Wednesday, July 17, 2013

A Perspective on the Mutual Fund Industry in India

This interview was first published in ISB Insight, Volume 11, Issue 1, 2013, pp55-58

Aditya Agarwal, the Country Manager of Morningstar India, has 20 years of experience in the financial services and investment management industry. He was the promoter of one of India’s leading fund research companies, ICRA Online, and is highly regarded as a subject matter expert on mutual funds. In a conversation with Professor Vikram Kuriyan and Nupur Pavan Bang of the ISB’s Centre for Investment, Agarwal discussed the reasons for the slow growth of the Indian mutual funds industry compared to developed markets and explained why investor education and awareness is required.
India accounts for 18% of the worlds population but only 0.37% of the global mutual funds industry in terms of assets under management, as per data from the Investment Company Institute. India has one of the highest savings rates in the world at about 33% for the year 2012. But this money does not find its way into the stock markets or mutual funds. Why is this so?

It is true that only a meager fraction of the savings in India goes into stocks or mutual funds. Indians prefer real assets such as gold and property to stocks or equity mutual funds. Many risk-averse investors prefer to keep their money safe with bank fixed deposits, and some even prefer to hold cash.

The primary reason for this is a general lack of awareness among individual investors about how stock markets work. Thirty years ago, the BSE (Bombay Stock Exchange) Sensex was at 125, whereas 10 years ago, it was near 4,000 levels. Thus, if you held a portfolio of the top blue-chip stocks similar to the BSE Sensex and left it untouched, your wealth would have grown 150 times and 4.5 times in 30 and 10 years respectively, or at a compounded annual growth rate (CAGR) of about 18% in both cases.

However, in most cases, investors fail to recognise that stocks and mutual funds are best when held over a longer term, say five years or more, for the volatility to even out, and instead, trade in stocks for the short term, leading to disappointing results. Financial literacy needs to improve in the country. Despite all the efforts from the regulator and various investor education initiatives run by fund companies, financial planners, and so on, the buy-in from investors just isn’t there. Funds are still not bought; they have to be sold to investors.

It is no secret that stocks generally outperform all other asset classes over the long term – this has been demonstrated and proven in every market over different time frames; however, a relative lack of understanding of this among investors, and as a result, their bitter experience with the asset class, has resulted in Indian savings not being channeled into the asset class as much as they should be.

Private players entered the mutual fund industry in 1993. The industry is 20 years old today, but yet it is far from mature. What are the reasons for this? In terms of accountability, mutual funds have not performed well or beaten the benchmark consistently.

The entry of private players has definitely raised the standard and professionalism of the industry, but that is unlikely to have a bearing on the industry’s growth. The reason for this is that with 75% of the industry’s assets in debt and liquid funds, it serves institutions well to park their surplus funds and gain a tax advantage. Until the average retail investor starts to believe in a big way that wealth can be created from equity investments, we won’t see the industry maturing in the way it has in developed markets.

On the question of funds not performing well, we often confuse poor returns stemming from the market’s dismal performance during the past five years (five years ago, stocks were nearing the end of a multi-year bull run) with relative underperformance. One cannot expect equity funds to post sterling returns when the market itself has given zero or negative returns. At the relative level, we need to do more comprehensive studies to see how many funds are underperforming relative to their benchmarks before concluding that it is an alarming picture. It all depends on which way you look at the data.

For example, a recent study pointed out that over the past five years, over 50% of equity funds underperformed their benchmarks. But the study looked at the absolute number of funds, and not at the funds in light of their assets under management (AUM). Consider, for instance, a hypothetical category comprising two funds managing INR one billion (100 crores) and INR nine billion (900 crores) respectively. If one of them underperforms, it means that 50% of the funds underperformed. However, if the bigger fund outperforms the benchmark, then we can say that 90% of the AUM outperformed. At the asset level, a preliminary analysis we did over the same time period showed that about 80% of funds (assets) outperformed their benchmarks because the more successful funds tend to manage larger assets.

It is the perception of investors that mutual funds do not give returns. Year on year, mutual funds may perform well, but investors are actually losing money. The number of investors who lose money is greater than the number of investors who make money.

Over the long term, equity mutual funds have shown robust performance, but in the short term, stocks and stock funds can post disappointing results. It’s the nature of the beast. Investors often tend to have a herd mentality and flock to asset classes after they have seen years of outperformance and the markets are at near peaks. The recent mania for gold and for stocks towards the end of 1999 and 2007 are a case in point here; investors entered the markets at precisely the wrong time and burnt their fingers badly.

Then there is also the problem of capital-weighted return. Suppose a fund with INR one billion (100 crores) in assets gains 100% in one year. By the end of year one, due to the fund’s stupendous performance and investors chasing it and putting money in it, the asset size swells to, say, INR 10 billion (1,000 crores). Then the next year, the fund returns a negative 50%. In such a scenario, the net return at the fund level would be the same, but far more investor money would have been lost as the fund had fewer assets when it gained and more when it lost. At Morningstar, we call the concept “investor return,” and in countries where flows data is available, we often see a considerable difference between a fund’s total return and investor return (or the internal rate or return investors got, capital-weighted) over any time frame.

In markets such as the United States (US), the gap between a fund’s investor return and total return is often glaring and remains wide for some volatile categories of asset classes. We would love to see the difference between the two for Indian funds, but we do not have enough disclosure data to calculate it. However, considering that Indian markets are more volatile than many other markets and because, as we mentioned earlier, investors tend to pour in capital more often than not at the wrong time or near market peaks, we think the gap would be significantly large.

Until we have sufficient investor awareness and disciplined, buy-and-hold investing becomes more widespread, we will see the problem of investor disappointment manifest itself even if overall fund performance is good.

People in India view insurance only as a means of tax saving. Are mutual funds going the same way? If so, what can be done to prevent such a mindset?

Mutual funds will remain a push product as long as investors feel more comfortable with the 9% stable return that fixed-income instruments such as fixed deposits (FDs) provide. They tend to forget that this 9% return is often entirely eaten into by inflation and ignore the higher 20-21% return that the average mutual fund has logged over the past 10 years, albeit with greater volatility.

A big driver of this growth could be the introduction of mandatory savings into equity products by the government, something similar to the 401k in the US (a kind of defined contribution plan to save for retirement). The (National Pension System) NPS is a start, but if we revamped something like the Employees’ Provident Fund (EPF) and partly linked its returns to the market, 10 or 20 years down the line, investors would have, out of force, learned the magic of disciplined investing in stocks.

Over the course of time, as investors develop greater comfort with equities, we will see more investors come out and buy equity mutual funds.

Exchange-traded funds (ETFs) have not done well in India, whereas they are popular across the world. ETFs have only about 2% of the market share in spite of their many benefits. Is this due to weak distribution networks and low sales commissions for agents?

ETF is a wonderful product as seen by its popularity in the West, offering passive, often niche strategies for investors who focus on asset allocation. But ETFs are far ahead of their time in India. Active management is preferred here, and we do see large outperformances by managers compared to the West, where beating the market is becoming exceedingly difficult. Further, investing in ETFs in India also has its set of operational issues. One of the challenges for small investors who do not invest in stocks is the lack of a demat account. To buy an ETF, one needs to open a demat account, and not everyone wants to do that. The point about low commissions is also one of the key reasons why they are not sold as widely in India.

One argument put forward by some commentators is that if Indians prefer to invest in gold and real estate, why not give them funds that invest in gold and real estate?

We do have gold funds and ETFs that offer an excellent way to invest in the yellow metal. Real estate mutual funds are a different equation, however. Asset management companies say they face practical difficulties with respect to regulations, valuations, and so on.

Who is accountable for the performance of the funds? Do fund managers in India have the necessary qualifications to manage thousands of crores of someone elses money? A person without a background in finance may not be the right candidate to manage funds. What is your view?

As a whole, we believe that the industry’s assets are in good hands with adequately qualified people to manage the money. Of course, there will always be times when some managers are outperforming while others aren’t, but that is the nature of the market. If some are underperforming for a long time, you will see investors leaving the fund and assets drying up and going to better performing managers and funds. It is a self-correcting mechanism.

At the ecosystem level, we believe the regulator has drawn up enough regulations and put in place processes that safeguard investor interest.

What are some of the things that the Securities and Exchange Board of India (SEBI) can do to better support the industry? What are the regulatory bottlenecks that keep the industry from growing?

We believe SEBI has done a brilliant job of regulating the industry, especially after the 2004-2007 boom and subsequent crash when some of the practices were less than ideal. The abolition of entry load and the introduction of direct plans are good moves to help the investor save on expenses and make the product more attractive. The regulator has set the ground for the industry to grow in a sustainable manner. Now, it is left to market performance to pick up and start drawing in more investors, and for investor awareness to increase, all of which will launch the industry into its next growth orbit. That said, we would like to see a greater focus on independent research and higher levels of transparency and disclosure in the industry.

You spoke about research. What research topics in this industry would you advise budding researchers in India to pursue?

If the question pertains to fund research, I would like to point out the acute lack of awareness that exists in India on this subject. For many distributors, recommending funds means picking the recent top performers. At Morningstar, our unique approach, developed through decades of expertise in the field, is to offer investors not just unbiased and independent but also cutting-edge research that helps investors take informed decisions. I would urge budding researchers to try and stay up to date with the best global fund research practices, qualitative and quantitative, followed by our firm and also our peers. Knowledge, information and widening your perspective will give you an edge over others.

Monday, July 8, 2013

What influences prices of depository receipts

This article was first published in the Hindu Businessline, Investment World, July 8, 2013; Co-Author: Kaushik Bhattacharjee, IBS Hyderabad.

The globalisation of the Indian stock market is reflected in India’s sophisticated institutional capacity, facilities and international practices, which have increased capital availability and market liquidity in India by attracting FIIs.

Unimpeded financial markets allowed Indian companies to cross-list in international exchanges and raise capital by issuing depository receipts and convertible bonds.

Issued by US banks (acting as custodian), ADRs are negotiable certificates that represent the ownership of shares in non-US companies. They enable US investors to invest in foreign securities and non-US investors to invest in US markets.

These instruments provide a unique opportunity to investigate interaction channels between the US and other equity markets, both in synchronous (eg. US and Canada) and non-synchronous (eg. US and India) time settings.

Information transmission

In synchronous settings, ideally speaking, in the absence of any frictions like capital control or illiquidity or differential tax structure, information should flow into both the markets at the same time instance.

However, in non-synchronous settings like NYSE/Nasdaq in the US and NSE/BSE in India, various issues of market efficiency such as price transmission and price discovery beckon investigation.

On any calendar day, the Indian market opens first and the US market is the last to close. Therefore, if markets are efficient, the ADRs should react to new market-wide information in India when US markets are closed and vice-versa.

If the exchange rate remains approximately constant over time, an upward (a downward) movement of the underlying assets will move up (down) the corresponding ADR’s price.

On a given calendar day, Indian markets close first. Therefore, if the two markets are fully efficient and the prices of underlying shares truly affect the prices of ADRs, then we expect that a shock from the underlying shares would be reflected in ADR prices (as well as price changes) in the same calendar day. However, a shock in the previous trading day should not affect the ADR.

Exchange rate impact

ADR prices get indirectly influenced by the INR/USD rate. For foreign portfolio investors, directly holding INR denominated shares, profits from investments in Indian markets are subject to exchange rate risk.

Movements in INR/USD rates directly affect Indian ADR prices until possible arbitrage profits, triggered by foreign exchange movements, disappear.

An upward (a downward) movement of the underlying stock coupled with an appreciation (a depreciation) in INR/USD rates will exert greater pressure on that particular Indian ADR to move up (down). However, if these two move in opposite directions with the same magnitude, the effect is netted out and the ADR price remains the same.

We find that, the way changes in ADR returns relate to changes in the S&P 500 Index, Nifty index and exchange rate differs from how ADR prices change subsequent to changes in underlying stock prices. The contemporaneous changes in Nifty index positively influence ADR returns, followed by a significant (mostly negative) price response on the following days. The exchange rate emerges as significant for some stocks at different lags. Thus, while ADRs seemingly under react to information on underlying securities and overreact to information on their own lagged values in gradual diminishing magnitude, this is not the case with market indices.

This indicates that information transmission to and from the domestic and U.S. markets is not completely efficient. It is reasonable to conjecture that besides market frictions, such as conversion fees and capital control restrictions (e.g. the famous headroom issue), the mis-pricing is due to varying expectations of investors in these two markets.

Thursday, July 4, 2013

Quantitative Easing and its impact

This article was originally published in Postnoon on July 4, 2013

Vishal was waiting for me at the cafeteria when I went to get my usual cup of the morning coffee. He has been investing small amounts of money in the stock market with reasonable success. He would usually stop by to tell me about the performance of the stocks in which he has invested. Today he looked troubled.
Nicky: What is it Vishal?

Vishal: Professor Nicky, you must help me. My dad will beat me.
Nicky: Why? What happened?

Vishal: Last few weeks have been pretty bad. The SENSEX has been shedding points and the prices of the stocks I hold have also been going down. My dad has threatened to stop my pocket money and force me to withdraw all my investments from the stock market if there are any further losses.
A lot of the newspapers are talking about the withdrawal of Quantitative Easing by the US. They say that it will result in foreign institutional investors withdrawing money from the stock markets in India.

I don't understand any of it. Firstly, what is Quantitative Easing (QE)? Secondly, why should Indian markets go down if US withdraws QE?
Nicky: I am glad that you are reading the papers.

Quantitative Easing is a means to increase money supply or liquidity in the economy to stimulate growth. Countries like the US, Japan, UK and the Euro Zone, decided to infuse capital into their economy by buying corporate bonds, equities or mortgage backed securities.
Vishal: From what I know, these countries have huge debt and high fiscal deficit. Where do they get the money to infuse it into the system?

Nicky: Simple. They print it. Printing money does have the danger of making the domestic currency weaker. But the idea is to promote growth by increasing consumption, development and expansion. That is demand.
When the government supplies capital, some of the money finds its way to emerging countries like India, as the interest rates in emerging countries are much higher than in US, Japan, UK or the European Union. Some of this money also goes into the stock markets in the hope of better returns than the investors would find in their own countries.

When the Chairman of the Federal Reserve of US, Ben Bernake, announced plans to taper down the QE last month, it resulted in foreign institutional investors withdrawing money from emerging nations, including India. This resulted in the markets going downhill.
Vishal: You said that printing money has the danger of making the domestic currency weaker. But dollar is becoming stronger.

Nicky: Dollar is getting stronger as it is still seen as a safe haven. Also, the rate of dollar appreciation increased after the announcement of tapering the QE came.
Vishal: We are truly living in an integrated world. I must not just look at the Indian economy when taking decisions, but also the global economy.

Nicky: Yes indeed!

Wednesday, July 3, 2013

Islamic Banking: A Central Banker Looks Back

The interview was first published by the Global Association for Risk Professionals on July 2, 2013. Co-author: Prof. Vikram Kuriyan

For six years starting in 1999, Dr. Ishrat Husain was governor of the Central Bank of Pakistan. He was responsible for a significant restructuring of the central bank and implementation of banking sector reforms. During his tenure, a court decision mandated that the nation's banking system conform to Islamic law. Husain's skillful oversight helped to maintain banking sector stability during a period of economic growth.
"Islamic banks did not suffer as much during the financial crisis as conventional banks because they did not deal in exotic derivatives or artificial money creation instruments such as collateralized debt obligations," Husain observes.

"There should not be a division between
the central bank and supervisory
authorities," says former Central Bank of
Pakistan governor Ishrat Husain.
As central bank governor, he was a member of the government's economic management team. Later, from 2006 to 2008, he was chairman of the National Commission for Government Reforms, reporting to the president and prime minister. In March 2008 he took charge of the office of the dean and director of the Institute of Business Administration, Karachi, the oldest graduate business school in Asia. He was also a member of the Mahathir Commission 2020 and advised the Islamic Development Bank on the creation of its poverty reduction fund.

With degrees from Williams College (master's in development economics) and Boston University (doctorate in economics), Husain also graduated from the joint executive development program of Harvard University, Stanford University and INSEAD. He spent much of his earlier career with the World Bank, including as head of the Debt and International Finance Division and chief economist of the East Asia and Pacific region.
Author of numerous books and monographs including "Pakistan: The Economy of the Elitist State" (Oxford University Press, 1999), Husain is currently a member of the International Monetary Fund's Middle East Advisory Group and the United Nations Development Program's Regional Advisory Group; chairman of the World Economic Forum Global Advisory Council on Pakistan; and board member of the Benazir Income Support Program, the largest social safety net and conditional cash transfer program serving the poor in Pakistan.

In this recent interview -- conducted by Dr. Nupur Pavan Bang (, senior researcher, and Dr. Vikram Kuriyan, director of the Centre for Investment, Indian School of Business, Hyderabad -- Husain reflects on the introduction and development of Islamic banking in Pakistan, as well as risks faced by the conventional banking system, financial crises and the challenges faced by emerging economies.
Please give the historical background on the origin and development of Islamic banking in Pakistan.
The Supreme Court of Pakistan has an appellate bench that deals with Islamic laws. Someone approached this bench in 2000 and represented that the banking system in Pakistan was anti-Islamic, as it is based on usury and exploitative interest rates and Islam is against usury and exploitation. Thus, the banking system should be declared illegal. The court decided that by June 30, 2001, all banks should conform to Islamic banking, and the existing banking system should be abolished. I was astonished because the repercussions on the economy of such a drastic measure were not fully realized. The economy would have been completely dislocated if a change of such a magnitude was implemented in a short period of time.

As central bank governor, I formed a commission for the transformation to Islamic banking. The commission comprised academicians, practitioners, bankers and Islamic scholars. It recommended that there should be a parallel banking system that allows Islamic banking to coexist with conventional banking. The choice would be available to consumers to shift from conventional banking to Islamic banking if they wished to do so. If every consumer decides Islamic banking, it will emerge in the country. I persuaded the cabinet and the president that we would implement the Supreme Court decision in a practical way that did not adversely affect the smooth functioning of the economy. The decision ought to be taken by 28 million customers whether they wish to opt for Islamic banking, and not by the government or the central bank. On this basis, we introduced Islamic banking in 2001 and provided the regulatory framework.

What options were available to the public?
We decided that there could be three forms of Islamic banking. First, full-fledged Islamic banks could be established and licensed if they met the prescribed criteria. Second, conventional banks could set up a subsidiary bank that would be totally separate in terms of deposits, assets, balance sheets, etc. Third, the conventional bank can have Islamic banking windows that operate independent of the conventional bank without any commingling of deposits and assets. They would offer only Islamic instruments and products to the public. Meezan Bank was the first to apply to become a full-fledged Islamic bank, and it was granted the first license. It has since done extremely well with innovative products, services and staff. It is the market leader with a one-third market share.

What is your view on Islamic banking in the context of the recent crisis?
There are two characteristics of Islamic banking which distinguish it from conventional banking. One is that every transaction has to be backed by real assets. Every loan should be backed by collateral such as real estate, business, etc. You cannot create wealth or money without associating it with real wealth creation.

Second, the borrower is a partner in the business in which the bank has invested as financier. There is no guaranteed fixed rate of return. If the business is not doing well, the bank will suffer along with the account holder. In contrast, conventional banks offer a fixed return to depositors. The bank has to pay interest irrespective of the performance of assets.
In Islamic banking there is no predetermined interest rate. The rate is determined at the end of the year based on the profits and losses. These distinguishing features of Islamic banking, if applied to International banking, would have avoided the possibilities of panic, failure and crisis. The fact is that Islamic banking is too small and insignificant to contribute to the safety of the international banking system, because 98% of the banking is done in the other way.

What major reforms are necessary to prevent future crises?
First, there should be separation between trading and retail banking, because banks have become trading platforms putting the depositors' money at risk. Assets are piled up, and buying and selling happens at prices which are not related to the intrinsic value of the underlying assets. That is what the Dodd-Frank legislation and the Volcker Rule in the U.S. are about -- that client-based trading should be separate from proprietary trading. Proprietary trading should be carried out separate from the main bank and limited in scope.

Second, the bank should have adequate capital. In manufacturing and services sectors, 60% to 70% is shareholders' money and 30% to 40% is borrowed. The financial services business is quite different. Shareholders' equity is 7% to 8%, and 92% of the money belongs to depositors. If shareholders take excessive risk with the depositors' money, the upside gains are captured by the shareholders and managers, and the depositors don't get anything extra. But, if they lose money, taxpayers have to bail them out. This asymmetric relationship in incurring risk and appropriation of reward makes the financial sector more vulnerable to exogenous shocks. Indian and Pakistani central banks had tough regulations, and thus their banking systems survived during crises. This was not the same in the U.S. and Europe.

What are your views on Basel III?
I believe the capital and liquidity buffers are appropriate, but the risk-weighting schema needs to be carefully reviewed. Internal models do not always adequately capture the risks assigned to different loans, and the supervisors have to develop the capacity to test the veracity and accuracy of these internal models by rigorous stress testing. Risk management systems and internal controls within the banks, particularly the systemically important institutions, have to be strengthened and examined from time to time.

What can the emerging markets learn from the crisis? Can it happen in India and Pakistan?
The crisis can happen there if financial institutions are not continuously monitored and supervised. It is asymmetric risk taking in the sense that all positive gains are preempted by shareholders and managers and losses are borne by someone else. Therefore, government regulation becomes important. This was not done in the U.S. and Europe. In India and Pakistan, shadow banking was not allowed to emerge, exotic products were discouraged, and cautious liberalization was pursued in respect to capital account opening. These are the safeguards that need to be observed.

A lot of countries are facing very high debt-to-GDP ratios and fiscal deficits. Are populist politics and subsidies to blame?
The starting point and initial conditions of a country determine what policies need to be pursued. The current debate between fiscal and monetary stimulus versus fiscal austerity cannot be taken as an abstract proposition, but rather in the context of prevailing circumstances. If Spain has half of its youth unemployed, fiscal austerity measures over an extended period of time will become politically and socially unacceptable. Japan, despite having a very high debt-to-GDP ratio, has recently decided to embark on monetary easing because for the last 15 years the economy was trapped in low-level equilibrium and was not able to come out of it.

Is austerity the answer?
No. Lending standards by the banks should not be compromised, and credit should flow to the private sector to stimulate the economy if public sector imbalances do not permit this. We should not overextend and must learn from the subprime mortgage crisis. Why should we give a loan to a person who does not have income to qualify for a loan? The lenders were assuming that the price of housing will keep on going up and the owner's equity in the house will be built up, enabling him to repay the loan. That was a wrong premise -- it was unrealistic to expect a unidirectional movement of housing prices.

What about regulatory and political challenges in emerging markets, particularly South Asian countries?
South Asian countries must strengthen their supervisory and regulatory bodies. There should not be a division between the central bank and supervisory authorities. The Financial Services Authority model in England that everyone cheered did not work out, and supervision has gone back to the Bank of England. This is because the central bank has information both at the macro and micro level, but the FSA had information only at the micro level. They could not use macro-prudential regulation to supplement the micro-prudential measures. Furthermore, they did not have bank resolution authority that the Bank of England had as the lender of last resort. Likewise, South Asia should strengthen its central banks and not have separate regulatory bodies.

Is Africa the next BRICS? Which countries might investors look at favorably?
Africa has done remarkably well in the last decade. It has grown at 5% a year on average. And this pattern was not limited to the commodity- and oil-producing countries, but also encompassed Ghana, Kenya, Tanzania, Rwanda, Mozambique and others. Investment opportunities in Africa are enormous, and the first-mover advantage will certainly help.

What challenges does Africa face as the next investment destination?
Political instability and fragility of institutions of governance continue to pose serious risks, although this varies from country to country. Investors have become more discerning; they do not treat Africa as a monolithic, homogeneous territory and are selective in their choices. The effect of these choices on the countries that are left out is positive, as they also take measures to improve their policies and business environment.

Financial inclusion and financial literacy are challenges for many emerging nations. What is the way out? Do multilateral organizations like the World Bank and IMF have a role to play?
I think the multilateral institutions can only provide the lessons of experience and exchange information as to what has worked and what has not in some countries. The primary responsibility for raising awareness and financial literacy remains with the central banks and governments. The conditions of each country differ, and therefore the solutions have to be tailor-made and specific.