The flip side | Do mutual funds need a P-Note like system?

Updated on Oct 19, 2007 12:11 AM IST

This has been a week of heady highs and terrible lows in the country’s stock markets, thanks to the controversial participatory notes, writes Narayanan Madhavan.

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Hindustan Times | ByNarayanan Madhavan

This has been a week of heady highs and terrible lows in the country’s stock markets, thanks to the controversial participatory notes (PNs) that the regulators and the government are trying to moderate by asking that these instruments be phased out over 18 months or get them regulated by proper registration.

Now, PNs are used by overseas investors as a proxy to play in the Indian stock markets, and they are one of the key forces behind the dizzy flow of billions of dollars coming in through foreign institutional investors (FIIs), driving up the wealth of small and big investors alike.

We should not complain about that, but the timing and the manner in which the Securities and Exchange Board of India (SEBI) moved to moderate the PNs and the finance minister’s clarifications that they will not be banned raise some legitimate questions. Were the regulators worried particularly because the Sensex had reached levels where its fundamental value based on earnings seemed stretched?

Pundits and critics alike would think that it is not fair for the government to decide on the valuations of stocks, and they are probably right in their own way. But I am thinking of looking at the other side of the picture.

What is the gain or loss for small investors or mutual funds that represent them in such a scenario? Typically, the spiel surrounding mutual funds is that they represent long-term investments and are thus insulated from the volatility and cyclical movements of the stock markets. While this sounds great on paper, I do think mutual funds are highly vulnerable.

For one, mutual funds are required to deploy the better part of their garnered funds within specified time periods in the market and do not have much elbow room to sit on cash piles. They also cannot or do not play much in derivatives, which FIIs and high net worth individuals (HNIs) use to gain from rallies or mitigate shocks.

In other words, mutual funds hardly enjoy a rally when it occurs. In an ideal world, if the valuations based on earnings and fundamentals for many of the Sensex stocks were stretched, mutual funds should have been selling them to book profits this week or last week. I do not think that really happened on a significant scale. There are always arguments that their investments are for the long term and that they drive down prices when they sell in huge quantities.

My argument is that mutual funds are not able to make much gains from dizzy rallies because of three reasons. One, their fund managers are too conservative by nature, training and attitude, and simply act like bystanders during rallies. Second, SEBI regulations do not allow them legitimate elbow room to gain at the cost of speculators. And third, they do not have flexible instruments that can help them leverage on their research and presence in the markets.

I wonder if mutual funds should be allowed to invest through something like participatory notes (PNs) where they buy in a low market and adjust the purchases against future proceeds from small investors.

In the current scenario, I feel mutual funds are like sitting ducks. They seem to buy stocks all the time and merely keep up with market benchmarks, without the fund managers really outsmarting the speculators or outperforming the indices when valuations turn stretched.

Privately-managed portfolio management schemes (PMS) can do pretty much the same job, but PMS schemes do not have enough muscle in the Indian markets. I do feel the market needs players who can help stabilise the system based on fundamentals, to avoid a situation where the government has to do their job. A healthy dose of realism is always good within the market sphere.

Any suggestions on how this can be done without government participation?

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