Independent scholar Ajay Shah says that it is the duty of every household investor to diversify his or her portfolio all over the world so as to benefit from global diversification.
Excerpts from CNBC-TV18's exclusive interview with Ajay Shah:
The initial feedback that we get from most mutual fund houses is that they might want to tailor specific schemes which will lead investors to invest in overseas securities but your contention seems to be that they should be woven into the main fabric of the mutual fund schemes or diversified schemes. Is that right?
Actually I would go one step further. It is the job of every investor, the job of every household to diversify all over the world. This can be done either with a mutual fund giving a full product that does that or a mutual fund that offers one local scheme and one off shore scheme. Then the investor should spread his money across the two so as to benefit from global diversification.
What is the key gain for a household person in doing this, is it basically a risk mitigation thing because of diversification across economies and geographies or do you think you can actually maximize returns by doing this?
The two questions are not that different. Firstly I will emphasize on what was said about the point of diversification. One should never put all their money in one company or country; one should spread their money across countries in order to reduce risks.
For the mutual funds themselves though in terms of what the Sebi has put forth in guidelines, are they getting enough elbowroom to go out and invest like they want to?
This is a very small window. This is like a small toddler trying to take his first step. What has been given to them is a miniscule set of limits. The Sebi says that the grand total investment by all mutual funds cannot cross $2 billion; the investment by any one mutual fund cannot cross $100 million. The investment by any one mutual cannot cross 10% then there is a window for exchange-traded funds of $1 billion.
These are all very tiny numbers and I guess that is how India works. We get going with something small and then gradually we do things on a bigger scale. What I would like to say to every household of the country is that this is very big, this is a profound change in the risk return opportunity available for the Indian household. Roughly speaking one can reduce his risk by half if one diversifies globally, this is big stuff.
How would you build it, if you had that money to play around with, is it the Indian ADRs, GDRs or the ETFs. What looks like a more lucrative pocket to get into?
I would basically put my money into the index funds of the top 20 countries of the world.
Is that because of limited expertise of selecting stocks in overseas markets or companies which you may not track or basically restrict yourself to the indices and try and mitigate risk there of?
There are two reasons. Firstly, I do agree that we do not know much about the French economy, for instance. But the second point is that in industrial countries, in the large matured market economies of the world, the stock market tends to be extremely efficient.
It is relatively difficult to beat the market, it is relatively difficult to find undervalued stocks or overvalued stocks and index funds are extremely cheap in the industrial economies. You can get index funds managed for 5-10 basis points, so it is a very low cost high quality asset.
The first thing that I would advise every household in India is that more than half of their money should be spread across 20 countries.
In a sense, since the markets are so competitive out here, do you see the mutual fund managers actually being hesitant or reluctant to participate in this because investors probably understand the concept of returns much better than the concept of risk.
So in a competitive world, if you are mitigating risk but the return is being lowered because you are participating in another market, which does not generate as strong returns, could mutual fund managers shy away from using that tool?
My answer would be in two parts. First I would say that there is no trade off in terms of lower levels of return because one can always juice up returns by using the index futures.
So instead of just holding a spot position on S&P 500 one can just hold an index futures position on S&P 500 and get back to the Indian levels of returns. There is no alternative there. It is not like you cannot achieve Indian style returns by being in the US market.
My second point is that suppose the mutual fund is not knowledgeable, it does not have the staff skills and don't do overseas diversification, then what will happen is that there will be five houses in India, which will do proper global diversification.
Their products will deliver a better reward to risk ratio. Then you guys will be on television saying that look these are the good mutual fund schemes that they are delivering a better reward per unit risk and customers will flock to those skills.
I don't think there is a choice. I think every single mutual fund will have to go global on a giant scale as I said the rational thing in India to do is to have more than half your money outside the country.
Is there no reverse case to be built of greater vulnerability because it is exposed to global cues? How do you get more vulnerable by having more diversification?
If I spread my money across 100 companies instead of 10 companies I only get better. If I spread my money across 25 countries instead of 1 country I only get better. No, there is absolutely no case to be made that your risk goes up. Your risk only goes down.
What about the foreign exchange risk, just to play the devils advocate, is that an important part, you have crunched a lot of numbers on relative performance of markets and indices but adjusted for foreign exchange fluctuations do they still deliver superior returns?
The answer is yes. Net of all foreign exchange fluctuations you still get superior portfolios by global diversification. There are two schools of thought here; some people believe that in the long run all currency fluctuations add up to zero. The long run global equity investor should just not bother hedging currency risk.
There is another school of thought, which says that one should judiciously try to manage that currency risk by using the currency derivatives. But once again that is a choice that the fund manager has to make.
My opinion would be that it is not a big deal, one will still get fundamentally superior diversification by being all over the world whether or not you hedge the currency risk.
You said that all mutual fund schemes should try and take on a certain amount of global diversification but Sebi's directive seems to say that only mutual funds or AMCs with outbound investing experience should go into this. Is that restrictive you think?
Yes, Sebi says that only people with experience and outbound investment can launch an ETF. But that is not a very good thing to do as, in India, many fund houses do not have much experience with outbound investment.
So I personally feel that this requirement of having experience with outbound investment should not be there.
How long will it take you think for it to be a really bi thing so much so that we talk about an exposure to the Dow futures as a regular thing to see in mutual fund portfolios?
That is up to every single person as to how they would want to play this. In my humble opinion this is a very big development, it is not a small thing.
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