Global portfolio managers invest on the basis of some portfolio theory, such as the modern portfolio theory or the traditional portfolio theory, which seeks to balance the risk-return paradigm in tune with the investor's preference.
When we begin to address the issue of attracting foreign investments to India, it is important to understand that one of the prime drivers underpinning these investment decisions emanate out of the use of these models.
A rough estimate indicates that over 80 per cent of global investment flows are subject to one or the other of these portfolio theories. Indian efforts in attracting investments could be well aided by aligning its strengths along the fundamentals espoused by these theories.
Currently, since we are predominantly concerned with equity investments in India, the strategy is to divide the universe of opportunity into some logical classifications, such as developed markets or emerging markets, or along geographical lines such as North America/the US, Europe, Asia/Asia-Pacific/Emea.
The theory then considers the risk-return paradigm of the assets so classified, their interactivity, operating environment, the tax and policy regime, currency stability or appreciation, the quality of operations and management, etc.
This of course will be balanced against perceived risks such as the uncertainty of earnings, over-valuations, change of policy, currency depreciation, frauds, and access to legal recourse.
By understanding the risk-adjusted return potential of each asset class under consideration and by establishing the correlation of dependency between various asset classes, portfolios are carefully constructed to deliver desired returns within the risk boundaries defined by the investors.
This yields an algorithm of allocation of different amounts of the overall funds to be invested to different assets to achieve the investment goal.
Portfolio allocation algorithms generally work on a "top-down basis", where risk returns are compared and an allocation made to each asset class based on these theories.
First, funds are allocated to a broad classification such as equity, fixed income, currency, commodity, real-estate, bullion, derivatives, etc.
The next step is finer classifications, such as developed vs. emerging markets in the case of equity, short-term and long-term for fixed income, staple or exotics in terms of derivatives.
The third level of the allocative algorithm involves allocating across various geographies against each asset sub-classification from the previous step. One variation out of many such possibilities in the top-down approach is deciding the asset classes on a global basis, and then choosing the constituents under each class, following a bottom-up criterion such as liquidity, trading volumes, sector exposure, or some similar stock-picking methods.
A few boutiques and fund houses use the bottom-up construction approach, which are both cumbersome and complex on a global scale, and often unreliable to return portfolio-wide performance.
Given the portfolio construct considerations, it is important to understand how portfolios are allocated to various asset classes and where India fits in. From the geographical aspect, India could be categorised in South Asia or Asia-Pacific.
To be in contention from mainstream investors, it is better to be as central a piece of asset as possible. For most investors, Asia-Pacific is a geographic class that has been in existence with a long, chequered history of risk-adjusted returns.
Against that, creating a new classification such as South Asia is difficult. India could also be under the emerging market classification, or the exotics, or BRIC. Perhaps the best bet is to be under the emerging market bucket, with the potential to garner a larger share in the emerging market category with our superior performance relative to other emerging markets.
The second aspect is to keep getting as close to the top of the allocation pyramid as possible. If we are able to create a healthy allocation for a new, distinctive category called BRIC it might increase allocation to India.
It is also important to consider the index weight that India carries in various global investible indices such as the S&P Global Index and MSCI. Since India still attracts only a small portion of global funds, several global portfolio managers might not spend time understanding the Indian investment paradigm, and rather go by index allocations as a surrogate allocative guidance.
Thus, understanding how these indices are constructed and what could increase the weighting of India will be a sure way of enhancing fund inflow into the country.
One other consideration is to make India figure in more than one allocation category. Currently, India allows portfolio investment mainly in equity. Asset classes such as fixed income, commodity, real estate, and money market and currencies are largely missing for India.
This reduces the inflow to India. There is also the risk of disorderly exit as only equity investments are possible in India, thereby increasing the chance that all managers may take similar calls to short India as an asset class.
The absence of any of other investment opportunity forces exit out of the country. In contrast, in the case of the US, an investor could choose from various asset classes, instead of writing off the country as a whole. This diversity stabilises the foreign investment flow to some extent, and presents a more developed perspective to an international investor.
Especially now, when there is considerable investment that has already flowed in, such an asset diversification prospect will improve India's ability to retain investments over longer periods.
In the absence of that ability the domestic market remains vulnerable to outflows, which might disturb not only the equity market but also the short-term money markets and the exchange rates.
Further, by allowing multiple operations across asset classes, not only do foreign investors enter India in several asset classes, but it also presents a logical case for taking India as an asset class by itself.
Ultimately, the goal for India should be to become an asset class in its own right. In many funds, Japan figures in a class of its own. Given the shallowness of its financial markets, China has not made it to this exalted category, even though the country as a whole is considered an attractive investment destination.
Perhaps, by playing our portfolio cards well, India will be able to beat China in attracting foreign investments: An opportunity that could potentially tackle the contagion risk and the China competition surely deserves a long and hard thought.