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Home > Business > Special


How to lower risks, get higher returns

Devangshu Datta | April 16, 2007

Ten men decide to float a shipping concern with equal equity. They will own a fleet of 10 identical ships. Does it make a difference if each equity-owner holds individual title of one ship or whether each holds one-tenth shares of the collective fleet? Of  course.

If they hold individual titles and one ship sinks, the respective owner's equity is wiped out. In contrast, each loses one-tenth of his equity if the ownership is joint. Similarly, profits are smoothed out in case of joint ownership because each has a claim on all assets.

That's the powerful argument in favour of a joint stock corporation. It can be extended to argue in favour of portfolio diversification. If you own shares of several different businesses, your risks are lower and your returns less volatile.

A talented entrepreneur such as Bill Gates, Steve Jobs, Azeem Premji or Baba Kalyani can become very rich by concentrating on a single business. If, however, you don't reckon that your entrepreneurial skills are in the same league or you don't have the business-picking skills of a Warren Buffett, it's probably better to own a broadly diversified stock portfolio.

Again, this argument of lower risks and less volatile returns can be extended to asset classes. If you own equity, debt, commodities and real estate, some of your portfolio will usually be performing (once in a while, all will be performing). Unless of course, the entire economy is in the doldrums - when that happens, maybe nothing will perform.

Extend the argument further. We can make a case for diversifying across national economies. When one national economy is on the downslide, another is booming.  And, of course, diversifying across economies also offers exposure to currency fluctuations.

Currency risk adds another potent variable. Forex is the biggest and most complex market in the world. In currency traders' jargon, "one buck" equals a minimum lot, which is actually $1million. You can make or lose a lot of money by playing currencies.

Assuming you've bought the argument for diversification, let's consider the assets you would like to marry in to a portfolio. Ideally you want low or negative correlation between assets. That way, you have hedges wherever the trends may go. Indians are fairly lucky.

Due to decades of isolationism, Indian markets are not very strongly correlated to global trends. Of course, some segments are - commodities and the IT industry are strongly correlated to world trends. But many segments are out of step. So, external diversification should in theory, work well.

Unfortunately, the Indian government is paranoid about currency risks. As a result of its controls, a flourishing hawala trade has developed. This is large enough to be a major vested interest. Attempts at full float are vehemently opposed because every political faction stands to gain from perpetrating the current system.

The slow relaxation of controls has meant that, until 2006-7, Indians could invest a grand total of $25,000 abroad. Now, it's $50,000. But the guidelines are unclear and there are few structured products that allow overseas exposure.

At the same time, two macro factors make the case for immediate overseas diversification compelling. The Indian economy is slowing down and market returns have been lukewarm in the past 6 months or so. Overseas returns, especially the Asia Pacific region especially, have been better.

The rupee is at an eight-year high versus the dollar. Interest rates have hardened to a point where the credit cycle is likely to top out within the fiscal. That means, in the long-term, the rupee is likely to soften and a softer rupee boosts overseas returns.

Put it together and it must be logical to seek diversification overseas. Indeed the Fidelity International Opportunities fund offers that. It targets allocations of 65 per cent in the Indian BSE 200 universe and 35 per cent abroad in Asia Pacific (excluding Japan).

In the past six months, that region's MSCI index (All Countries- AP-ex-Japan) has yielded dollar returns of 22 per cent - that's a lot better than the BSE 200, which has just about 5.5 per cent in the same period.

However, this is a new instrument with no track record and relatively high entry-exit loads. It has a mandate to invest in derivatives. The fund will also require currency management skills. It's an open-ended fund - you can enter later. There's also the Principal Global Opportunities and Templeton India Equity Income - both have performed reasonably.

Does it make sense to wait for the RBI notifications on the $50,000 limit? There could be a burst of new products. Also there would be a track record and the derivative/ interest rate/ currency management style of Fidelity's new offering would be clearer. That would be the cautious thing to do. 



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