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 production­migration can occur if cost­-effective resources are available locally. An example is Indian software sector, where production migrated from the West since India offered cost­effective 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 mind­set 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 non­residents 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 over­time, increasing his ability to allocate over­time. 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 over­time. Facilitating this would expand the fund’s assets and the aggregate mobilisation into capital markets. This includes intermittent, lump­sum 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. Open­end 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 counter­productive 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 over­shoots 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.

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 inflation­adjusted 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 loss­making, 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 actively­managed 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  pin­point  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 fund­raising 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 counter-parties 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 counter­productive to deepening the market. This includes increased roles to self­regulating 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 end­note. 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 B­School 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 soft­skills, 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.

Image Courtesy: Reuters Blog

Originally published here –


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