I was in Mumbai recently, meeting fund­­­ managers to understand where India was on the smart beta road. How fast was investor education evolving? What was the appetite for ETF’s? And what should be done from the regulation point of view to take the Indian markets to the next stage?

I don’t know how fast India will get the financial sophistication necessary to have a thriving ETF Market, fixed income products and a revival of the commodities market, but the stats stack up favorably. Emerging means higher returns and even from a size point of view, India should have a $100-400 billion ETF market. This means more knowledge at the investor, institution­­ and regulator level. But many things are amiss. It’s like going to Mumbai and being amazed at the tower-scape happening all around and then just finding one metro from Versova to Ghatkopar. A city with the capacity to make India a great financial center, suffocating because of bottlenecks.

Risky business

The very first thing the country needs to do is to get a move on its risk education. The Indian investor is willing to assume more risk because he/she focuses on returns. A more sophisticated market is focused on returns that are risk-weighted, mainly returns measured on the scale of volatility. An average annual return of 10% at 12% annual volatility is a lot different when the same 10% return is measured on a scale of 24% annual volatility. Volatility means that the average returns can erode or increase by the level of annual volatility. Volatility is good when positive, but the problem arises when it starts eroding wealth. A three-year negative period can erode the annual gains from 10% to 4.4% in case of higher volatility, and to 6.8% in case of lower volatility. The long-term damage to the investors’ wealth thus could be irrecoverable.

Illusion of Money

Putting it plainly, it’s like buying a fake Gucci. It looks the same, but there is no brand, no service, just an illusion of quality. Of course, it comes at a perceived value, but in the end, it spoils many things. It encourages poor quality, lack of accountability and illusion of money. In the long term, the fake strategy is a short-term pleasure, which does not generate long-term wealth, or erodes the existing wealth faster. And the very fact that the Indian markets are almost double in volatility compared to their US counterpart, the risk just amplifies, making it imperative to look at the risk-weighted return.

What will happen if the regulator emphasised disclosure of risk-weighted performance? Fund performances will become more accountable. The average annual 8% return fund that seemed poor in performance will suddenly start looking better than a 10% average return fund. Such initiatives have to come from investors, regulators, and institutions. If we don’t talk about risk-weighted performance, we are not being transparent about the inherent risk, which is an ethics issue and can’t be just blamed on investors’ lack of education. But at the end of the day, the regulator might not have the courage to adopt a proactive approach. Hence, the institution has no incentive to be transparent about its real performance. This leaves the investor to fend for himself. If investors don't understand the difference between absolute and risk-weighted performance, they will consume what they are served — a fake Gucci. This investor revolution has already happened in the US, where investors refused to pay higher fees to managers who did not perform on a risk-weighted basis.

Coming back to the regulators, they want good for the industry but by not enforcing accountability in the active management process, they are doing more disservice to managers with better products, real innovations and hence the investor and the market. It’s an unfair level playing field stacked against deeper pockets and brands vs. real alpha generators.

Beating the benchmark lie

Additionally, it is misinformation that active managers in India have beaten the passive styles of investment. Until we compare apples with apples, all comparisons are misleading. If Indian investors believe buying the benchmark, smart beta or passive investing is a poor choice, it is because they do not understand risk and neither regulators nor institutions want to lead the best practice of disclosing risk-weighted returns. This is why the industry is suffering from misconceptions. How strange is it that it’s so hard to beat the S&P 500 but everybody in India beats the Nifty 50? Beating the benchmark means beating it at the similar risk, similar turnover, and same components historically.

Come to think of it, an indexing business is built on the idea of different weightings for a set of components in the basket. How many ways can you build a basket to beat the same basket? Same 50 stocks, different weights and still more alpha? In the US, smart money seeks such rare top performers that beat the benchmark on a risk-weighted cost basis.

Mukul Pal is the founder of Tralio and CEO of Orpheus Indices