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| Home > Archive > Article: FIIs, Hedge Funds and Information Asymmetry |
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FIIs, Hedge Funds and Information Asymmetry
Raghu Rau |
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What do international investors look for in investments? Ideally, we would like to earn large positive returns, preferably greater than our benchmarks, with a minimum amount of risk. Would investment in India fit the bill? On the surface, India looks like a wonderful investment opportunity, with a populous middle class, robust democracy, and relatively young population. India is the fourth largest economy in the world in terms of PPP. However, in terms of Foreign Direct Investment or even in terms of Foreign Institutional Investment, the amounts coming into India are miniscule in comparison to China, for example. Why is this? Well, there are a number of risks to investing directly in India – the slow development of infrastructure, the lack of structural reform in the financial markets, and a legacy of protectionist policies.
Instead of direct inflows therefore, many foreign investors choose to invest in the equities markets. Currently however, a foreigner wishing to invest directly in the Indian stock market finds it very hard. There are around 1,000 firms listed on the National Stock Exchange. However, SEBI restrictions prevent foreign institutional investors from investing in equity more than 10% of total issued capital of an Indian company. Consequently, there are a limited number of hedge/mutual funds that invest directly in India. These funds (for example, the Eaton Vance Greater India Fund) have very high expense ratios. While there are a number of emerging market Exchange-Traded Funds, these invest in India only as a part of their overall investment across emerging markets. Finally, a handful of Indian companies (Infosys, Wipro, ICICI, Tata motors etc) have also issued ADRs in the US. None of the firms issuing ADRs have low P/E ratios compared to equivalent Indian stocks – they are not value buys by any means.
Is such foreign investment desirable? Should these restrictions be relaxed? It can be argued that the restrictions have helped protect the Indian economy – for example, during the South East Asian crisis in 1997, the Indian economy was largely untouched. A standard argument is that foreigner tastes are fickle – at points in time, they show wild enthusiasm for certain countries and rush to invest. At other points in time, they pull back en masse, leaving a crisis in the country as stock markets crash, the country defaults on its debt and so on. South America is often pointed to as an example of such a situation. Would India not be better off discouraging such fickle investors and only focus on direct investment?
To answer this question, let us go back to some fundamental principles of valuation. In modern finance theory, risk and return are inextricably related. The market is efficient in that every investment earns exactly the return that compensates the investor for the risk that he bears. If the market is efficient, no investor can hope to beat the market on a consistent basis and earn super-normal returns (returns in excess of the compensation for risk). While empirically, there have proved to be exceptions to this theory (the dotcom bubble being a notable example), by and large, it is accepted that markets are in fact pretty efficient. What this means in practice is that if new information comes out about a firm, markets will react instantaneously to incorporate that information into the price until once again the stock is correctly priced – providing a return exactly compensating the investor for the risk he bears. As an example, in 2002, a couple of researchers used an atomic clock to measure how fast the markets react to announcements on public TV. They taped the exact time firms were discussed on the Morning Call and Midday Call segments on CNBC TV. The segments report analysts’ views about individual stocks and are broadcast when the market is open. The researchers found that prices respond to the reports within seconds of the initial mention, with positive reports fully incorporated within one minute. The impact of negative reports is more gradual, lasting 15 minutes. They also found compelling evidence that viewers trade based on the information in the segments. Trading intensity doubles in the minute after the stock is mentioned on air, with a significant increase in buyer- (seller-) initiated trades after positive (negative) reports. Traders who lock in prices within 15 seconds of the initial mention make small but significant profits by trading on positive reports during the Midday Call.
What then does risk mean? What is the right compensation for risk? We all have intuitive measures for risk. If you ask a random investor to rank a set of investments for risk, the answers will be pretty standard. Stocks with a high variability in their returns will be ranked the riskiest while stocks that do not move very much as economic conditions change will be ranked the safest. An example of a safe investment might be therefore a Unit Trust bond, while a risky investment might be a share in a fly-by-night tiny company listed on the Sensex. However, the problem with this classification is that different people with different tolerances for risk will rank different investments differently. An extremely risk-averse individual might decide that even Unit Trust bonds are too risky, preferring to keep his money under the bed in a small safe. But the measurement of risk is crucial in defining what the price of the stock should be – highly risky stocks should trade at lower prices today (with higher expected returns tomorrow). With different measures of risk, different shares will have different prices and we know that is not possible.
Modern finance theory tells us that when shares are combined into a portfolio, some risk is eliminated. For example, consider an umbrella company that only makes money when the weather is rainy. A second company is an ice-cream manufacturer that only makes money when it is sunny. Each of these two investments may be individually very risky. However, an investment in both of them will lead an investor to make some returns regardless of the weather. When the weather is sunny, the investor will lose money on the umbrella manufacturer but this is more than compensated for by the fact that he makes money on the ice-cream manufacturer. The opposite is true when the weather is rainy. Therefore, in combination, an investment in both the companies is less risky than either individual investment. This means that the only correct measure of risk is not how the individual securities change their profits when the weather for example, changes. It is how the combined securities in a portfolio vary when the situation changes. To put it in more technical terms, it is the covariance between the securities that matters in determining the risk, not the individual variance. Note that not all risk is eliminated in the above example. If the economy as a whole is bad, neither the umbrella manufacturer nor the ice-cream manufacturer will do well. People will substitute cheaper items (a plastic bag over the head when it rains for example). This risk, called systematic (for system-wide) risk, cannot be eliminated regardless of how many securities you hold in your portfolio and it is this risk that matters in determining the price of a share. Note also that the degree to which one security offsets the risk of another, its covariance, is purely a mathematical construct – it does not depend on individual investor preferences. Shares with a low covariance with other shares in your portfolio (or even move in opposite directions to the other shares in your portfolio) may be intrinsically more risky, if held by themselves - but in combination with the shares already existing in your portfolio, reduce the total risk and are safer.
This point may appear to be obvious but is subtler than it appears. Consider the following problem. Suppose you are an international investor. You have investments all over the world. You currently are trying to decide whether to invest in Wal-Mart or Compagnie des Comptoirs de Madagascar (CCM). Wal-Mart is based in the US and CCM is based in Madagascar. You would like to make a $10 million investment in each. Which investment is safer? Madagascar faces problems of chronic malnutrition, under-funded health and education facilities, a roughly 3% annual population growth rate, and severe loss of forest cover, accompanied by erosion. Agriculture, including fishing and forestry, is the mainstay of the economy, accounting for 30% of GDP and contributing more than 70% to export earnings. Major industries include textile manufacturing and the processing of agricultural products. The growth in output in 1992-2004 averaged less than the growth rate of the population. Growth has been held back by antigovernment strikes and demonstrations, a decline in world coffee prices, and the erratic commitment of the government to economic reform. The Madagascar stock market is largely unaffected by events in the rest of the world, depending almost entirely on the local economy. However, investing in the Madagascar market would have earned an investor an average of 19% per year over the last 20 years – the market is however, extremely volatile, with volatility over 4 times the volatility of the US stock market. In contrast, the US market has earned on average 12% per year over the last 60 years. The current US government bond rate is 4.5%.
Even after understanding the concepts discussed previously, many people will automatically say that Walmart investment is safer. For an international investor however, the Madagascar stock market is tiny and uncorrelated with the world market. For such an investor therefore, there is no additional risk by adding CCM to his/her market portfolio. On the other hand, Walmart is a large company in the US stock market, highly correlated with the US stock market, which in turn is a significant part of the world market. CCM is safer than Walmart for the international investor. Consequently, you would use the US market return (12%) as a proxy for the expected rate of return for Walmart, In contrast, you would use the US risk free rate (4.5%) as a proxy for the expected rate of return for CCM. For a Madagascar investor who cannot invest anywhere but Madagascar, the situation is reversed. The CCM investment is highly risky, since it is highly correlated with all his other investments and so he will charge a high discount rate to invest in it.
In turn, this brings us to the last point in our analysis. The final fundamental point in modern finance theory is that investment decisions depend on the cost of capital. We discount the payoff from any investment at the cost of capital. If this payoff is greater than the initial investment, it is worthwhile making. Otherwise not. The lower the cost of capital, the higher will be the discounted value of the payoff. Everything else being equal therefore, low costs of capital will lead to more projects being valuable and worthwhile to undertake. Projects that might not be undertaken with a high cost of capital suddenly become viable with a lower cost of capital. Foreign diversified investors, with their lower costs of capital, should therefore be encouraged to invest in India. This will allow India to undertake more worthwhile projects, projects that otherwise would be uneconomical. This is a point that is not often made – foreign investors are desirable not because they are superior investors to Indian investors, not because they contribute valuable know-how that Indians do not have, but because they are more diversified and consequently demand lower discount rates to invest than domestic investors would demand.
Why then is foreign investment in equity so low and limited at the moment in India? Is it solely the restrictions placed on direct investment? Partly, yes. However, the Indian market is itself unattractive for a second reason. The analysis above depends on one crucial assumption not mentioned so far – that information is symmetric. What does this mean? This means that managers, domestic investors and foreign investors all have the same amount of information in order to make decisions. In practice, this is not realistic. Managers typically have more information than markets. This does cause investment distortions even in US markets. If markets believe that managers have better information than the markets, this causes markets to pay lower prices for securities than they would otherwise. These kinds of investment distortions are unavoidable.
However, there is a second kind of information asymmetry – between foreign and domestic investors. If foreign investors are kept in the dark, they will tend to over-react in comparison to domestic investors - tiny changes in information will be followed by massive swings in prices. This will cause high volatility and increase risks of sudden exits of foreign capital in India. Consider for example, the recent massive increase in volatility in 2006 when hedge funds were rumored to have withdrawn abruptly from India. To prevent this volatility, Indian politicians and the press even argued that restrictions on capital flows are correct and should be imposed. In contrast, I argue that this volatility is unavoidable as long as foreigners have less information than Indian domestic investors.
What kinds of information asymmetry am I talking about? The first is transparency. Indian corporate accounts are notoriously opaque. It is very difficult to understand what is really going on behind the scenes at most companies. The government does not help either. Research has shown that owners of business groups in India expropriate minority shareholders by tunneling resources from firms where they have low cash flow rights to firms where they have high cash flow rights. In addition, government officials are often regarded as corrupt, demanding bribes to relax restrictions. Both the government officials and corporate insiders are pursuing their own interests at the expense of outside investors. Research has shown that when these twin problems are significant, diffuse ownership is inefficient and corporate insiders must co-invest with other investors, retaining substantial equity. The resulting ownership concentration limits economic growth, financial development, and the ability of a country to take advantage of financial globalization.
To conclude, India needs foreign investors who are more diversified and consequently demand lower discount rates to invest. This encourages more investment in India. However, these investors will not invest (or invest but be extremely volatile) as long as the financial and economic system in Indian remain opaque.
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| After his MBA from IIM Bangalore, Raghu Rau got his PhD in finance from INSEAD France. He is currently Professor of Finance in Purdue University and has taught corporate finance and investments to MBAs and executives in the US, South America, Europe and Asia for the last 7 years. |
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This article raises an interesting question of particular relevance to small domestic investors. The FIIs are big players today and market valuations depend largely on them. But if information asymmetry is deliberately maintained, might the opaqueness in the system not be assisting company circles in buying, especially insider traders? Is there not the possibility of a vicious cycle in which the market is gradually driven up and this taken advantage of by those privileged with more information? The frequent ‘melt downs’ may not be occurring because of ‘profit booking’ by FIIs as is generally believed but because they are over-reacting to partial information. When the FIIs over-react because of information asymmetry, the market perhaps corrects drastically, each time at the expense of the small investor. When the market loses a trillion rupees the next time, where is the agony actually being felt?
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