In the race between greed and stupidity, the latter always wins - Straight from the Hip by J Mulraj
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Investing in India - Straight from the Hip by J Mulraj
In the race between greed and stupidity, the latter always wins A  A  A

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11 OCTOBER 2008

The crash in global stockmarkets is going to lead to a lot of introspection about the causes and action in changing the financial architecture to prevent its recurrence. We in India tend to forget to do this and move on, after the crisis has blown over, with our daily lives. Those who forget the lessons of history are doomed to repeat them. One wishes that SEBI and other regulators would have a debate over the way we manage some of our financial markets.

Take mutual funds. Assets under management of mutual funds are Rs 5 lac crores, which is significant. Fund managers often have a fixed component and a variably pay component, linked to performance compared to a benchmark index. So if, e.g. the Dow had gone down 30% in a year but the fund only 28%, the management team would get a bonus! If this has happened in India, SEBI ought to think whether there is a better way to compensate fund management teams with an element of incentive to induce performance, without rewarding those who lose money for investors. One idea is to have all those involved in management of funds (including directors of AMCs/Trustee companies as well as the fund management team) to put a part of their fees/earnings into the fund so that their interests are aligned with the fund performance. Another is not to reward performance where investors lose money.

Rewarding on the basis of relative performance reminds one of the two trekkers who encounter a wild bear in the woods and decide to run for it. One of them starts putting on his jogging shoes. When told he could not hope to outrun the bear with jogging shoes, he stated that he didn't need to; he only needed to outrun the other guy! It makes one wonder if the 'd' is silent in mutual fund!

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Another area that needs thought and clarification is what I call an assumption mismatch. When mutual funds are sold, they are sold on the basis that fund managers are better equipped than individual investors to decide which of the over 6500 listed stocks to invest in. When a market hits a peak, investors assume that the fund manager would also be better equipped to bail out. However, the manager assumes that the responsibility for bailing out vests with the investor, as it is he who makes the asset allocation decision. There is thus an assumption mismatch, and it is the investor that suffers for it. At the very least, SEBI ought to bring this mismatch to the notice of investors. The suggestion made above, viz. to align the interest of fund management with that of investors by ensuring that some of the assets of the former are invested in the fund, could also help here.

SEBI should also review here, whether its diktat of % investment in equities is hurting or helping. Equity funds are required to maintain 75% of assets in equities and can only hold cash to the extent of 25%, on pain of losing tax exemptions. This also provides an excuse to fund managers not to exit whenever they feel the market has overheated. They hide behind the law.

Interestingly sector funds are allowed to go even fully into cash if they do not see worthwhile investing opportunities in the sector, if they have so disclosed it in their IPO, as has Reliance Power fund, for example. But diversified equity funds are not allowed to hold more than 25% in cash.

This restriction, combined with the linking of fund manager pay to relative performance, leads to lemming like behaviour. Fund managers tend to invest in similar manner, for fear of being bested and so earn smaller bonuses, and tend to exit simultaneously.

There also needs to be some thought on how to popularise closed ended funds. Open ended funds have become popular because of the ability to exit any time at NAV. However, this limits the ability of a fund manager to invest for a longer term and thus creates short termism. This short termism, combined with shareholder pressure for quarterly performance, converts itself into short term outlook by industry managers. It is this that destroyed Lucent Technologies, the erstwhile famous Bell Labs of AT&T, renowned for its innovation.

IDBI AMC had once floated a quasi closed ended fund, with bi-annual exits at NAV provided by the bank. Some such ideas could be floated. Perhaps some additional fiscal benefits could be offered to investors who invest in 3 or 5 year closed ended schemes.

The reason is that we have not developed long term sources of funds. Long term lending (such as mortgages) require long term funding which comes from insurance companies and pension funds, ie. institutions that have an annuity stream of income. We have been slow in opening up the insurance sector and are still dragging our feet over pension reform. Thus if a commercial bank gives a 15 year mortgage, it finances it with short term deposits, hoping to roll them over, or depending on interbank borrowing to tide over crunches for short duration. In a crisis such as this, when banks are scared to lend to each other, this creates a liquidity problem.

Another thing SEBI ought to mull over is the inability of individual investors to sell short. The old, discredited, 'badla' system permitted this, under the control of the stock exchange; the new F&O system does not. The 'futures' part of F&O is too risky, with mark-to-market requirement and the 'options' part of it is mispriced, leaving little on the table for the investor except in very volatile moves. Institutional investors, meanwhile, are able to borrow stock and arbitrage between markets. The more sophisticated also take advantage of interest rate differentials.

The global mess has been created by unrestrained and unsupervised financial innovation that created, through a whole host of derivative products, layer upon layer of funny money. In an Economist (Oct 9) survey of the world economy, the Bank for International Settlement estimated the value of outstanding derivative contracts end 2007 to be $600 trillion, which is 11 times global GDP! It has grown, in the past decade, from $75 trillion, then 2.5X global GDP. This problem is going to take some time to unwind, despite the enormous attempts by central bankers to ease it by pumping in huge amounts of liquidity. The RBI cut CRR a further 1% last week, on top of the cuts last week, but it didn't help stabilise the market.

The freeze on money flow is impacting the real world. Prices of steel have fallen 20-70%, of iron ore by upto 50% and the Baltic Dry freight index has dropped 86%, largely because of inability to open letters of credit. Oil has dropped to $ 70/b and prices of zinc, aluminium and other commodities are down.

Domestically, airlines are in dire straits, and are making huge losses due to untenable cost of aviation turbine fuel which bears an extraordinary burden of taxes. Jet and Kingfisher announced an alliance under which they would co ordinate flights to remove excess flights to the same destination. They hope to surrender surplus aircraft to lessors and to terminate services of staff, to bring down costs. Jet, which terminated 1900 employees, was compelled to take them back after huge protest. It has a large outstanding liability to IOC for jet fuel. So has Ministry of Finance, to IOC/BPCL/HPCL, for oil bonds to compensate them for subsidies on petro products that belong to the Budget but are loaded to oil marketing companies to hide the true fiscal deficit. Air India, now NACIL, has offered 15,000 employees the option of a 5 year leave without pay.

Goldman Sachs feels that the fiscal deficit would go up from 6.2% of GDP in 2007-8 to 8.4% next year. Whilst revenues are holding up, expenditure has gone through the roof, thanks to the Sixth Pay Commission, the NREGS, the rising subsidies on petro products and fertilisers and the farm loan waiver.

Last week the BSE-Sensex fell 552 points to close in 4 figures after 24 Feb 2006, the first time it closed above 10,000. It ended the week at 9975. The main contributors were Reliance (229 points of the fall), ONGC (85) and L&T (67). The NSE-Nifty fell 205 points to end at 3074.

Technically the market is oversold and 9800 is a support level, from where it had bounced in June 2006. But will it rally? The global situation remains bad because distressed assets are yet to be fully discovered. Also domestic politics comes into play. There are two money bills which are to come up in Parliament and if these fail to get a majority vote, the Government falls. And some MPs from Tamil Nadu, whose support is crucial for the Government, have resigned, asking the Government to pressure Sri Lanka to cease fire in its war with its Tamilian minority.

So investors should accumulate stocks at prices they are comfortable with, without chasing prices up. The market would move sideways, or slightly lower still on global factors, for a few months.

J Mulraj is a stock market columnist and observer of long standing. His weekly column on stock markets has run for over 27 years. An MBA from IIM Calcutta, he has been a member of the BSE. He is Conference Head - India, for Euromoney. A keen observer of events and trends, he writes in a lucid yet readable style and takes up issues on behalf of the individual investor. Nothing pleases him more than a reader who confesses having no interest in stock markets yet being a reader of his columns. His other interests include reading, both fiction and non-fiction, bridge, snooker and chess.

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