Deepening capital markets in frontier countries – Part 3

By Sourajit Aiyer

A version of this article was originally published in Financial Express, Bangladesh in December 2014.

The first part of this article looked at the areas of competitiveness that frontier countries can use as building blocks for their capital markets, while the second part investigated ways to invest and the best instruments to use.

This third, and final part looks at whether equities are the best asset class for investors frontier countries and what else is needed for the development of capital markets.

People have to be made aware of the necessity to invest, if the frontier countries’ capital markets are to deepen. Many developing countries see low propensity to save, where long-term savings are 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.

For direct-investors into equities, how can the risks be reduced? Should they even look at equities in the first place?

Flows of money into equities

Capital flows into equities have fluctuated. Source: Bank of America Merrill Lynch

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 their 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 way of reducing the investment’s longevity, if that money forms a portion of the investor’s savings which he can ill-afford to lose. Retail investors should have a long-term bias, so that they realize 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 understood why this is important, to avoid negative surprises later.

The correct product should be based on investors’ savings, spending, risk 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.

Another issue that could scare investors — even the more sophisticated ones — is the risk of volatility. To address volatility risk to some extent, brokers may pitch baskets of stocks based on specific styles/themes, rather than just individual scrips. That might reduce single-stock risk.

Retail investors often fall 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 computerized trading offer 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 or time and it can be done 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 futures and options 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 markets also include fixed income debt. Corporate debt instruments are picking up to complement bank credit. Those searching for lower risk levels can look at long-term bonds and debentures.

The role of financial planning

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 channel this money into products based on the investors’ objectives, abilities and profile.

We stressed 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 assets-under-management-based incentives. Commission-based incentives 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 structures work 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 realize upside. This includes both buy and sale calls.

Sitting on loss-making, low-grade stocks is a psychological feature of retail investors. 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 sensitize 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.

The role of the government

What are 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 also scare 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 Organizations (SROs), as well as fast action on any malpractices so that investors’ faith is not shaken.

Manpower supply is worth mentioning as an end-note. This includes leadership who bring insights of what works and what may not, as the markets expand. It also includes advisors with client relationships, and analysts with research skills and institutional relationships.

B-School faculty with industry-experience, who train the next generation of management graduates, are also included here, as are data analysts who can mine business intelligence to assist strategic decision making. Trainings in soft skills, as well as product training, is necessary.

I will conclude by saying that competition is high. A lot of countries, and asset classes within each country, are fighting for foreign and local monies. Countries who 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, the investments cannot be frozen totally, as competition will not wait.

– The author, Sourajit Aiyer, works with a leading capital markets company in Mumbai. All views are his own.