Curb on liquid funds to ensure fair play

New Sebi ruling ensures fairplay for all liquid fund investors


New rules ensure that investors cannot get their units allotted till their money actually reaches the fund.

Last week, SEBI tinkered with rules that govern investments into liquid funds. The rule changes ensure that investors cannot get their units allotted till their money actually reaches the fund. Some fund companies have welcomed the move, while some have privately said that this will impact business. Which is not surprising because it has seemingly been a long time since SEBI made any changes that haven’t affected business.

The interesting part is that some regular liquid fund investors as well as their distributors are privately very unhappy at these changes. And since these people were the ones who had made it a practice to exploit a loophole in the earlier arrangement, I guess the new rules can said to be right thing to do. Basically, some investors had made it a practice of getting a day’s extra returns from their investments in such funds. And given the way fund investments work, these extra returns were not extra in any real sense. Instead, they returns derived from some investors’ money that were going to some other investors.

Liquid funds are prone to this sort of gaming because they are typically used for short term parking of cash by corporates. Each day’s return is highly predictable and safe and getting returns for say three days, on a two day investment can boost returns significantly. Up till now, when an investor invested, the fund companies would allot the units immediately, even if the money took a few hours or a day to arrive. To invest this money that did not exist yet, it would use bank credit for that short period of time. The cost of this credit was paid for by the fund, that is, other investors.

What is worse is that some investors would time their investments and redemptions (or switches) to other funds in such a way that they would get a day’s returns without having to deploy their money on that day. Systematically done, this could get you more than 450 days’ worth of returns in a year. The sad part is that in one form or another, this has been going on for years. Till March 2004, this used to be done by ‘pre-dating’ investments. In those days, if you were a large and favoured investor, you could give in a cheque at 5 o’clock in the evening and persuade the fund company to treat it as if it had been given earlier in the day, possibly even the previous day. In March 2004, SEBI brought in new regulations to enforce a cut-off timing. Now, this has been tightened further.

At the end of the day, it should be self-evident that the only fair way of running a fund is to not let one investor get gains from another’s money. It’s strange that enforcing this self-evident principle has proved to be such a struggle.

-- Dhirendra Kumar

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Strategies for a Bull Market

Protect downside risks as you profit from the bull run


The markets offer opportunities to profit at various points; play it to your advantage

The Indian equity markets have risen twofold since their lows of March 2009. The Sensex’s current PE (price to earnings ratio) is around 24, which is almost 33 per cent higher than its 10-year median PE of 18.10. Over the last one year large caps have given returns of around 23 per cent, but they have been far outpaced by the mid- and small-caps which have run up by 36 per cent and 49 per cent respectively over this period. Further, most of the market’s gains have come since the beginning of September: while it was up barely 2.3 per cent from the beginning of the year to the end of August, it has risen sharply between the beginning of September and the end of October.

After the latest run-up, the ‘C’ word (correction) is once again on investors’ minds. Moreover, the markets have been driven largely by inflows from abroad with foreign institutional investors (FIIs) having invested about US$ 22 billion in the Indian equity markets this year. Since the ghosts of 2008 have not yet been exorcised, another fear preying on investors’ minds is whether there could once again be outflow of foreign funds. Further, with the markets poised at high levels, the value investor’s task of finding undervalued stocks has become harder.

Against this backdrop, there are many questions on investors’ minds today: how should he go about booking profits? How should he protect his portfolio against a possible correction and at the same time continue to participate in the long-term India growth story? To read more about the eight strategies tweak your asset allocation, reduce exposure to mid- and small-cap, get rid of lemons in your portfolio, do a reverse SIP and more. To read the full story, pick a copy of Wealth Insight that details all the eight strategies for a bull market now.

-- Dhirendra Kumar
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Super Size Funds

In the Indian context, as of now, fund size has not posed to be a problem


The size of a fund really does not have much impact on its performance, however, a large-sized fund may lose flexibility

As the size of the fund increases, fund managers tend to back away from their flirtation with concentrated bets and are forced to court diversification. HDFC Equity, one of the largest funds in the country, is a classic case in point. In its earlier days, the fund would get by with just around 20 stocks. This was in December 1999 when its corpus was around Rs 50 crore. Its favourite stock - Infosys Technologies, had an allocation of 20 per cent at that time. Not so any longer. Seven years later, the fund’s assets burgeoned to Rs 4,000 crore and the number of stocks rose to 38 with the highest allocation at 9 per cent (December 2006). Currently, the portfolio now sports around 56 stocks with the highest exposure at around 10 per cent.

“When one migrates from a lower asset base to a higher one, the implied passivity increases,” says the fund manager of a fund that has crossed Rs 2,000 crore. “It’s not passive per se, as in the case of an index fund, but it definitely restricts agility when compared to a smaller offering.” He immediately stated that he did not want to be quoted in case his investors lose faith in him. What he is trying to say is that it is tough to liquidate a 5 per cent position in a large fund, but that would never have been a problem when his fund size was much smaller. Strong and swift moves are difficult to implement once the corpus starts ballooning.

Let’s say the fund’s portfolio is Rs 100 crore and the fund manager wants to bet on Stock A which is a small-cap, illiquid one. If he takes a 2 per cent exposure, it would amount to Rs 2 crore of the corpus. Now if the same fund manager is managing a corpus of Rs 1,000 crore, he might shudder at taking a 2 per cent exposure, because this time it would be valued at Rs 20 crore. The price impact of the trade would hold him back. He is more capable of buying and selling Rs 2 crore worth of stock without significantly impacting the price, than in the case of Rs 20 crore. So while the fund manager’s investing strategy does not change, it gets more difficult to execute certain ideas. Tactically, this poses to be a limitation. Moreover, the opportunities get more limited. A smaller fund, on the other hand, has a much wider universe and can take stronger bets. Taurus Starshare, during its heady days, for instance. Between October 2005 and March 2006, Jai Prakash Associates and Crompton Greaves tog ther accounted for 50 per cent of the fund’s portfolio, the maximum size of the portfolio touching Rs 155 crore. In January 2006, Jai Prakash Associates was the top holding of the fund with an allocation of 33 per cent. It did well that year and so did the fund. But on the flip side, the portfolio is also inherently risky when the fund manager takes such bold bets.

So a fund manager may have no problem in aggressively positioning his portfolio by taking huge positions in stocks, even if they are substantially illiquid, if his corpus is tiny. If his bets play out well, the returns could be fabulous. This leeway changes with the size of the corpus. In the September 2010 portfolios of equity funds, there were six fund houses that invested in Ahluwalia Contracts. When the stock price began to fall because of the controversy regarding the company’s role in the Commonwealth Games, a fund manager confessed to having a problem exiting the stock because of his substantial holdings.

-- Dhirendra Kumar

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Why do scandals and stock performances coincide?

There is a clear connection between scandals and stock underperformance


They are not only directly related, there is also sentiments at play

Two weeks ago, I wrote in this column about the Sensex getting back to the previous highs. At that time, I’d pointed out how some Sensex stocks had lagged far behind the general recovery.

Since that weekend, news headlines have been devoted to an astonishing variety of scams and scandals that have risen to the surface. As an investment analyst, I can’t help but note that the clear connection between the worst scandals and the Sensex stocks that have underperformed the most.

Since the market hit its bottom in January 2008, the worst underperformers have been telecom and realty stocks. And as we can see now, in both these sectors, nothing is as it seems. Is it just a coincidence that scandals and stock performance coincide? I don’t think so.

In telecom, for example, the severe erosion in value of the older companies has taken place because the erstwhile telecom minister drastically changed the competitive landscape almost overnight by bringing in a flood of operators. As an investor, whatever you could have projected was turned on its head because UPA coalition partner DMK’s goals and priorities took the telecom sector in an entirely unforeseen direction.

Something similar seems to have happened in real estate. Although the loan scandal is still unfolding as I’m writing this, it’s clear that the financing of realty companies was determined not by business considerations but their proficiency at bribing officials in banks and finance companies.

Basically, these companies were able to hold on to the absurdly inflated housing prices because they had free access to a pool of capital from government banks and finance companies.

As an investor, or as an investment analyst, it becomes that much harder to pick the winners from the losers when they are being picked not by market forces but in secret by politicians and officials. Of course, you could say that this is the way it always has been. As the promoter of one of the new ‘first-come first-served’ telecom companies told me recently, “X ab bahut shareef banta hai. Dus saal pahle isne kitna khila-pila ke licence liya tha,” where X stood for the well-known promoter of one of the established telecom companies.

How will this ever end? I’m not sure, but perhaps the answer lies not in the headlines of the scams that are breaking, but in the headlines from Bihar over these last few days.

-- Dhirendra Kumar

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Coal India changes nothing

IPO investing is no more a lottery; make sure you see value when investing in them


Do not draw the wrong conclusions from the Coal India IPO

The recently listed Coal India scrip has been a far bigger success than anyone had envisaged. However, it is important that investors do not draw the wrong conclusions from this. Unlike most issues in recent years, Coal India has had a robust subscription from retail investors. Given the state of the markets, it is also very likely that the stock will register good returns when it starts trading.

However, investors should not use Coal India as a guide to whether to invest in other IPOs to follow, whether from the public sector or from the private sector. The basics of IPO investing have not changed because of Coal India. Whether you make money from a particular IPO or not remains a toss-up that depends on how the general market outlook will be and how generous the promoters are.

To take a less charitable view, it depends on how scared the promoters and the investment bankers are of the issue bombing. For investors, the best combination is that of promoters and investment bankers who are afraid that the issue may not do well along with a robust market at the time of the stock listing. This will ensure a reasonable price coupled with a strong opening. In Coal India's case, this is exactly what has happened. The issue was probably priced reasonably because there was some nervousness about its massive size.

Going forward, this may not be the case. If there's an 'IPO season' up ahead, then investment-worthy issues will have to be selected carefully. The success of the Coal India IPO will doubtlessly encourage other issues to be priced to the hilt. Anyhow, none of this changes the basics of IPO investing, as it applies to individual investors. By and large, it doesn't make sense for individual investors to invest in IPOs. In India, we have this idea that IPOs are somehow especially suited for retail investors. This is an outdated concept that actually makes little sense, as I've written earlier.

There is nothing about IPOs that makes them especially suited for the casual retail investor. If anything, compared to listed stocks, IPOs are actually less suitable for such investors. The reason is simple. IPOs are lesser-known entities. The balance of power (in the sense of information) lies with the seller. The companies have not been in the public eye at all. Invariably, the promoter has spent the preceding months carefully building up an image to ensure that the investing public has a positive image. Unlike listed stocks, the financials haven't been scrutinised by analysts quarter after quarter for years. And of course, the price is the promoter's gambit, rather than one that has been through the price discovery cauldron of the market.

In the case of the government's offers for sale, this is even truer. In this case, while the promoter may not have been able to organise any elaborate window-dressing of the company, the money is not going to the company and is therefore not making any contribution to the improvement of the company's fortunes.

No matter how much of a sure bet an IPO appears to be, investors must approach it with caution. In the old days, it was possible that an IPO could go up by a huge margin on listing and never again be available at the original issue price. Such lottery tickets simply don't happen any more, least of all in a booming market. Each IPO should be evaluated on its own merit, and then most of them should be rejected.

-- Dhirendra Kumar

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Microfinance mess result of a deep malaise within

A market functions when there is symmetry of information between the buyer and seller


Take a good idea, a straightforward product and later take it in some direction which is completely contrary to the original purpose

A lot of people now believe that the microfinance industry is imploding. According to news reports, a large proportion of borrowers across Andhra Pradesh have stopped repaying their loans. It seems they are being encouraged to do so by politicians who are now competing to lead what they believe is emancipation from the evil of microfinance.

There is no doubt that microfinance operators have themselves created an opening for this. An activity that started off with an intention of transforming the lives of the poor now stands accused of being little better than the traditional moneylender.

The general formula seems to be to take a good idea and a straightforward product and then take it in some direction which is completely contrary to the original purpose. Mutual funds, insurance, housing finance are three major examples. Consumer loans of all kinds, currency hedging products mis-sold to exporters (including a lot of small companies), the list is endless.

Mutual funds were supposed to be a vehicle for encouraging retail investment into stocks, but a huge part of the industry's attention stays focused on short-term corporate business. Insurance was opened up because Indians had so little risk and life cover but the industry has become a weird mutant which avoids selling risk cover so that it can focus on abusively-priced investment products. Housing loans has become a vehicle for highly-leveraged speculation in housing, which itself has become a major factor that is driving up prices. The RBI has now had to enforce that borrowers put down a minimum of 20 per cent to try and reduce this. Last year, when the rupee made a sharp move there was a huge crisis because it turned out that banks, instead of helping exporters hedge against adverse currency movements were basically selling leveraged currency speculation products.

Of course, the financial services industry offers the excuse that this is a free market and customers freely choose what products and services they buy. This is bunkum. A market functions when there is symmetry of information between the buyer and seller. However, in each of the above, the financial types' energies are dedicated to creating an information gap, services which are designed to ensure that the buyer doesn't understand what he is buying. I think there is a deep malaise in the way these industries approach their business. I don't know whether it's the people, the culture, the incentivisation or what, but there's a widespread attitude that the customer is an idiot and his money is there for the taking.

-- Dhirendra Kumar

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Fairy Tales for Investors

Stick to the basics and do not lose sight of the fundamentals of the assets into which you are investing...


Emerging economies may become less coupled to the US over time but it will never be good for them if the US is doing badly.

The absurdity to which the game of short-term global stock punting has descended was made amply clear by the recent rally-and as of November 11-the sudden drop. Indian investors are understandably euphoric at the way the markets moved up decisively, and there's nothing wrong with that.

Nonetheless, I'd like readers to pause, step back and take an objective look at the reasoning behind what has happened in the world's stock markets over this short period. The centrepiece of this entire cycle of events is the announcement by the US central bank that the recovery in that country is now unacceptably weak and that they will unleash a huge flow of dollars to try and boost the US economy. The reason why the Fed is taking this route instead of the normal one of lowering interest rates is that there is no room for lower rates. US rates have been effectively been zero for a long time now. However, the global stock markets shot up as a result of this action by the Fed. In fact, the rally began days before the actual announcement because the step was widely anticipated.

The markets shot up because it was thought that with so much extra money flooding into the global economy, a good chunk of it was bound to find its way into assets like stocks, commodities, gold and other types of assets. Therefore, punters around the world bought heavily into practically everything.

Now, think carefully about what this whole chain of logic amounts to, if it can be called logic. Starting point: The US economy's recovery is very weak. Final effect: There was a heavy inflow of money into stocks and other asset classes, leading to a string upsurge in prices.

I don't know about you, but I detect something fundamentally wrong here. To buy into stocks because the Fed's excess liquidity will flow into assets basically amounts to relying on a side effect of a side effect of bad news in order to create a little temporary good news, a great 'story', to use the favourite word of today's investment analysts. Far from pointing to any underlying good news, it shows the complete dominance of what I'd call story-oriented investing. Make no mistake; the only people who make money in these short-term cycles are those who don't actually believe in the stories. They see a potential story, help develop it by buying early and then get out before the larger mass of investors realise that the story is just a story.

The US economy is the largest and the most important in the world and will remain so for a very long time indeed. Emerging economies may become less coupled to the US over time but it will never be good for them if the US is doing badly. There is no way that its poor prospects can be good news for anyone but the storytellers of this world.

To see what serious people think of the Fed's dollar deluge, you only have to read the news from the G20 meeting in Seoul where every other country, including India, has expressed worries about this liquidity causing problems for them. Investors should be cautious about these stories, stick to the basics and not lose sight of the fundamentals of the assets into which they are investing.

-- Dhirendra Kumar
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LIC: Of Notional Losses and Profits

LIC's discovery of short-fall in three of its guaranteed return scheme is of as much a concern as its guaranteed return promise


The real guarantee with LIC is its scale and size that makes it too big to fail.

Last week, there was this news item in a number of newspapers about the Life Insurance Corporation discovering (or admitting to, it wasn't clear which), a Rs 14,000-crore shortfall in three guaranteed return annuity schemes that it runs. This shortfall has come to happen because these schemes were launched with guaranteed returns of around 12% during the 80s and 90s.

Now, the fixed income returns that are realisable in the Indian economy are sharply lower and so there's a gap between what the assets in these schemes should be worth if they are to meet future liabilities and what they are actually worth.

In its defence, LIC has offered two mitigating factors - one, that these losses are notional. And two, the shortfall will be compensated by other plans - there are always some plans which have a surplus and some in deficit. This is encouraging to hear but nonetheless a little problematic.

Firstly, I think the experience of the 2008 economic crisis has made all of us a little sceptical of the actual nationality of notional losses. I often wonder why companies dismiss notional losses in such an off-handed manner while never managing to do the same for notional profits.

After all, if some schemes are always in deficit and in some in surplus, then the surpluses must, correspondingly, be precisely as notional as the losses. Why don't we ever hear a company management say, "Listen, don't pay any attention to all these gains we have on our investments - they are mere notional profits. They are irrelevant." Why this step-motherly treatment for notional losses alone?

In any case, the root cause of this gap doesn't sound notional to me. A gap between the returns that are guaranteed is not only real but more alarmingly is very likely to grow at an exponentially higher rate. Fixed income returns in India are likely to be lower than the 12% the schemes need in the foreseeable future. Quite possibly, the annual gap will be at least three to four per cent on a sustained basis. This means that the shortfall, whatever it is, will grow at a compounding rate. The guaranteed schemes yet have a few decades more to run. A three per cent p.a. gap will compound to 80% in twenty years and to 165% at 5% a year over the same period. It's very likely that the gap will always be a manageable proportion of LIC's total asset base, but it certainly will be a far from trivial amount.

Still, as an LIC customer, you needn't ever worry. If there's an organisation in India that really is too big to fail, then that's LIC. No matter how much it mismanages its products or its investments, the Government of India will step up to the plate. Whatever be the shortfall, the taxpayer will fill it. And that's the real guarantee.

-- Dhirendra Kumar

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