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Wednesday, August 16, 2006

Global diversification is not a side show

Capital controls have been in India since 1955, and have deep roots at the level of ideology, rent seeking and the interests of existing agencies. Take 1 on outbound investments from India came to naught through the introduction of a clause that Indian mutual funds could only buy shares of companies abroad which had FDI in India. So, for example, an Indian mutual fund could not buy index funds outside the country, since most global index components have no FDI in India.

SEBI recently put out guidelines on international investment by Indian mutual funds [pdf] which have solved this problem. The spirit of these guidelines appears to be one where mutual funds will do a little international investment, with a raft of QRs: no more than 10% per fund, no more than $100 million per fund, no more than $2 billion overall per year (or roughly 5% of mutual fund assets under management, or roughly 0.3% of GDP). And they say that if you want to run an exchange traded fund (ETF) on an offshore index, you can only do this if you have prior experience with overseas investment (which, of course, is a rarity in India given the elaborate system of capital controls which has been in place). As a consequence, the firm with 90% market share in ETFs (Benchmark) won't be able to launch an ETF on offshore assets. As Jayanth Varma points out, the political economy which could be at work here is: Conventional actively managed funds have an incentive to block the growth of ETFs since they represent dangerous low-price competition.

Sigh. Small pieces of progress on economic policy in India seem to take a long time.

I wrote an article Global diversification is core to fund management in Business Standard arguing that global diversification is not a sideshow in fund management. I show sample calculations of computing efficient portfolios based on the historical covariance matrix of weekly returns, across 4 indexes, over the last 16 years. I know, estimation of covariance matrices is hard, but I think the results illustrate the basic point. And I do have 837 weeks of data with only 4 indexes.

Diversification is a free lunch. When a portfolio is spread across the globe, the reward/risk ratio unambiguously improves. This issue goes to the core of portfolio formation, it is not a side show. Efficient porfolios involve a much bigger role for offshore assets when compared with the tiny numbers that RBI and SEBI are talking about. As an example, Israel has a rough balance between capital inflows of 9% of GDP and outbound investment by local households and portfolio managers of the same amount.

Economic logic thus suggests that every portfolio in India should be unabashedly globally diversified, with large fractions of offshore assets. If some portfolios manage to have more globalised portfolios, their Sharpe's ratio will beat that of autarkic portfolios, and they will gain market share.

I am reminded of the broader issue of home bias. The home bias literature points out that industrial country portfolios underdiversify into the third world, they keep too much at home. Home bias seems to be the consequence of capital controls in the third world, and mistrust of third world institutions in the eyes of first world investors, which is assisted by asymmetric information.

Now we are seeing this problem in reverse. In autarkic India today, we have extreme home bias: capital controls have prevented agents from diversifying globally (other than the hawala route). The incentive to globalise assets is probably a bit higher in India, since the Indian investor respects UK institutions (say) more than the UK investor respects Indian institutions. On the other hand, I sometimes meet people here who are dazzled at the high rates of return on Indian equities and don't quite understand why they should diversify into low-yield assets such as the S&P 500. My BS article seeks to show the benefits of global diversification to such a person.

The rise of hundreds of Indian multinational firms, with subsidiaries across the world against which transfer pricing can be done, along with the enormous growth of the current account, has thrown up a wealth of opportunities for shifting capital across the boundary. It is common knowledge that many hundreds of billions of dollars of assets are outside India, controlled by Indian households, based on evasion of capital controls. I think this reflects the enormous benefits from global diversification: so economic agents have strong incentives to achieve global diversification by evading capital controls and building portfolios out of reach of RBI inspectors implementing capital controls. Until decontrol takes place, this will remain the main strategy which agents will adopt. The present approach, of having a host of highly restrictive QRs, will not make a dent on this phenomenon.

Paradoxically, the system of capital controls increases the incentive to hold assets outside the country, since in addition to considerations of risk and return, there is the greater flexibility of utilising those assets. By holding money outside India, you have the option value of doing what you want with it, without interference from the Indian State. Holding assets outside the country eliminates the the risk of future evolution of capital controls in the years to come. That option value is out of the picture when decontrol takes place, after which normal considerations of risk and return should come to prominence.

Chet Currier has a column on Bloomberg which points out that US home bias has made progress - a full 25% of equity funds are now placed outside the country. Of course, this is only progress and not a resolution of the problem; most economists would argue that the US investor should hold much more than 25% of his equities outside the US. And, I think Chet Currier gets it wrong when he thinks about the forces at work. Global integration means that global diversification is less attractive - the more correlated is the GDP growth of various countries, the less is the benefit from diversification across countries.

I recently saw a web site offering offshore securities trading to Indian customers. Does this work well?

Update: Watch me talk about this. (It was a while ago, right after the BS article came out).

1 comment:

  1. SEBI seems to be a super fund allocator – one prescription for all! Who needs a portfolio manager for non-Indian funds now?!

    Also, home bias is surely not third world phenomena. I know in US it’s very wide spread - investment advisors routinely talk of having just 5-10% of assets in foreign stocks or funds that invest in non-US stocks. UK and French investors are a little better; Germans are worst than Americans.


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