The inbuilt volatility in financial markets…

A recent speech by Raghuram Rajan of the IMF, at a conference of central bankers on June 8, makes interesting reading. He analyses the phenomenon of the risk tolerance of investors when the markets were going up and their sudden risk aversion when the markets are going down. The reasons for risk aversion, according to him, lie in the structure of incentives for investment managers, those that manage financial assets on behalf of customers.

A typical compensation contract for a hedge fund manager is 2% of the assets under management, plus 20% of annual returns in excess of a minimal nominal return. When risk-free returns are high, compensation is high, even if the fund takes on little risk. But when risk-free returns are low, it encourages the manager to take additional risks to improve his compensation. The manager generates returns based on the systematic risk he takes?the beta risk?and the value his abilities contribute to the process ?- his so-called alpha. Shareholders would like to pay managers for their successful alpha capabilities, that is, the extent to which they ?beat the market.?

Rajan argues that there are very few sources of alpha. The first is to be a Warren Buffet and to be able to identify undervalued assets. Very few have this ability. The second is to provide activism through aggressive takeover of a poorly managed asset to turn it around and add value. The third is through superior financial engineering that would create new instruments and staying ahead of the market.

Finally, alpha can be generated from liquidity provisioning. That is, having access to liquidity, they can hold illiquid positions to maturity. The unique ability of picking stocks or aggressive turnaround managers or financial engineering is rare. Since funds and managers that perform well attract further investment, there is a pressure on managers to distinguish themselves. And they often do so by hiding the risks they are taking from the investors.

These are strategies that have the appearance of producing very high alphas, but have the tail-end risk of blowing up every once in a while. Since the manage-rs know these are risky, there would be a herd mentality in that all the managers would tend to take similar risks ?they would know their underperformance would be excused if everyone is in the same boat.

Rajan further argues that this risk-taking behaviour is exacerbated during periods of low interest rates. Suppose interest rates are low. A finance company that has put out an assured return product promising, say, 6% returns, is hard-pressed to produce this level of returns. It gets pushed into high-risk assets. Conversely, if monetary conditions are expected to tighten substantially, we should see a reversal of this behaviour, which would be attributed to increased risk aversion. The behaviour would be accentuated by genuine uncertainties surrounding any turn in monetary policy.

The analysis leads to some interesting hypotheses regarding recent market behaviour in our bourses, and could perhaps be a pointer of things to come. Ideally, shifts towards high-risk and low-liquidity assets by some speculators should be compensated by other rational investors, especially investors trading with their own money, who do not get into the issues of compensation problems of fund managers. In India, on the other hand (and perhaps in most emerging markets), the management of the bulk of the funds is in the hands of institutional investors and not with rational individuals. Actually, the behaviour of the small retail investor in India has been characterised, again and again, by emotional rather than rational behaviour, by uninformed risk-taking rather than rational fund application. The resultant aberrations in behaviour can, therefore, generate systematic distortions in asset prices. The pressure of redemption on mutual funds, the avoidance of risk by FIIs and, indeed, fundamental uncertainties about monetary policy are contributing to the volatility in the market.

The integration of our financial markets with the international markets thus brings in its wake the integration of sentiments, of market behaviour and of risk perception. To this is added our own indigenous approach to risk, the jumping in with eyes shut and expecting a bailout, that has characterised the small investor in India for several decades. Coupled with the fears of inflation, fuel prices and uncertainties in the reforms process, it is not surprising that the market is today only in the hands of a few ?players? that are leveraging these uncertainties.

It is, however, somewhat surprising that the integration of markets has not extended to the integration of regulator behaviour. All this while, for the past five to six weeks, the actions of the regulators, both Sebi and RBI, have been remarkably out of sync with the behaviour of regulators in other volatile markets. Dampe-ning of volatility, for example, requires imposition of sharp additional margins that can then be withdrawn once the curve is smoothened. We have seen little evidence of regulator measures to dampen volatility. The approaches of committees to study and to come up with a blueprint for discussion do not really apply in an era where reaction time needs to be in hours and minutes. When one travels round the world, the behaviour of our regulators often crops up as a question. On several decisions, one is asked why. And, more important, why a convoluted path is taken when a straight approach is available that will solve a problem quicker. Perhaps the only reply possible is that, ?We are like this only!?

?The writer is a former finance secretary and economic advisor to the Prime Minister