Tuesday, October 14, 2014


I was the only senior man in the finance ministry who had ever invested in the stock market. Since I knew something about it, investment managers and other speculators would often seek to see me and cadge some secrets. After I left the ministry, I was even more popular with them; one fund took me on its board, and taught me much about the international financial markets. So once in a while I analysed international financial trends, for example in this column from Business Standard of 12 December 2000.


Developing countries may have a millennia-long history; but for the US equity investor they did not exist till the 1970s. Then came the oil crisis, which made some developing countries rich overnight. It became possible to sell the dream that the some developing country or other would far outstrip industrial countries in growth and returns.
Amongst the glowing oil-rich countries was Mexico; in 1981, it became the first developing country for which a country fund was set up. By the mid-1980s, the Asian tigers were beginning to make news; that was when a number of New Asia and specific country funds were set up. India was also hyped up as a hopeful tiger-in-the-making; UTI floated its India fund in 1988 – just before Rajiv Gandhi fell from power and India was engulfed by caste warfare.
Then there was another period of popularity for developing countries in the early 1990s. East Asia was booming spectacularly, and even the Latin American countries had got through the wringer of structural adjustment and seemed to be ready for healthy growth. That was the period when most of the existing country funds were set up. India was one of the countries that underwent a truncated structural adjustment and opened up its stock market; it attracted three funds – Jardine Fleming, Morgan Stanley and Magnum.
But India had just caught the tail of an emerging market boom. The long US boom had already started, and once it gathered momentum, US investors lost interest in emerging markets; most emerging market funds went into discount. And when existing funds are at a discount, it is difficult to sell a new fund. New funds would also be expected to trade at a discount; and investors in them would make an immediate loss. Most investors would rather buy into an existing fund at a discount rather than invest in a new one. For a new fund to be saleable in those conditions, it would have to convince investors that it had an exceptional management or that existing funds had exceptionally poor management; and neither is easy to do. Only a handful of funds have been floated after 1994, mostly for Eastern Europe.
New funds were not being set up, but at least the existing funds were doing all right. That is not a great achievement. All country funds are closed-ended funds. Money can easily flow out of a country fund for reasons quite unrelated to the performance of the underlying companies – because of fears about the balance of payments, about political stability, about government finances, etc etc. So no one thinks of developing countries as appropriate for open-ended funds.
Investors cannot exit from closed-ended funds, anyone who wants to exit has to find a buyer, and the more people want to leave, the more they have to persuade someone to buy their holding. They do that by bidding down the unit price of the fund. So the worst that can happen to a closed-ended fund is that it will trade at a discount.
So, at any rate, their managers thought till recently. After long years of suffering, it has suddenly occurred to their unit-holders that if a fund is trading at a discount, its holders can make an immediate profit if it is liquidated. It has also begun to strike them that they are own the funds, and can throw out their managements.
So in the past three months, shareholders moved resolutions to dissolve eleven funds and distribute the proceeds. They succeeded in five funds, and failed in three. Even the managers of those three funds must be thinking how they can be sure of defeating the next vote for dissolution when it comes.
This shareholder activity has lit a fire under the boards of the funds, which have spent sleepless nights plotting a survival strategy. Two funds closed down; another two open-ended – which means they would survive until their country lost favour with investors. Three have opted to merge with other similar funds.
But the most popular actions have been tender offers and buybacks. In tender offers, the managements offer to buy back a certain proportion of the equity at a price close to the net asset value. They thus involve almost that much reduction in equity; and if they are repeated a number of times, they will eventually reduce the corpus to a level which will no longer support management services. At that point they will have to be liquidated.
Also, since tenders give the shareholders who accept them automatic profit, all alert shareholders will opt for them. Hence the shares tendered will always exceed the shares offered for tender, and the offer will have to be rationed out amongst the tenderers. The latter will make a profit equal to the  the proportion they are allowed to sell back multiplied by the difference between the tender price and the market price (which is close to the market discount).
Finally, since tenders bring a large and certain profit to tendering shareholders, they will attract speculators – arbitrageurs as they are politely called – who might buy just before a tender offer and sell soon after it is over. Hence tender offers have to be decided very secretly, and the share register must be closed as soon as they are announced and until the tender purchases are over. And speculators must not be able to anticipate tender offers – which means such offers must not be made at regular intervals, and must not be too frequent.
Buybacks too reduce equity and if repeated often enough would make a fund unviable. But they are made closer to the market price; and the management controls the volume of buyback. Thus they are more favourable to the shareholders that stick on – and less so to exiting shareholders – than tenders. So they are not so popular with those who invest for speculative reasons – which means most investors.
Managements think buybacks “add value” to a fund; since shares are bought back at a lower price than NAV, the NAV per remaining share would go up. But this is a static view. The current NAV depends on the current market prices; the gain or loss made on buyback should be compared, not to the NAV at the point of buyback, but to the current NAV. The management may buy back at a 20 per cent discount on NAV (which may still be higher than the fund’s market price). But if, later, market prices fall by over 20 per cent, the purchase will be seen to have been at a price higher than NAV, and to have resulted in a loss.
Hence I think the buyback price should not depend only on the market discount, but should be as close as possible to the lowest absolute NAV. One way to approximate this objective would be to institute buybacks whenever the current NAV goes below the minimum reached in the previous three years.

All these worries would go away if a fund consistently performed better than its peers. I think country funds should be thinking hard about new investment strategies that might outperform their country indexes and straggling competitors.