Deepening capital markets in frontier economies

As the growth expectation in most frontier-economies improves, what is the first step that can help translate this growth into increased capital market activity?
The first would be looking at what one is selling. This means the supply of good-quality, growth-realising and professionally-managed companies into primary and secondary capital market. That will strengthen what the market is offering to investors. A bad product can break the market, irrespective of efforts of market players. This supply should move in line with the economies' growth. Otherwise, some investor activity may flow into low-grade companies, which would reduce their longevity. Broadening the base of quality companies will help focus most of the investor activity solely on that base, and evince greater interest from both existing and new investors.
This would require creating an ecosystem around competitive advantages, entrepreneurship, growth capital, regulations, foreign investments and technical partnerships. Frontier economies are identifying areas of competitive advantages, which leverage on domestic demand or global sourcing. It includes sectors where production-migration can occur if cost-effective resources are available locally. An example is Indian software sector, where production migrated from the West since India offered cost-effective skills. Competitive advantage provides a rationale to invest and create enterprises for future growth. Countries with limited physical resources should tap intellectual resources. Offshoring (KPO/BPO) is a sector which India has capitalised on. Mid-sized countries are partnering to tap complementary resources and create broader production platforms. Many frontier economies lack high-end manufacturing technologies, restricting its ability to diversify. Including technology-transfers within foreign investment agreements may help, but this really depends on bargaining power. Investors prefer companies which develop a differentiation to capture market share ahead of peers, as that stretches its long-term potential. Fostering entrepreneurship would require a change in the society's mind-set of viewing it as a career option, institutionalised incubation support and growth capital through private equity or VC funding, with the aim to list eventually. Sunrise sectors based on production-migration need to encourage non-residents experienced in those sectors to return from abroad, as their experience would be invaluable to build those businesses locally.
Listing of only a handful of quality companies for capital raising and trading can transform the interest level in the markets. In India, it took few quality companies like Infosys, TCS, Airtel, Hero Honda, HDFC, etc to list since the 1990s and take market activity to the next level. Today, technology is the 2nd largest sector after banking, and holds 15 per cent of India's US$1.5 trillion market capitalisation. Twenty years ago, this sector did not even exist. Primary market activities have been a useful entry point for new retail investors into the markets in many countries. Hence, large-size issues of good-quality companies would give a definite fillip to addition of new demat accounts and aggregate market activity.
Earnings growth of these companies will be the main yardstick that sustains long-term interest in equity markets. Price appreciation comes from earning growth and multiple expansion. Multiple expansion is good to some extent as it reflects market optimism. But beyond a point, it suggests overheating and limited upside for new buyers. Earning growth reflects the fundamental performance. It supports the multiple within reasonable range, helping continued interest from newer investors. Frontier economies also need to look at dividend policy. Dividend is the only return that value-investors realise as they buy and hold for long duration. Brazil has already initiated compulsory payouts from profits.
It is worth remembering that the opportunity a country offers outranks other factors influencing investment flows. This includes ease of doing business, where a frontier market like Bangladesh actually ranks higher than an emerging market like India. India may have an opportunity advantage in sectors based on domestic demand since Bangladesh's population is 13 per cent of India's. But global sourcing opportunities in each one's area of competitive advantage can be on a more equal footing. Size of the local market is inconsequential here, since it depends more on procuring resources and building an efficient production. Many of India's competitive advantages are in global sourcing opportunities.
Is it better for retail to enter capital market through asset management route rather than direct-investing? What should be the focus areas for firms to capitalize on this opportunity?
This writer is a firm believer in institutionalisation of retail savings into mutual funds. Provided the investor does not redeem units in the short-term, this has a better chance of realising long-term wealth from capital market. A reason for retail's short-term bias is the lack of faith and understanding in the scrips which a fund manager can judge better. But this requires the investor to place faith in the fund manager's skills.
To mobilise retail savings, open-end mutual funds often work better than close-end funds or ETFs. The allocation a retail saver can make into funds has a limit. In most cases, he saves from a salary. However, he can invest this limited allocation periodically each month. This salary would increase over-time, increasing his ability to allocate over-time. More employees are entering jobs each year, and each would have the ability to allocate a portion of earnings. All this means that the fund should enable accepting additional inflows on a periodic basis as people's income increases, monthly income accrues and as more workers enter. The ability to allocate increases over-time. Facilitating this would expand the fund's assets and the aggregate mobilisation into capital markets. This includes intermittent, lump-sum investments and systematic investing plans (SIPs). In comparison, the assets of a close-end fund or ETF focused on retail get restricted to the inflows from the offer period.
Close-end funds bar subsequent inflows even if people get the ability to invest. ETFs require making demat accounts, which can be perceived as additional paperwork. Open-end funds can reach a larger base, as it does not require a demat account, which is in itself a small base. Restricting the ability of expanding the asset base is counter-productive to make a scalable and profitable asset management industry, especially in markets where investor awareness about sophisticated products like ETFs and close-end funds is still evolving.
Firms, which combine asset management with stock broking, can gain from the funds' annuity income, to support the cyclical broking income. Asset management is a business of scale, and the expansion of assets through open-end funds can be a focus area to maximise annuity fee.
Firms need to build a suite of differentiated funds aligned to market conditions and investor preference. That means the assets can be switched between own-funds depending on situations, and the value-creation from the assets remains captured within the group itself. On the other hand, too many 'me-too' products end up confusing the investor. Apart from staple funds, firms might look at category/styled funds based on themes, cycles, sectors, opportunity, geographies, volatility, etc. Unlike an index or market cap based product which captures all scrips, category funds can leverage only those scrips exhibiting a certain rationale.
One may try 'market-leader' fund, which captures well-managed, market-leading companies across sectors, 'Value Buy-and-Hold' fund which captures value-picks expected to realise growth over the long-term, or 'Global-Access' product which gives exposure to foreign equities like the USA, Europe, India, etc. Global equity products help benefit from growth stories of those countries, plus can be a useful cushion when the local country is undergoing economic stress relatively.
However, global-access structures would need regulations on compliance, KYC, taxation, repatriation, etc. At another extreme are 'Niche' funds, which concentrate on specific niches seeing local demand. Entertainment is a popular niche in Asian countries. Niche funds might be invested in content production, although this is more practical on the private equity side rather than for mutual funds.
Does that mean close-end funds or ETFs are not useful then in evolving markets?
They are useful products, provided they are used for the right objective. ETFs can be useful products for asset allocation, especially for hard-to-access asset classes or to invest at low costs. Enabling access to hard-to-access assets is a reason why gold ETFs or foreign equity ETFs based on Nasdaq 100 or Hang Seng became popular in India. ETFs were convenient platforms to benefit from such assets which were otherwise not easily available. These are also useful for institutional investors, to get allocation at low cost. Core-satellite portfolios of institutions often combine high-risk assets with active funds in satellite positions to generate alpha, and low-risk assets with low-cost ETFs to balance the risk and costs. Institutions also use ETFs for short-term, tactical positions to gain from changes in market conditions. Subsequent inflows into ETF assets occur mainly from institutions, as they have the ability to pay the huge amount for a creation-unit. This is a basic reason hindering subsequent inflows from retail investors into ETFs, curtailing its asset size unless it was able to generate the threshold corpus during the offer period itself.
Close-end funds are useful in terms of efficiencies in asset utilisation. However, in nascent capital markets where awareness and interest are low, close-end funds often end up trading at severe discounts to NAVs. Traders in developed markets latch on to funds trading at discounts, expecting that market prices would eventually trend closer to the NAV and they can book gains. But this opportunity may be restricted in nascent markets, unless the trader is prepared to hold till maturity when he redeems at NAV.
But that means locking in the capital. If the fund over-shoots its deadline, that would be an added risk. Fund trading at discounts may also impact the initial interest in newer close-end funds, since human nature always loves buying anything at a discount later rather than paying the full-price upfront. In developing countries looking to mobilise increased savings into funds, close-end funds cannot accept subsequent inflows even if savers gain the ability to allocate later. The fixed tenure means that long-term savings is not possible unless there is a new fund available right around that redemption date.
The author is a finance professional based in Mumbai, India. Views expressed are entirely personal.
sourajitaiyer@gmail.com