTI had picked up a strange instrument called compulsorily convertible warrants (a warrant by nature is to be exercised at the option of the investor and attaching a compulsory clause makes nonsense of the concept) in Reliance Industries. Apart from not only agreeing to it, the UTI exercised this instrument and took shares at prices much higher than the market price. This is one of the deals where information is public. But one never knows whether similar deals have been done by UTI. Such deals do no good to investors.

Clearly, there have been many investment decisions that were of a questionable nature and which go against rational behaviour. Whether these were done under extraneous pressure or not, the investors have paid a price. Notably, even between the crisis point in July 1998 and now, stock prices barring PSU stocks and capital goods, have shown increases ranging from 10 to 93 per cent. If in this backdrop US-64 is in a mess again it only points to poor investment management, the dip in reserves due to peculiar pricing and the adverse impact of volatile corporate flows.

The UTI has also not done justice to the most important recommendations of the Deepak Parekh Committee. These include a move towards NAV-based pricing (which would have meant more transparency), a shift towards debt instruments in the portfolio and a separate structured fund management team for US-64. The UTI claims to have implemented 18 out of 21 recommendations. But without any action on the core recommendations, the fringe ones have not had the kind of effect they ought to have had. Judged qualitatively too, the nature of compliance with some recommendations has been dubious, as highlighted by the dalliance with Ketan Parekh stocks.

With so many skeletons in its cupboard, the UTI has been happily selling the scheme as one that offers regular income, safety (it has used to good effect a survey finding of US-64 being the third safest option), anytime liquidity and the trust of two crore investors.

The scheme's portfolio has never been designed to offer a regular income. If it was doing it comfortably till the capital base ballooned during S.A. Dave's time, it was because of its early entry into many stocks. Considerably higher inflows during the 1993-95 period and subsequent years were not profitably employed. In any case, given the very nature of equities, a fund with 65 per cent exposure to this class of securities could never offer a guarantee of regular income. As the reserves have run out, the UTI has struggled in the last few years to maintain yields at respectable levels.

Even after the troubles of 1998, the government continued to turn a blind eye and allowed the UTI to sell apples as oranges. Having blatantly marketed an equity oriented scheme as an income scheme, the UTI now leaves itself open to legal action.

This aside, the Deepak Parekh panel recommendation to bring it under the ambit of SEBI seems to have been put on the backburner as far as US-64 goes. This move would have ensured better disclosures and at least made it possible for investors to get a better idea of the scheme's position. Hopefully the current muddle would force the government to push the scheme under SEBI's regulatory ambit. This would ensure that a full-fledged offer document is made with adequate disclosures aiding investor's cause.