Risk and Innovation

At the recent 15 year anniversary of the SIBIU Futures Exchange, Romania, I met Professor Gabriela Anghelache. She heads the Securities Market Commission for Romania and is a highly regarded woman for her efforts to develop the capital markets. Being well connected with capital market participants, she also queried me on my capital market vision and told me to ponder till we met the next time. On one side I was elated that my opinion mattered to her and on the other side it set me thinking. Capital market vision was more important than forecasting, trading, economic cycles, as it tells us where we want our markets (an embodiment of society) to head tomorrow.
The question took me back to the Bombay Stock Exchange training institute. My derivatives training started with the question, what is more risky, a future or the spot. Being the basic program, I had to spend more than a few minutes explaining how a 20% move on derivatives could wipe the trader out. The thoughts took me back to my early days with Nifty Futures. Many incidents flashed in front of me. Early 2000, I asked a senior colleague, Rajiv Handa from Indiabulls (brokerage house) early basement days. “Rajiv when a trader can make enough in the stock market, why go through all the trouble of creating a business?” His answer still reverberates in my mind. While I was conjuring up two comparisons, on one side a large industry structure generating 10% return on investment and on the other side 10% gains in a day on Nifty Futures, he said “Mukul the business has more staying power than the stock market gains”. The idea is that somewhere investing has more staying power than reckless speculation. You got to learn how to stay in the trade.
Then there was my MTA mentor, Rona Shroder, Asset Manager, Zurich. Rona starting 2007 consistently mentioned her worry regarding the market. She went in cash, returned the funds to her clients and mentioned the strong need for deleveraging of portfolios. “The dangers of leverage” she pointed out are huge. Then there was this survey I took in Martin Pring’s book on investment psychology explained. The survey was to find out the risk profile; speculative or risk averse. The survey went out to explain that based on the risk profile what instruments I should be trading. Then my thoughts moved to “Save More Tomorrow: Using Behavioral Economics to Increase Employee Saving” program conducted by Behavioral Finance gurus Richard Thaler and Shlomo Benartzi. Saving rate of India, China statistics started travelling behind my head.
What market vision should thinkers give back to the society? Only a few ask the question and a few attempt answering it? We have lost many of our modern thinkers to Twitter. They are busy tweeting than visioning. Where are the guys who can teach the society about the difference between risk and return? A trader should ask himself if he has read one investment psychology book? Have I ever taken a risk profiling survey? Do I know where I belong? Majority of capital market trainings are about return training, where is the risk training? Society had moved so high on return trajectory, crisis forced us to reflect. Before you blame the fund manager understand your risk profile. Are you better investing passively? Or are you the trader profile?
According to a latest article in the Wall Street Journal, “Will we ever Again Trust Wall Street? For many investors, the market’s turbulence hasn’t just destroyed wealth. It has shattered their faith in the financial system itself”. Now that Greek woes revive seven-year old Goldman swap story, the same question pops up again, the question of how well we understand risk? Well psychologists could help understand the human mind. They have created a subject of behavioral finance now. But emerging markets give less importance to a psychologist. If we have not read investment psychology, visiting a psychologist is a long shot.
Well it’s all not general, there are societies who understand risk more than others and there are companies who thrive in risky times. Understanding risk also creates opportunities. Now we have MAVINS taking over BRICS, we have Fundamental Indexing and we have ETF Securities. Financial innovations are another aspect of capital market vision after deleveraging and risk profiling. We have talked about the fundamental indexing on prior occasions. Fundamentally based indexes are indices in which stocks are weighted by a fundamental factor or composite of fundamental factors. The fundamental factors can be book value, revenue, cash flow, profits, price/sales ratio and even the number of employees. The fundamental index approach stands in direct contrast to capitalization weighted indices.
Another four year old financial innovations are the ETF securities. This company started in 2006 offers investing opportunities to purchase commodities, currencies as non leveraged spot instruments. This is high convenience for an investor who could neither own a commodity physically nor take too much risk buying the commodity derivative. With a few dollars one could buy a unit of crude oil or Natural gas. The company offers more than 140 instruments and has $16 billion assets under manangement. This all growth happened in four years and despite many awards, the innovation does not stop here. Alpha pair trading strategies can now be done without leverage or with contained leverage. Long Sugar – Short Corn, Long Gold – Short Platinum, Long Natural Gas – Short Oil, all without margin or contained margin.
Despite the fact that the crisis has come from the developed economies and the respective countries have somewhere failed in containing and understanding risk, there is an attempt to bring new financial innovations to fill the gap. There is also an attempt to teach investors about risk and risk profiling. The ongoing crisis should also be used by emerging markets to embrace, create and adapt such ideas to local needs.
On a specific note, India still lacks sectoral focus. Bombay Stock exchange should dust up its sectoral portfolio of indices and launch financial innovations similar to ETFsecurities, allowing investors to look beyond stocks and into sectoral broad based allocations. This could not only boost volumes on Dalal Street, but energize the overall market. Emerging markets like Romania should take cues from India. The broker – exchange community is well knit in India. There is more dialogue, more training, and more hand holding. This was one key reason markets moved from a few thousand contracts to nearly 3 million contracts today. Arbitrage happened not just in derivatives, it also happened in spot markets.  Arbitrageurs have to be nurtured, passive instruments should be given due weightage and a balance has to be found between over regulation and under regulation. Only then maybe we can have some idea about where we want to go tomorrow.
ORPHEUS RESEARCH AT REUTERS – UNITED KINGDOM
ORPHEUS RESEARCH AT REUTERS – USA
Share