The Great Liquidity Crunch – Private Equity Firms Re-invent Themselves

About Author and article

Vaibhav Gupta – ZENeSYS Consultant, IIM Indore (2010-12 Batch). Vaibhav completed his B.Tech. in Mechanical Engineering from Delhi College of Engineering. Before his MBA, Vaibhav has worked in Project Management role for 4 years with Siemens Energy. Vaibhav intends to join the Management Consulting industry after his MBA. He can be reached at p10vaibhavg@iimidr.ac.in.

This article has been written as a part of a research project undertaken for ZENeSYS. All information and content has been derived from secondary research and insights gained from recent projects at ZENeSYS for the PE industry. Credits have been provided in the references for text and data.ZENeSYS provides Market Research and Market Intelligence services to PE Industry on a regular basis.

 Main Article

Over the last decade, uncharacteristic of what one might think, the private equity industry has gone through an economic cycle just like the stock market does – up and down. The up phase of the PE market started around 2003 and it continued to boom till 2007-2008 or just when the financial crisis kicked in.

During the up phase, which started after the telecom burst in 2002, the PE industry saw the largest leveraged buyout (LBOs) taking place in history. In the year 2006, PE firms had bought more than 650 US companies for a figure of $375 Million, which was around 18 times the transactions, closed in 2003  alone.

The LBO movement was fueled by decreasing interest rates, low lending standards and tight regulatory framework of owning a public enterprise (Sarbanes Oxley Act)  . Consequently, it is one of the reasons why venture capitalists started relying on sales to strategic buyers for an exit.

The arrival of financial crisis in 2008 and the liquidity crunch brought about a quick halt to the LBO frenzy. The leveraged finance market almost stood still during and after the financial crisis. Not only that but as a result of this crisis, many deals were withdrawn or had to be re-negotiated .

PE industry is measured with help of two metrics – fund raising and investment activities. The fund raising refers to the money, investors have committed to PE funds in a year. That fund raising activity had fallen to $150 Billion globally in 2009 from $450 Billion in 2008. Coincidentally, the 2009 figure is the lowest since 2004. The lack of debt in the following year of 2010 meant no hope of any speedy recovery.

The other metric, investment activity, which represents the financing of businesses, had fallen from $181 Billion globally in 2008 to just over $90 Billion in 2009. It 2010, it picked up to $110 Billion . This minor jump could possibly be attributed to increased investments in Small & Medium Enterprises and emerging markets such as Brazil, China and India.

Since PE funds acquire firms so that they could be sold at a profit later, life becomes difficult for them during an economic slowdown. Especially more so, where there is a liquidity crunch factor in addition. This was apparent from the total value of PE exit transactions. They fell from $151 Billion in 2008 to $81 Billion in 2009.

From here on to the next five years till 2016, over $800 Billion in loans extended on committed deals would become due or will have to be refinanced . This $800B is distributed almost equally between bank loans and high-yield bonds. To add further complication in hiving off these assets the US government has passed a bill that would require any PE firm which has more $150 Million in assets under management to register with SEC.

The implications are public disclosure of risks, business activities names of the personnel involved, assets owned, amount owed to each creditor, performance metrics, debt and defaults .

According to estimates , there is one trillion dollars’ worth of dry powder in PE funds globally. However, LPs are now demanding more control and requesting more information about their investments. The LPs want to keep track of the draw-down capital so that GPs don’t overdraw their limits⁸. This in effect has created a liquidity crunch of sorts, within the PE community itself.

This puts PE funds in a tight spot. How should they service their existing debts and acquire new assets? The solution for servicing debts is to look for different options such as secondary markets, restructuring the deal or employ turn-around specialists to improve valuations. For acquiring new assets, they must look harder in the marketplace or find greener pastures in emerging markets.

Hence, turn-around specialists are in demand nowadays. PE firms are turning away from traditional leveraged deals and looking into investing in distressed companies. They feel it is better to restructure deals based on a change in strategy rather than to take money out and pursue matter in courts.

Turn-around is becoming more and more important as top lines (revenues) are shrinking. Even vendors have stopped extending favorable credit terms. Hence the success of any PE acquisition is down to operational excellence. This means improved management, optimizing expenditures, and rooting out inefficiencies such as overcapacity created in high growth years.

Interestingly, PE firms have identified a new gap in the market – companies, which do not have the means to hire expensive management consultants, are now finding this as a welcome opportunity to bring aboard high quality leadership.

Emerging markets such as Brazil, China and India are still attractive and PE firms need to find ways of entering them. China and India are the two fastest growing economies even during the recession and they need to develop infrastructure to support the high growth. Brazil is set to hold 2014 World Cup and 2016 Olympics.

With increasing pressure from the regulators, lack of liquidity, and tighter control demanded by general partners, future PE deals would need to be financed and executed with better insights and strategic planning. This means deeper research before deals are struck, awareness of best practices in target markets for operational excellence and market intelligence for finding the right buyers quickly and at the best price.

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Insights into Market Efficiency

Author : Harish Srigiriraju, MBA Capital Markets

 "I'd be a bum on the street with a tin cup if the markets were always efficient." – Warren Buffet

Efficient market hypothesis (EMH) formulated by Eugene Fama in 1970, suggests that at any given time, prices fully reflect all available information on a particular stock and/or market. This implies that the stocks always trade at their fair price or its intrinsic value. Now if this were true then does it make sense in investing in stocks?

If this hypothesis is true then generating excess returns would not be possible. All investors will perceive a stock in the same fashion as it is assumed that all investors are fully aware of all the information on that stock. There would be no need of performing valuation of companies or identifying undervalued stocks. It would not be possible for Warren Buffett to beat the market over several years.

Now it is clear that the markets are not always efficient but in few instances they are. It is generally accepted by value investors that markets are efficient in the long run. So the next question to ask is how long is long? Value Investors look for undervalued stocks in view that they will reach their true value at some point in time. This may vary from stock to stock. A particular stock may reach its value within one year while the other may take ten years. Now the time frame is important as our return depends on this ultimately. So how to identify stocks which will reach its potential quickly? A stock whose information is available to greater set of people will have quicker chances of reaching its fair value. Consider two stocks RIL and KCP(Assumption here is that they are undervalued) . RIL is a stock which will be followed by a large number when compared to KCP. Now if RIL is undervalued there will be many who will invest in this which will lead to price appreciation. For KCP there will be few who track this and hence may take more amount of time to reach the fair value. There definitely will be exceptions to this. So for the value investors out there it should be a learning that just investing in undervalued stocks will not suffice.  

It can be conveniently assumed that Large Cap stocks are more followed than Small Cap. If a stock makes its way in the Sensex 30 or Nifty 50 then all the more attention will be given due to the index funds coming into picture. So if an investor is able to identify stocks in them then it can be called a safe bet. Probably this is one of the reasons why Warren Buffet prefers to invest in bigger companies.

So how can we measure market efficiency for a market say in India. Is it possible to quantify it? One way to do it would be calculate the fair value of each and every stock in the Indian market. Then measure the standard deviation with respect to the CMP. Also as mentioned earlier the stocks would then need to be classified on basis of flow of Information and then efficiency for each category would have to be calculated separately. Even if we were to achieve this the biggest critique would be how will you arrive at a fair value of a company? Is it not a perception and hence will vary? There is no standard method to calculate the fair value of a stock. In most of the research shortcuts are used to avoid hard work. So I can do something similar here. What can be done is ,take the 30 stocks in Sensex. Calculate their fair value in 2000 based on the cash flows from 2000-2005. Here we use 2 stage DCF model as it is the best available tool for valuation. An alternative can be Market multiples but it wouldn’t make sense as the whole idea is to measure inefficiency and in Market Multiples you assume markets to be efficient.

Based on the fair values obtained, the standard deviation can be calculated with respect to the prices in 2000. Similar methodology can be done in 2006. The resultant standard deviation now can be used as a measure to compare efficiency in 2000 and 2006. This can be used in the current scenario also, however the fair value would need to be calculated on the growth estimates from 2011 and this may not be accurate. The values and the results will be presented to you in our next quarterly edition.

This study will be based on the inference that the CMP are the fair values of stocks. However the EMH was mainly focused on the flow of information and not on valuations. To study this, the market needs to be observed for flow of information in various instances like,

1)      Stock Splits

2)      Mergers and Acquisition

3)      Yearly or Quarterly results

4)      Scams

5)      Macro Economic changes

6)      Changes in capital structures

7)      Buyback

8)      Dividend Announcements

Unit root test, Co-integration Test, variance ratio tests, autocorrelation test and few other tests are generally used to test the EMH. For a week form, a study is carried out whether the CMP are a reflection of the previous prices. For a semi strong, a study is done to measure the speed at which a particular piece of information affects the stock price. For a strong form, a study can be done to check if any mutual funds, investment funds or individual investors have generated above average returns over the years. So is a study required for a strong form? Can we straight away say that the markets do not have a strong form of efficiency because there are people like Warren Buffet and Rakesh Jhunjunwala? Can we say that there is no strong form as there are scams like in case of Satyam where investors did not have the accurate information? The answer to these is “yes”. There is only weak and semi strong form. This will again depend on the information flow, media, investors and ultimately the rationality of investors.

So why is it taught in many places that the markets are efficient? It should be taught no doubt but it should be also taught why this theory fails many a times but no doubt holds true in the long term. Flow of information is something which each one should learn as there will be opportunities to make money. In the previous edition of Investocraft, if you have read the article Takeover Arbitrage, we have seen how there is an arbitrage opportunity due to lack of information equally among all investors. "Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn't do any good to look at the cards. It has been helpful to me to have tens of thousands (of students) turned out of business schools taught that it didn't do any good to think."-Warren Buffet. The point Warren Buffett is making is true. Phew! At least the competition is reduced if you know what Buffett and I mean.

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E-Commerce -Will the Bubble Burst ?

Author : Ricky Gupta,MBA Capital Markets,NMIMS

                Harshita Mathur,MBA

The recent expansion of E-commerce in almost each and every nook and corner of the product and service space is just an example of the bullishness of the businessmen who see E-commerce as the future. With the overall E-commerce industry valued in billions of dollars today, more and more customers are buying online. Unlike the trend 2-3 years ago when an Indian consumer won’t buy anything more than a travel ticket or a mobile top up from online stores today the same customer is buying a wide range of products like apparels, home and living products, fitness products, consumer durables, etc. There has been a huge increase in the number of online fashion stores in just a few years and today stores like fashionandyou, yebhi, snapdeal, myntra, flipkart, etc. boast of being the market leaders in the E-commerce industry.

But, is this tremendous growth in the number of online retailers sustainable. Sustainable in the sense is there enough demand from the consumers such that each of these stores is able to get their share of the bread? Of course not. But then what is driving the Indian E-commerce industry and till when will this driving force have the momentum to sustain this industry. This hard question can be answered by having a look at the E-Commerce market and analyzing if there actually has been a bubble in the forming or not.

About the industry

Opening an online store today is not a hell of a job. It’s cheap and easy. Why? Thanks to the increased role of VC funding in the E-commerce markets. The VCs have been particularly very bullish in this sector and have infused money liberally. Every person who wants to open an online store need not worry about the money; it is present in the market at free hands.

A thirst to add more and more customers to their portfolio has exposed somewhat ugly side of the E-commerce industry. Retailers today are fighting for customers and selling products at very low prices so much so that it doesn’t even cover their costs. And what is the result of this. The precious investor money is going down the drain. It is estimated that some of the leading online retailers (names not mentioned here to maintain anonymity) are losing around 5-6 crores of rupees every month due to aggressive price wars and this has certainly started taking its toll on the weak players. One example is of “taggle.com” which recently shut its operations in the country owing to aggressive price wars which were not sustainable for the company.

Delivery costs in India are huge due to poor supply chain management and infrastructural problems. Added to this is the unique cash on delivery and free shipping that is provided by most of the retailers. Cash on delivery orders are not always executed due to increased risk of customers not accepting the delivery once the order reaches them and this means lost sales and waste of money.

The motive of low pricing by the online retailers is something which has worked in the west. There, main aim is to generate initial demand by giving discounts and in the long run stabilize the prices to match the normal market and start earning profits. But taking the case of a typical Indian consumer his behavior pattern is very different from that of the consumer in west. For example, if you buy an apparel from an online store at 50% discount, will you buy the same type of apparel next time online at no discount? The answer is a big no and this is the Indian customer mindset we are talking about. The trade strategies being adopted by the online retailers are not sustainable in the Indian scene.

All of the above factors are an indicator that things are not really fine in the online space. The business practices which are being followed are not really sustainable due to excess supply, wrong pricing mechanism, inefficient payment systems and lastly the mindset of Indian customer. A bubble is definitely going to burst in case the present policies of the Indian online retailers are not checked.

The way to go

There is no doubt in the fact that the power of E-commerce is immense and if used in a subtle way it can be a huge market, thus the need of the hour is some consolidation in the market. It can also be termed as the survival of the fittest in the market. Weak players need to realize that now it’s high time and time has come to give market some space to breathe. E-commerce has no doubt served customers well and Indian customer is happy with it but with so many choices available it is becoming difficult for the retailers to survive in the market.

Consolidation – A Lifeline

The steps towards this consolidation have started sprouting in the market. The recent acquisition of “letsbuy.com”, India’s 2nd largest online retailer by “flipkart.com”, the biggest online retailer in India at a whooping price of around $ 25 million is a signal by the India’s biggest online giant that the market needs to consolidate to fight and tackle competition. The volumes in the market are not low but increased distribution between a large numbers of retailers is making the share of each retailer low. Flipkart for example sells 20 products every minute and with the acquisition this number will rise further. The interest of Amazon in the Indian E-commerce industry is also an indicator of the bullishness of world’s largest online retailer for the industry in India.

Another step taken by the retailers is that they are now trying to diversify. A classic example of snapdeal can be sited here. The site which started off by providing deals on restaurant, gym, hotel, travel, etc. deals at low prices is more than just a deal seller now. It has integrated other services and is now a multi-commodity online store offering apparels, jewellery, lifestyle products, etc. This is a step towards greater expansion and new revenue sources. Flipkart’s prior acquisitions of chakpak, mime360 are also examples of the hunger for diversification of the online retailers.

Conclusion

E-commerce has definitely a long way to go in India, it’s up to the retailers when they would be able to catch the real pulse of the market. Big retailers have started to realize what is needed at the moment to beat the bubble but hundreds of startups and small retailers are still shooting in the dark just in hope to hit the target.

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LIBOR or LIE-MORE?

Author :Chakhsu Agarwal , NMIMS

The recent London Interbank Offered Rate (LIBOR) scandal has cost Barclays heavily with its top 3 officials including the CEO Bob Diamond resigning from the firm. Before digging into the LIBOR scandal, let us first get an insight into what LIBOR is all about. 

What is LIBOR?

 LIBOR, or the London Interbank Offered Rate, is the average interest rate estimated by leading banks in London. The Banks charge this rate for lending credit to other banks in the London Interbank Market. Libor is calculated and published by Thomson Reuters on behalf of the British Banker’s Association (BBA) after 11:00 AM (and generally around 11:45 AM) each day (London time). LIBOR is calculated by BBA daily wherein they survey 16 large banks. The BBA, then surveys different banks’ interbank interest rate quotes. The rate at which each bank submits must be formed from that bank’s perception of its cost of funds in the interbank market.

The top four and bottom four values of the quotes are discarded and the remaining interest rate quotes are averaged to form the daily LIBOR. LIBOR rates are provided for period up to 12 months. LIBOR rates are provided in 10 currencies namely US dollar, euro, Japanese yen, Swiss franc , Canadian dollar, Australian dollar, Swedish Krona, Danish kroner , New Zealand Dollar. There are ten LIBOR panels, one for each of the ten currencies for which the rate is determined. Each panel is composed of at least eight contributor banks, chosen for their reputation and their perceived expertise in a given currency.

Why is Libor significant?

Not only does LIBOR provide information about the cost of borrowing in different currencies, it actually influences it. Banks look at it every day to figure out what they should charge for not just home loans, but car loans, commercial loans, credit cards. LIBOR ends up almost everywhere. Variable interest rates are often quoted as LIBOR + a percentage. For example, a loan that was LIBOR + 5% would charge 10% interest when the LIBOR is 5% and they would get charged 7%, when the LIBOR is 2%. So deals on trillions of dollars around the world are done based on this number.

What is the LIBOR scandal?

The inquiry into the suspected LIBOR scandal started over the allegations of Interest Rate Manipulation during 2008 sub-prime crisis. In order to stimulate the economic activity and show rosier than actual picture of banks, banks showed lower than actual interest rates. The lower interest rates therefore resulted in lower LIBOR and thus shored up the confidence and increased lending. Allegations of Libor rigging are not new but for the first time it has come to the surface that LIBOR manipulations were sanctified by the officials. As Libor is the average of the interest quotes by different banks, so rigging of Libor would have involved many banks. In the wake of investigation over the phone conversation Diamond had with Paul Tucker, the Deputy Governor of bank of England, Barclays decided to come clean about Libor fixing and settle ahead of the other banks which were also under investigation. They launched an internal investigation which cost 100 million pounds and in its report to regulators claimed that they had official sanction to lower the interest rates. But their strategy backfired politicians and regulators quickly turning against the bank as public outrage rose and were fined $455 million by US regulators for rigging the Libor rates. The CEO of Barclays, Bob Diamond, had to bear the brunt by resigning from their respective jobs.

The BBA is currently undertaking a review of the way LIBOR is set and will publish its findings shortly.  The FSA is working to support market-led reviews of existing arrangements, with the goal of ensuring such arrangements continue to command the confidence of all stakeholders. Once the investigations are over, it would more clear as if any other banks were also involved in this scandal.

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A Carbon Exchange in India

With the world gearing in for emissions reductions as per Kyoto Protocol, India is leaping in at the opportunity created by this immediate global concern.  Mr. Jairam Ramesh’s statement clearly indicates that India does not want to be left behind in this brand new market.  The Indian government is designing the National Mission on Enhanced Energy Efficiency under the NAPCC so as to create a roadmap for energy reduction and efficiency.  As per 2004 data India’s carbon emissions stand at 1/20^th of those produced by the USA.  This presents to us an immense opportunity for trading our lower carbon production levels with countries that intensively consume energy and increase carbon emissions.  However, in order to maximize advantage, India needs to follow the carrot and stick approach; enforce strict regulations governing carbon caps on one hand and promoting energy efficiency through trade and tax mechanisms on the other.  This is necessary as huge investments to the tune of about EUR 600 billion may be required and the government would have to create monetary mechanisms to promote the same.  After having created strict emission caps, the creation of an internal carbon trading system on the lines of existing international models, would help Indian companies reach these cap levels.

When we talk about ‘trade’ one may ask ‘how exactly do companies trade pollution’?  The latest currency on the block is the ‘carbon credit’ which measures the amount of carbon emitted into the earth’s atmosphere.  1 carbon credit is equivalent to 1 metric ton of carbon dioxide CO₂ emitted into the atmosphere.  The United Nation Framework Convention on Climate Change (UNFCCC) has established various mechanisms, International Emission Trading, Joint Implementation and Clean Development Mechanism, to facilitate trading of these Carbon Credits.  Within these mechanisms, India comes under the purview of the Clean Development Mechanism (CDM) established for Non Annex 1 or developing countries.  The carbon credits generated from CDM projects are called Certified Emission Reductions (CERs) and can be traded bilaterally or on exchanges such as the MCX only with Annex 1 or developed countries.

As of now, the commodities exchange of India, the MCX, is involved in futures trading of carbon credits.  The exchange has enabled Indian companies to get more fair prices for their carbon credits as opposed to those obtained by bilateral agreements between companies.  However the drawbacks of the MCX exchange is the lack of liquidity in the trade of carbon credits within the exchange.  Further, we need to have a mechanism by which companies can efficiently trade carbon credits within India, and create a free market for intra-India trade.

As mentioned, we need to go a step beyond status quo so as to monitor carbon emissions in India and create mechanisms to reduce them.  This can be done by first creating targets as per sector and size of a plant.  The NMEEE has designated a 3 step PAT or Perform Achieve and Trade process to enable Indian companies to achieve energy efficiency.  The first phase involves goal setting specific energy consumption (SEC) target for each plant, second phase is the reduction phase where companies would need to achieve these targets. The third phase would be the trading phase whereby companies that meet or over-perform on these targets may be issued energy certificates or permits that may be traded on an internal energy exchange.  Companies that do not meet required standards would be penalized.  

In order to promote projects that promote energy efficiency, tax breaks and exemptions for the profits made on energy efficiency projects could be given, a national fund to support such projects could be created, and risk guarantee funds for banks to insure them against risks associated with leverage be provided for such projects.

Overview of the Indian Market

In India there are a number of small and dispersed projects being rum primarily by SME’s to improve their processes.  As of Feb 1, 2010,475 CDM projects were registered with the CDM executive board in India out of which 243 were small scale. The Estimated CER generation stands at 240 million.  This indicates the potential that such a market may hold in case an internal trading platform is created.  Growth and diversification of carbon markets will be linked to investor and companies’ understanding of such a market and its instruments.  In the event of creating exotic carbon based derivates and instruments, rating agencies will also play an important role.  For instance, in the European Union strong local demand and supply has enabled development of exchange based carbon futures and spot markets.  However, the absence of a local market deters the prospects of carbon trading in India.  Indian firms need access to such a platform which provides them with sufficient liquidity in terms of energy/ carbon permit trading.  Such a market may also attract huge overseas investments.

Prospective market structure and players in India

India may soon have such a carbon trading system, with the government pondering over market based instruments to keep industrial emissions under check.  Mr. Jairam Ramesh has asked state pollution control boards to automate their emission monitoring process by following the Tamilnadu model.  Real-time emission monitoring is the starting point for the three step PAT process recommended by the NMEEE.  The Cap and Trade system permit based trading will, in effect, offset excess credits and mobilize credits within the country.  In the credit/permit transaction, the buyer is paying a charge for polluting, while the seller is being rewarded for having reduced emissions.  Thus, in theory, those who can reduce emissions most cheaply will do so, achieving the pollution reduction at the lowest cost to society.

Price Discovery

The mechanism of price discovery is very important to understand the trading system.  Unchecked energy use and hence emission levels are predicted to keep rising over time. Thus the number of companies needing to buy credits will increase, and the rules of supply and demand will push up the market price, encouraging more groups to undertake environmentally friendly activities that create carbon credits to sell.Whether the company will set or not will depend on the Marginal Abating Cost (MAC) incurred by the company.  MAC is the cost the company would incur to reduce 1 metric tonne of carbon or to gain 1 credit.  Suppose Company A’s emissions exceed by 1 compared to the allowed limit, then it has two options, either buy the credits from another company B or Improve its processes to reduce the emission. Now if the price of the credit in the market is 15 and the cost for reducing the emissions for company is 50,then it is more profitable for the company to buy a credit from the market, however  if the cost of improving its own processes were to be 10 then it would go for the latter option.  This cost is called as the Marginal Abating Cost (MAC).  The MAC and price will be determined by demand and supply forces.

Market player

·         Speculative investors

The emergence of a new market attracts risk capital and early speculative investors who provide liquidity in return for higher returns. As the market will mature and liquidity increases, the involvement from mainstream investors is expected to step up and lower the costs.

·         Carbon brokers

They can come into picture when the transactions are highly structured and the value-add of a knowledgeable broker is considerable.  They can bring in information to aid the investors in the process of trading leading to a more structured market

·         Insurance companies

The need for insurers is seen on account of impact of climate change on property, health risks etc and the new business avenues arising out of the carbon market

·         Exchanges

A structured market and liquidity of credits will encourage more competitive market and new exchanges being setup for trading

·         Credit rating agencies

The potential of carbon emissions to impact the long term value or credit of a company will be enhanced by the entry of credit rating agencies that will help evaluate the financial standing of the company for CDM related loans.

Conclusion

Feasibility of such a market for trading depends on a number of factors such as determination of proper rules and guidelines governing emission caps, monitoring of emissions, setting up of regulation authorities and auditors, and many other factors.  Having said this, the market would immensely help India to reduce the overall carbon footprint, which will in turn make India an attractive destination for foreign investments.  This is especially true since India is growing at a phenomenal growth rate and will be requiring huge investments in the infrastructure and energy sectors.  Further, improvement of energy processes will help improve the bottom-line and reduce dependence on non-renewable resources.  The process could be a win-win proposition for all, and help India remain at par with global changes in technology and sustainability.

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ETF- Exchange Traded Funds or Exotic Traded Funds??? A Boon or a Bane??

Authors : Roy Paul  Mathew  , SJMSOM-IIT BOMBAY
              Bindiya Bansal , SITM 

Exchange traded funds, a low-cost form of investment which has immense popularity among retail investors, is becoming an increased source of fear of it being the source in waiting for a systemic institutional risk which can in turn lead to a Financial Scandal. This article analyses the functioning of ETF, its advantages and disadvantages and the growing concern of whether ETF can be a source of pollution instead of revolution by attaching too much risks by complicating a simple idea.

What is ETF?

ETFs are part fund, part stock passively managed schemes that invest their entire corpus in a basket of securities, such as equity shares. Think of an exchange-traded fund as a mutual fund that trades like a stock and reflect an index such as Nifty. An ETF, however, isn't a mutual fund; it trades justlike any other company on a stock exchange. Unlike a mutual fund that has its net-asset value (NAV) calculated at the end of each trading day, an ETF's price changes throughout the day, fluctuating with supply and demand. ETFs attempt to replicate the return on indexes; there is no guarantee that they will do so exactly.ETF doesn’t aim to outperform their Benchmark indices but rather follows passive tracking.ETFs first hit the market in 1990 and Some of the popular ETFs are Spider(SPDR trading under symbol SPY) which tracks the S&P 500 index and examples of ETF providers are  Barclays Global Investors (BGI) and State Street. ETFs can be basically of 2 types

    1)    Leveraged ETFs  

Leveraged ETFs offers a geared return on a given index.

     2)    Inverse ETFs

Inverse ETFs aims to go down when the bench mark goes up 

A view on the performance of ETFs

                                   

Advantages of an ETF

     1)    Automated Mechanism

ETF’s work on an automated mechanism and basically can be employed by investors who wants to avoid the fund manager. Hence ETFs are better products with more features for a lesser amount of money. ETFs are listed in stock exchanges which enables investors buying and selling and unlike conventional MF’s, ETFs can be traded all day long.

      2)    Diversification coupled with flexibility of a stock

      An ETF gives the advantage of diversifying an index fund. Since ETF’s trade like stocks, an investor can short sell them, buy on margin and even purchase a single share.It leads to financial democratisation, since small or big investors can trade on same terms. Nowadays ETFs which tracks private equity, vaccine stocks, clean energy, gold and much more available apart from the regular bets on standard indexes.

    3)    Lower Expense Ratio compared to Mutual Fund

Since cost of active tracking by fund managers is nullified by its automated mechanism, while buying and selling ETFs, the broker is getting paid the same commission as for a normal regular trade. It allows investors to get “beta” (market returns) on the cheap, while MF’s strive hard to achieve “alpha” (extra returns through skill), charging more for the privilege.

  

     4)    Greater Tax Efficiency and Liquidity

Since ETF units can be created and dissolved against a basket of shares, there is a constant cash component. Since the responsibility to create ETF units rests with the market maker, they don’t have to pay brokerages to stock brokers since ETF does not buy or sell securities in the market.

How does an ETF work?

The market makers in the stock market are appointed by fund house who are entrusted with the responsibility of buying the basket of securities (e.g. market index scrips) and pass it on to the fund house in exchange for a certain number of units. This process is called as “Unit Creation” .The market maker splits these units and  are sold separately on the stock exchange. Once unit creation and sale happens, it is up to the investors to buy and sell these units from the stock exchanges. Since ETF shares are purchased and redeemed directly from the exchange traded funds by financial institutions normally in bulk blocks and are called creation units. Institutional Investors receive or contribute a basket of securities of the same type and proportion held by the concerned ETF. The portfolios of ETF’s are transparent and hence it helpful for institutional investors to decide the assembly of portfolio assets for purchase of a creation unit.

Growing Trend of ETF to become Exotic Traded Funds

Complex New Types of ETPs(Exchange traded products)

Newer types of ETF fail to give the cheapness and diversification of the earlier traditional ones. ETFs are increasingly becoming a source for hedge funds to hedge and speculate on the stock market throughout the span of trading day which in turn allows them to make complex bets on highly illiquid asset classes. The earlier concept of ETFS to encompass a broad range of stocks is quickly giving way to derivative position with counterparty being an investment bank. This growing trend is worrying and it has certainly caught the eye of financial regulators. The Financial Stability Board (FSB), a committee of financial supervisors, issued a report on ETFs. The IMF and Bank for International Settlements (BIS) published global financial stability report and research paper on “Market Structures and Systemic Risks of Exchange-Traded Funds”.

The biggest worry for the regulator surrounds the “Synthetic “ ETFs and derivative linked products popularly known as ETPs( Exchange traded products) of which Exchange-traded notes (ETNs) and Exchange-traded vehicles (ETVs) are popular.

An ETN is basically a debt security issued by a bank or a index provider which gets traded on the market. An ETV is a debt security issued by a special-purpose vehicle.

Since it is almost impractical to replicate a targeted index, most of the ETF provider usually enters into a transaction known as total return swap with a leading bank. The bank is now entrusted with a tedious responsibility and risk of replicating the index. The bank on the other hand agrees to pay the provider an amount almost equivalent to the return on the chosen index benchmark. Since ETF provider has an inherent fear of whether the bank has a risk for going bust and hence requisites them to provide a collateral.

There is a big underlying risk in this financial model. The collateral collected from the bank may have no relevance with the index. Sometimes the collateral can be in the form of equities and bonds and mostly will have no connection with the index. Most of the bonds will be unrated and equity shares have no connection with the index. If the bank were to fail, the index provider will be left with assets which has no correlation whatsoever with the targeted portfolio.

      1)    ETFs as dumping ground for Unwanted Securities

For a Investment Bank to take up the role of mark maker, it necessitates to keep an inventory of debt bonds, equity stocks so as to enable itself with the volatile demands of buying and selling of the client. If the underlying securities are illiquid, the funding can be indeed costly. Once these stocks and bonds act as collateral assets to the ETF provider, the investment banks gets an added advantage of reduced warehousing costs for these assets. Hence the bank raises fund against an illiquid portfolio which left to itself has no ways of funding.

      2)    Lack of Liquidity

  

Not all ETFs enjoy a good liquidity. Since most of the actively managed funds through their expertise fund managers have always managed to outperform ETFs, hence lead to lack of attention to ETFs. E.g. Sensex Prudential ICICI Exchange-Traded Fund (SPICE) is a typical example for poor liquidity. Another striking example is the “Flash Crash” which happened on 6th May 2010 where Dow Jones Industrial Average shed around 1000 points.  Around 75% of the trades were the ETF. Most of the high frequency use ETF funds as a part of their complex arbitrage strategies. Nowadays, most ETFs offer an additional window which facilitates the redemption in the event of inconsistency in the sale of units. Since agents have an instinct to sell products which would fetch them higher commission, ETFs being low-cost products doesn’t pay much of commission failing to attract a rally in market and hence is not a major paying proposition.

      3)    Exposure to Asset Classes like Gold

There has been a spur of interest in Gold ETFs thanks to a rise in the bullion price. Gold ETFs has seen a mass inflow to the tune of $12 billion in 2009 and $9 billion in 2010. The largest gold ETF piled up more bullion than almost all of the world’s central banks san America, France, Germany and Italy. If  all of a sudden investors lose faith, markets can behave hay way as firms compete to take part of their profits.

      4)    ETFs- Bad Products for volatile markets like India

For stock markets of the like of India where there is large amount of volatility where indices are often subjected to periodic churn of going in and going out. This adds a lot of pressure on fund managers to sell off scrip which moves out the index and buy in the scrip which makes a cut into the index. Whenever the ETF fund manager performs the rebalancing act of the portfolio, the scheme has to bear the cost. Hence for unstable indexes which are subjected to constant change in the index to the tune of 10-20%,ETFs are not a good bet.

Growing tendency of ETF managers to top up their income with fees for lending the securities in their portfolio has led to forceful recall of loans in the event of ETF investors wanting their money back in periods of market disruption leading to liquidity pressures.

Conclusion

With the underlying assets being illiquid, ETF is transforming itself into a bet on the credit worthiness of a Bank and parallels are drawn with the failure of mortgage-backed securities. Despite these pitfalls which regulator should take care, ETFs remain as good products and being low cost product can make a part of the portfolio.

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