2 ways to reduce your knowledge gap

India's stock markets used to be a private betting club until the end of the 1970s. Then things changed. The forced dilutions by foreign companies on the one hand, and Reliance on the other, brought in that greedy creature called the small investor.

The small investor knew as much about the stock market as he did about nanotechnology or the interior of Pluto. Throughout the 1980s, when floating stock was no more than about 15 per cent of the total, he operated at the fringes.

Many even made money in the boom of 1985-87, only to be laid low in the collapse later that year. Until 1992, the small investor stayed away from the market, when along came Harshad Mehta and another boom.

The same story was repeated and, in the bust of 1995, the small investor withdrew from the market until another pied piper, Ketan Parekh, came along in 2000. A third encore, another retreat, until the latest and largest boom till date.

But this time, anecdotal evidence suggests that the small investor is hedging his bets by investing in mutual funds as well. He has figured out, at last, that the less you know, the more likely you are to lose money.

The theory is that mutual funds know more, both in terms of current information and the ability to analyse that information. So they are less likely to make mistakes (correct) and, therefore, more likely to help you earn more (wrong).

In a recent paper*, Marcin Kacperczyk, Clemens Sialm and Lu Zheng have tried to see how much better of an investor really is with a mutual fund. They say that although the disclosure requirements on mutual funds are extensive, "investors do not observe all the actions of the fund managers".

Then they do some econometrically and mathematically decorated high-wire jumping and conclude that "the impact of unobserved actions on fund returns using the return gap, which is defined as the difference between the reported fund return and the return of a portfolio that invests in the previously disclosed holdings after adjusting for expenses. . ." is pretty dramatic.

Thus, the "unobserved actions of some funds persistently create value, while such actions of others destroy value". Furthermore, future fund performance can be predicted from the return gap which suggests that "investors should use it as an additional measure to evaluate the performance of mutual funds."

In another paper on a similar predictive theme, Ajay Shah who recently moved on from the finance ministry and has touching faith in data and econometrics, along with Achim Zeileis and Ila Patnaik has developed a computer programme for predicting what the Chinese might be doing with their exchange rate.

Shah says they are giving this programme away as a public good. So if you want to make money betting on the yuan, you know whom to ask for help.

Everyone knows that China held its currency rock steady against the US dollar for almost eight years and this led to a huge increase in its exports to the US. This annoyed the US which eventually succeeded last July in pressuring China to revalue its currency and -- so everyone hoped -- move to a flexible exchange rate system.

Rubbish, say the authors. They have looked at the data since July and say "utilising contemporary ideas in the econometrics of structural change, we find that the yuan has remained pegged to the USD, rather than to a basket, and has extremely limited currency flexibility."

In short, it is business as usual for the Chinese. "There has been no evolution towards greater flexibility."

Unobserved Actions of Mutual Funds, NBER Working Paper No. 11765, November 2005