The risk of investing in the wrong product

For direct-investors into equities, how can the risks be reduced to some extent? Should they even look at equities in the first place?
Retail investors should definitely look at equity markets to enhance their savings over the long-term, be it through direct-investing or through equity mutual funds. Comparisons across countries on inflation-adjusted returns from asset classes show equities outperforming debt, gold and real estate in the long-term, despite its inherent volatility. This is all the more critical since most developing countries undergo high rates of inflation during their growth-phase, and hence investing only in bank deposits can be wealth-dilutive in terms of future purchasing power.
The key word here is long-term. A challenge for deepening direct retail participation in equities is that retail interest is mostly geared towards short-term gains using intraday, futures and options and short-term delivery. This is a sure-shot way of reducing his longevity, if that money forms a portion of his savings which he can ill-afford to lose. Retail should have a long-term bias so that they realise equity appreciation. Short-term trading should be restricted to High Net Worth Individuals (HNIs) who have a higher risk appetite, and have allocated capital for each investing style. The capital for short-term trading comprises a smaller portion of their corpus, and so it has a limited impact on the overall portfolio. If brokers look at overall trading volume from HNIs vs. retail in most markets, then HNIs do form a substantial portion of that pool.
Investor education is important to reduce the risk of investing in the wrong product. Awareness of capital market products is still low. In most cases, the investor needs to be made understand why this is important, to avoid negative surprises later. The correct product should be based on investors' savings, spending, risks and goals. Brokers may lose some business in the short-term, but it might build a lasting participant base in the long-term. Education is also critical since capital market products are non-discretionary spends. This means that most do not yet feel the need to demand this, unlike food, garments or phones. People have to be made aware of the necessity to invest if the market has to deepen. Many developing countries see low propensity to save, where long-term savings is actually needed since governments hardly provide social security. People have to be made aware why they should invest some savings in capital markets, including diversifying risk through mutual funds, holding for long-term, financial planning and asset-class balancing, if they have to reduce the risks and create long-term wealth.
To address volatility risk to some extent, brokers may pitch basket of stocks based on specific styles/themes, rather than just individual scrips. That might reduce single-stock risk. Retail often falls prey to 'herd-mentality' in calls, which accentuates volatility further. Uncertainties over corporate performance can be reduced by addressing regulations, approvals and delays. Information access through computerised trading offers real-time price discovery, limits arbitrage-thrillers and reduces impact costs. This includes broker terminals and online trading platforms. Online platforms have made trading convenient irrespective of location, time or on-the-move. Information access includes financial portals, business news channels and magazines dedicated to provide analysis and insights. Transparent reporting and corporate governance would reduce risk of information opaqueness. Equity derivatives might add to market volatility, and so brokers need to target F&O only to clients best suited for this. Any speculation by low-risk clients will reduce longevity and brokers will constantly need to replace them with new clients.
If equity risk is absolutely unacceptable, capital market also includes fixed-income debt market for direct investors. Corporate debt instruments are picking up to complement bank credit. Those searching for lower risk-levels can look at long-term bonds and debentures.
Is financial planning and advisory absolutely critical to achieve the objective of long-term wealth creation through capital market products?
Our countries are largely financially-illiterate, although meaningful pools of money exist. Financial planning would help channelise this money into products based on the investors' objectives, abilities and profile. We stress the importance of investor awareness regarding capital markets. That is all the more reason why planning is needed to deepen this market. But planning has to be based on an AUM-based incentive. In comparison, commission-based incentive can create a bias for products that give the best commission, but it may not be the best for the investor. That leads to negative surprises and early redemptions. Instead, AUM-based structure works best to enhance the investors' assets.
Timing the market is where the self-investor often goes wrong, i.e. sells low and buys high. Once they burn their fingers through wrong calls, the self-investor often ends up delaying decisions in further calls to avoid similar instances. This inertia expands the downside risk even further. Advisory might enable action on the correct calls at the correct time, and realise upside. This includes both buy and sale calls. Sitting on loss-making, low-grade stocks is a psychological feature of retail. They hope that prices would rise eventually, which rarely happens. In the process, they forgo better investment opportunities had they only liquidated their low-quality stocks and redeployed into better scrips.
Financial advisors and planners also help sensitise investors about new products. Savers in many developing countries favour physical savings over financial savings. However, innovations have today married physical savings with financial products - like Gold ETFs and REITs (Real Estate Investment Trusts). Awareness of these products is still low, and advisors can help here. India saw tremendous interest in Gold ETFs as awareness picked up. Innovations have moved up further in REITs. While traditional REITs invested in income-generating commercial properties, the lack of housing stock made Kenya think of Development REITs, which invests in developing residential housing.
What trends can frontier markets expect from foreign institutional flows into local capital markets?
For brokers, foreign institutional flows into equity markets (foreign portfolio investors) are a battle for market share. This is unlike retail flows where the focus is also on increasing the market size. Global allocations are decided by the asset manager for the respective countries the fund takes exposure to, often based on MSCI or FTSE indices. Each broker has to maximise his market share within this allocation. However, funds may decide to go underweight or overweight on allocation depending on market conditions, which may impact the overall allocation.
What this means for deepening the local capital market is that the flow per fund is restricted based on the allocation. Hence, expanding the foreign investor segment will depend on increase in the number of funds, rather than flow per fund. The universe of global funds investing in frontier economies currently comprises of broad FM funds, Asia FM funds, rather than country-dedicated funds or focused-geography funds. As the FMs perform, there will be a trend towards country-dedicated funds. For example, the main categories of global funds looking at India include broad EM funds, Asia Pacific ex Japan funds, BRIC funds and India-dedicated funds. The India-dedicated funds and focused BRIC funds materialised only when global investors built faith on the Indian economy and hence saw a rationale. Some funds might be index ETFs making asset allocations and chasing market returns during upcycles, while some would be actively-managed funds chasing stock-picks to earn alpha. In most cases, the active funds would benefit the local markets in the long-term, since ETF flows can fluctuate based on asset allocations.
While enabling economic transformation depends on the local government and industry, the local capital market community can play a role in disseminating their country's story and the analysis of the investible themes/ sectors/ stocks to the global investor community through corporate roadshows, analyst meets and engagements with global fund managers. Today, fund managers are swamped with information on various geographies. They don't need more information. But they do value insights, ideation and analysis which help them pin-point specific opportunities. This means creating value-addition through research, sales-trading and corporate access. Value-addition through research delivers thematic ideas, investing ideas, business trends, industry voices, sector and company analysis, as well as supports funds in their own analytical work. Value-addition through sales-trading means having an adequate base of institutional investor relationships to facilitate trades in slightly illiquid counters, as well as block trades. Value-addition through corporate access means getting investors to meet the who's who of the local government and companies so that they get better updates on what is happening on ground-zero. To support these initiatives, brokers have to invest in research and ideation skills, large-trade abilities and building institutional relationships.
Another factor that influences the growth of country-dedicated funds is the aggregate portfolio volatility of the whole basket. The correlation between the countries in any emerging basket is low initially, since the linkage between them is low. What impacts one hardly impacts the other! This means risks are localised and aggregate portfolio volatility is low. However, as the economies grow and its global linkages increase, they become susceptible to global shocks. This impacts portfolio volatility and fund managers see a rationale to develop country-focused funds.
Foreign investment in projects (strategic FDI) through foreign-owned companies, joint-ventures or inward acquisitions is critical as it increases the supply of companies for the future and improves market activity when they unlock value. Investment banks should look at QIP route for capital-raising. QIPs leverage on institutional investors, where the retail interest in IPOs is low. IPOs themselves have to be fairly priced, otherwise it impacts eventual returns and reduces interest from subsequent issues. Predominance of family-owned businesses is a challenge for investment bankers and private equity funds, since family promoters are resistant to stake dilution. Private equity in itself can be a useful route to expand the corporate base, as they bring in global experience in similar industries, strategic alignments and management inputs. Local regulators also need to put in place guidelines for offshore-fund structures, including Master-Feeder structure and simplify the fund-raising process. Tax treaties with countries to avoid double-taxation would help. The market also needs to deepen liquidity for scrips by developing market-makers, who act as valuable counterparties for trade.
Some of the imperatives needed from the government and regulators?
Facilitation to companies through single-window clearances and access to foreign capital by addressing taxation/repatriation come to mind. Things that scare investors - like changing regulations retrospectively, corruption in governance or changes in guidelines with a change in government, are best avoided. Political instability and insurgency extremism become challenges but global investors and countries which counter these challenges will benefit. The economic performance and state of public finances will also be monitored, a reason why Vietnam or Bangladesh looks better. Regulations need to move with fixed deadlines in place, and all the working and sittings of the committees need to work backwards with that deadline in mind. Only then can these countries deliver on required regulatory changes in time.
The capital market industry itself needs to be well-regulated. Low-quality institutions can be counter-productive to deepening the market. This includes increased roles to self-regulating organisations (SROs), as well as fast action on any malpractices so that investors' faith is not shaken.
Any last thought on any imperative needed as the markets deepen further?
Manpower supply is worth mentioning as an end-note. This includes leadership which brings insights of what works and what may not, as the markets expand. This includes advisors with client relationships. This includes analysts with research skills and institutional relationships. This includes B-School faculty with industry-experience, who train the next generation of management graduates. This includes data analysts who can provide business intelligence to assist strategic decision-making. This includes training in soft-skills, as well as product training.
Competition is high. A lot of countries, and asset classes within each country, are fighting for foreign and local monies. Countries which do not act fast to put necessary rules and facilities in place will lose out. Nifty future on Singapore Exchange is an example, which has taken away trading market share from NSE's Nifty future because NSE has been slow to respond. Every market has its own unique challenges, irrespective of its stage or maturity. Investments into expanding the market's capacity can be calibrated at a realistic pace to test the market and reduce upfront risk. However, investments cannot be frozen totally as competition will not wait.
The author is a finance professional based in Mumbai, India. Views expressed are entirely personal. sourajitaiyer@gmail.com