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Deepening capital markets in frontier countries
By Sourajit Aiyer
A version of this article was originally published in Financial Express, Bangladesh in December 2014.
Growth expectations in most frontier countries are improving, so investors, domestic as well as foreign, could well
benefit from being able to tap into this growth.
What would be the first step that could help to translate this growth into increased capital market activity?
Performance of frontier countries versus emerging markets looking at two major ETFs. Source: Yahoo Finance.
The first thing that frontier countries should do should be to look at what they are selling. This means the supply of
good-quality, growth-realizing and professionally-managed companies into the primary and secondary capital
market.
That will strengthen what the market is offering to investors. A bad product can break the market, irrespective of the
efforts of market players. This supply should move in line with the economies’ growth. Otherwise, some investor
activity may flow into low-grade companies, which would reduce their longevity.
Broadening the base of quality companies will help focus most of the investor activity solely on that base, and
extract greater interest from both existing and new investors.
This would require creating an ecosystem around competitive advantages, entrepreneurship, growth capital,
regulations, foreign investments and technical partnerships.

2. Frontier economies are identifying areas of competitive advantages, which leverage on domestic demand or global
sourcing. This includes sectors where production-migration can occur if cost-effective resources are available
locally.
One such example is India’s software sector, where production migrated from the West as India offered cost-
effective skills. Competitive advantage provides a rationale to invest and create enterprises for future growth.
Countries with limited physical resources should tap intellectual resources. Offshoring (Knowledge Process
Outsourcing/Business Process Outsourcing) is a sector which India has capitalized on.
Mid-sized countries are partnering to tap complementary resources and create broader production platforms. Many
frontier economies lack high-end manufacturing technologies, restricting their ability to diversify.
Including technology-transfers within foreign investment agreements may help, but this really depends on
bargaining power. Investors prefer companies who develop a differentiation to capture market share ahead of
peers, as that stretches its long-term potential.
Fostering entrepreneurship would require a change in society’s mindset to view it as a career option,
institutionalized incubation support and growth capital through private equity or VC funding, with the aim to list
eventually.
Sunrise sectors based on production-migration need to encourage non-residents experienced in those sectors to
return from abroad, as their experience would be invaluable to build those businesses locally.
High quality companies
Listing of only a handful of quality companies for capital raising and trading can transform the interest level in the
markets.
In India, it took a few quality companies like Infosys, TCS, Airtel, Hero Honda, HDFC, etc. to list since the 1990s
and take market activity to the next level. Today, technology is the second-largest sector after banking, and holds
15% of India’s US$1.5 trillion market capitalization.
Twenty years ago, this sector did not even exist. Primary market activities have been a useful entry point for new
retail investors into the markets in many countries.
Hence, large-size issues of good-quality companies would give a definite fillip to the addition of new dematerialised
accounts and aggregate market activity.
Earnings growth of these companies will be the main yardstick that sustains long-term interest in equity markets.
Price appreciation comes from earnings growth and multiple expansion.
Multiple expansion is good to some extent as it reflects market optimism. But beyond a point, it suggests
overheating and limited upside for new buyers.
Earnings growth reflects the fundamental performance. It supports the multiple within reasonable range, helping
continued interest from newer investors.
Frontier countries also need to look at dividend policy. Dividends are the only return that value-investors realize as
they buy-and-hold for long duration. Brazil has already initiated compulsory payouts from profits.
It is worth remembering that the opportunity a country offers outranks other factors influencing investment flows.
This includes Ease of Doing Business, where a frontier market like Bangladesh actually ranks higher than an
emerging market like India.
India may have an opportunity advantage in sectors based on domestic demand, since Bangladesh’s population is
13% that of India. But global sourcing opportunities in each one’s area of competitive advantage can be on a more
equal footing.
Size of the local market is inconsequential here, since it depends more on procuring the resources and building an
efficient production. Many of India’s competitive advantages are in global sourcing opportunities.

3. Foreign capital flows
What trends can frontier countries expect from foreign institutional flows into local capital markets?
For brokers, foreign institutional flows into equity markets (foreign portfolio investors) are a battle for market share.
This is unlike retail flows, where the focus is also on increasing the market size.
Global allocations are decided by the asset manager for the respective countries the fund takes exposure to, often
based on MSCI or FTSE indices. Each broker has to maximize his market share within this allocation.
However, funds may decide to go underweight or overweight on allocation, depending on market conditions, which
may impact the overall allocation.
What this means for deepening the local capital market is that the flow per fund is restricted based on the allocation.
Hence, expanding the foreign investor segment will depend on increasing the number of funds, rather than flow per
fund.
The universe of global funds investing in frontier economies currently comprises of broad frontier markets funds,
Asia FM funds, rather than country-dedicated funds or focused-geography funds. As the FMs perform, there will be
a trend towards country-dedicated funds.
For example, the main categories of global funds looking at India include broad emerging markets funds, Asia
Pacific ex Japan funds, BRIC funds and India-dedicated funds. The India-dedicated funds and focused BRIC funds
materialized only when global investors built faith on the Indian economy and hence saw a rationale.
Some funds might be index exchange traded funds making asset allocations and chasing market returns during up
cycles, while some would be actively-managed funds chasing stock picks to earn alpha.
In most cases, the active funds would benefit the local markets in the long term, since ETF flows can fluctuate
based on tactical asset allocations. Local brokers need to pitch stock-picks backed by well-founded research, to
engage the foreign fund managers about investible opportunities in their country.
If the pool of such investible stock picks is discerned to be larger based on the information disseminated, fund
managers might see a justifiable rationale to go overweight in that country, or even better, think of setting up a
country-dedicated fund for it.
That is a way in which country-dedicated funds see a spike, and eventually leads to increased flows from foreign
institutional funds into the country.
Enabling the economic transformation depends on the local government and industry. But the local capital market
community can play a role in disseminating their country’s story and the analysis of the investible
themes/sectors/stocks to the global investor community, through corporate roadshows, analyst meets and
engagements with global fund managers.
Adding value
Today, fund managers are swamped with information on various geographies. They don’t need more information.
But they do value insights, ideation and analysis, which help them pin-point specific opportunities.
This means creating value-addition through research, sales trading and corporate access.
Value addition through research delivers thematic ideas, investing ideas, business trends, industry voices, sector
and company analysis, as well as supporting funds in their own analytical work.
Value addition through sales trading means having an adequate base of institutional investor relationships to
facilitate trades in slightly illiquid counters, as well as block trades.
Value addition through corporate access means getting investors to meet the who’s who of the local government
and companies, so that they get better updates on what is happening on ground zero.

4. To support these initiatives, brokers have to invest into research and ideation skills, large-trade abilities, and build
institutional relationships.
Another factor that influences the growth of country-dedicated funds is the aggregate portfolio volatility of the whole
basket.
The correlation between the countries in any emerging basket is low initially, since the linkage between them is low.
What impacts one hardly impacts the other. This means risks are localized and aggregate portfolio volatility is low.
However, as the economies grow and the portfolio’s global linkages increase, they become susceptible to global
shocks. This impacts portfolio volatility and fund managers see a rationale to develop country-focused funds.
Foreign investment into projects (strategic FDI) through foreign-owned companies, joint-ventures or inward
acquisitions is critical, as it increases the supply of companies for the future and improves market activity when they
unlock value.
Investment banks should look at the qualified institutional placement (QIP) route for capital-raising. QIPs are ways
for companies to issue securities to investors without having to file for regulatory approval.
QIPs – which were introduced in India around 2006 as a way to keep capital at home rather than see Indian
companies issue securities on foreign stock exchanges — leverage on institutional investors when the retail interest
in IPOs is low.
IPOs themselves have to fairly priced; otherwise, too high a price impacts eventual returns and reduces interest
from subsequent issues.
Predominance of family-owned businesses is a challenge for investment bankers and private equity funds, since
family promoters are resistant to stake dilution.
Private equity can be a useful route to expand the corporate base, as they bring in global experience in similar
industries, strategic alignments and management inputs.
Local regulators need to put in place guidelines for offshore-fund structures, including Master-Feeder structure, to
simplify fund-raising from multiple geographies.
The market also needs to deepen liquidity by developing market-makers, who act as counterparties for the trade.
Is it better for retail money to enter capital markets through the asset management
route, rather than direct investing?
I am a firm believer in the institutionalization of retail savings into mutual funds. Provided the investor does not
redeem units in the short term, this has a better chance of realizing long term wealth from capital markets.
A reason for retail’s short-term bias is the lack of faith and understanding in the scrips, which a fund manager can
judge better. But this in turn requires the investor to place faith in the fund manager’s skills.
To mobilize retail savings, open-ended mutual funds often work better than closed-end funds or exchange traded
funds (ETFs).
The allocation a retail saver can make into funds has a limit. In most cases, he saves from a salary. He can invest
this limited allocation periodically each month. His salary would increase over-time, increasing his ability to allocate
over-time. More employees are entering jobs each year, and each would have the ability to allocate a portion of
earnings.
All this means that the fund should enable accepting additional inflows on a periodic basis as people’s income
increases, monthly income accrues and as more workers enter the workforce.
Facilitating this would expand the fund’s assets and the aggregate mobilization into capital markets. This includes
intermittent, lump sum investments and systematic investing plans (SIPs). By comparison, the assets of a closed-
end fund or ETF focused on retail get restricted to the inflows from the offer period.

5. Flows into equities versus flows into fixed income. Source: RBS
Closed-end funds bar subsequent new asset inflows even if people get the ability to invest. Although one can still
buy and trade existing shares of a closed-end fund from the market, it impacts the ability of long-term wealth
creation for that seller.
Moreover, if the fund is trading at a discount, then it hardly makes sense for someone to sell if they had originally
bought the shares in the offer period. Even in ETFs, one can buy existing shares from the market even if buying a
new creation unit is expensive.
However, ETFs and close-end funds require demat accounts, which can be perceived as additional paperwork by
small retail investors. As it is, the pool of demat account holders is still a small one.
Open-ended funds can reach a larger base, as investing in them does not require a demat account. For the asset
manager, its aggregate assets do not increase when investors buy existing shares from the market instead of
investing into new shares entirely.
Restricting the ability to expand the aggregate asset base is counter-productive to creating a scalable and profitable
asset management industry, especially when investor awareness about sophisticated products like ETFs and
closed-end funds is still evolving.
Differentiated funds
Firms which combine asset management with stock broking can gain from the funds’ annuity income, to support the
cyclical broking income. Asset management is a business of scale, and the expansion of assets through open-
ended funds can be a focus area to maximize annuity fee.
Firms need to build a suite of differentiated funds aligned to market conditions and investor preference. That means
the assets can be switched between own funds depending on situations, and the value-creation from the assets
remains captured within the group itself.
On the other hand, too many “me-too” products end up confusing the investor. Apart from staple funds, firms might
look at Category/Styled funds based on themes, cycles, sectors, opportunity, geographies, volatility, etc.
Unlike an index or market cap-based product which captures all scrips, category funds can leverage only those
scrips exhibiting a certain rationale.
One may try for instance a “Market-Leader” fund, which captures well-managed, market-leading companies across
sectors, a “Value Buy-and-Hold” fund, which captures value-picks expected to realize growth over the long-term, or
a “Global-Access” product, which gives exposure to foreign equities like USA, Europe, India, emerging markets, etc.
Global equity products help benefit from the growth stories of those countries, plus they can be a useful cushion
when the local economy is undergoing economic stress relatively. It is true that global-access structures would need
regulations on compliance, KYC (know-your-customer regulation), taxation, repatriation, etc.

6. At another extreme are “Niche” funds, which concentrate on specific niches seeing local demand. Entertainment is
a popular niche in Asian countries. Niche funds might invest in content production, although this is more practical on
the private equity side rather than for mutual funds.
Does that mean closed-end funds or ETFs are not useful then in evolving markets?
They are useful products, provided that they are used for the right objective. ETFs can be useful products for asset
allocation, especially for hard-to-access asset classes or to invest at low costs.
Enabling access to hard-to-access assets is a reason why Gold ETFs or foreign equity ETFs based on Nasdaq 100
or Hang Seng became popular in India. ETFs were convenient platforms to benefit from such assets, which were
otherwise not easily available.
ETFs and closed-end funds
ETFs are also useful for institutional investors, to help them to get allocation at low costs. Core-satellite portfolios of
institutions often combine high-risk assets with active funds in satellite positions to generate alpha, and low-risk
assets with low-cost ETFs to balance the risk and costs.
Institutions also use ETFs for short-term, tactical positions to gain from changes in market conditions. Subsequent
inflows into ETF assets occur mainly from institutions, as they have the ability to pay the huge amount for a
creation-unit.
This is a basic reason hindering subsequent inflows from retail investors into ETFs, curtailing ETFs’ asset size
unless they were able to generate the threshold corpus during the offer period itself.
Closed-end funds are useful in terms of efficiencies in asset utilization. However, in nascent capital markets where
the awareness and interest is low, closed-end funds often end up trading at severe discounts to net asset values
(NAVs).
Traders in developed markets latch on to funds trading at discounts, expecting that market prices would eventually
trend closer to the NAV and they can book gains.
This opportunity may be restricted in nascent markets, unless the trader is prepared to hold till maturity when he
redeems at NAV, but that means locking in the capital. If the fund overshoots its deadline, that would be an added
risk.
Fund trading at discounts may also impact the initial interest in newer closed-end funds, since human nature always
loves buying anything at a discount later rather than paying the full price upfront.
In developing countries looking to mobilize increased savings into funds, closed-end funds cannot accept
subsequent inflows, even if savers gain the ability to allocate later.
Their fixed tenure means that long-term savings is not possible, unless there is a new fund available right after that
redemption date in which the investors’ assets can be parked again.
People have to be made aware of the necessity to invest, if the frontier countries’ capital markets are to deepen.
Many developing countries see low propensity to save, where long-term savings are actually needed since
governments hardly provide social security.
People have to be made aware why they should invest some savings in capital markets, including diversifying risk
through mutual funds, holding for long-term, financial planning and asset-class balancing, if they have to reduce the
risks and create long-term wealth.
For direct-investors into equities, how can the risks be reduced? Should they even look at equities in the first place?

7. Capital flows into equities have fluctuated. Source: Bank of America Merrill Lynch
Retail investors should definitely look at equity markets to enhance their savings over the long term, be it through
direct investing or through equity mutual funds. Comparisons across countries on inflation-adjusted returns from
asset classes show equities outperforming debt, gold and real estate in the long term, despite their inherent
volatility.
This is all the more critical since most developing countries undergo high rates of inflation during their growth
phase, and hence investing only in bank deposits can be wealth-dilutive in terms of future purchasing power.
The key word here is long term. A challenge for deepening direct retail participation in equities is that retail interest
is mostly geared towards short-term gains using intraday, futures and options and short-term delivery.
This is a sure way of reducing the investment’s longevity, if that money forms a portion of the investor’s savings
which he can ill-afford to lose. Retail investors should have a long-term bias, so that they realize equity
appreciation.
Short-term trading should be restricted to High Net Worth individuals (HNIs), who have a higher risk appetite, and
have allocated capital for each investing style. The capital for short-term trading comprises a smaller portion of their
corpus, and so it has a limited impact on the overall portfolio.
If brokers look at overall trading volume from HNIs vs. retail in most markets, then HNIs do form a substantial
portion of that pool.
Investor education is important to reduce the risk of investing in the wrong product. Awareness of capital market
products is still low. In most cases, the investor needs to be made understood why this is important, to avoid
negative surprises later.
The correct product should be based on investors’ savings, spending, risk and goals. Brokers may lose some
business in the short-term, but it might build a lasting participant base in the long term.
Education is also critical since capital market products are non-discretionary spends. This means that most do not
yet feel the need to demand this, unlike food, garments or phones.
Another issue that could scare investors — even the more sophisticated ones — is the risk of volatility. To address
volatility risk to some extent, brokers may pitch baskets of stocks based on specific styles/themes, rather than just
individual scrips. That might reduce single-stock risk.
Retail investors often fall prey to “herd mentality” in calls, which accentuates volatility further. Uncertainties over
corporate performance can be reduced by addressing regulations, approvals and delays.
Information access through computerized trading offer real-time price discovery, limits arbitrage-thrillers and
reduces impact costs. This includes broker terminals and online trading platforms.

8. Online platforms have made trading convenient irrespective of location or time and it can be done on-the-move.
Information access includes financial portals, business news channels and magazines dedicated to provide analysis
and insights.
Transparent reporting and corporate governance would reduce risk of information opaqueness. Equity derivatives
might add to market volatility, and so brokers need to target futures and options only to clients best suited for this.
Any speculation by low-risk clients will reduce longevity and brokers will constantly need to replace them with new
clients.
If equity risk is absolutely unacceptable, capital markets also include fixed income debt. Corporate debt instruments
are picking up to complement bank credit. Those searching for lower risk levels can look at long-term bonds and
debentures.
The role of financial planning
Is financial planning and advisory absolutely critical to achieve the objective of long-term wealth creation through
capital market products?
Our countries are largely financially illiterate, although meaningful pools of money exist. Financial planning would
help channel this money into products based on the investors’ objectives, abilities and profile.
We stressed the importance of investor awareness regarding capital markets. That is all the more reason why
planning is needed to deepen this market.
But planning has to be based on assets-under-management-based incentives. Commission-based incentives can
create a bias for products that give the best commission, but it may not be the best for the investor. That leads to
negative surprises and early redemptions. Instead, AUM-based structures work best to enhance the investors’
assets.
Timing the market is where the self-investor often goes wrong, i.e. sells low and buys high. Once they burn their
fingers through wrong calls, the self-investor often ends up delaying decisions in further calls to avoid similar
instances. This inertia expands the downside risk even further.
Advisory might enable action on the correct calls at the correct time, and realize upside. This includes both buy and
sale calls.
Sitting on loss-making, low-grade stocks is a psychological feature of retail investors. They hope that prices would
rise eventually, which rarely happens. In the process, they forgo better investment opportunities had they only
liquidated their low-quality stocks and redeployed into better scrips.
Financial advisors and planners also help sensitize investors about new products. Savers in many developing
countries favour physical savings over financial savings. However, innovations have today married physical savings
with financial products – like Gold ETFs and REITs (Real Estate Investment Trusts).
Awareness of these products is still low, and advisors can help here. India saw tremendous interest in Gold ETFs
as awareness picked up. Innovations have moved up further in REITs.
While traditional REITs invested in income-generating commercial properties, the lack of housing stock made
Kenya think of Development REITs, which invests in developing residential housing.
The role of the government
What are some of the imperatives needed from the government and regulators?
Facilitation to companies through single-window clearances and access to foreign capital by addressing
taxation/repatriation come to mind.
Things that scare investors — like changing regulations retrospectively, corruption in governance or changes in
guidelines with a change in government– are best avoided.

9. Political instability and insurgency extremism also scare global investors, and countries which counter these
challenges will benefit.
The economic performance and state of public finances will also be monitored, a reason why Vietnam or
Bangladesh looks better.
Regulations need to move with fixed deadlines in place, and all the working and sittings of the committees need to
work backwards with that deadline in mind. Only then can these countries deliver on required regulatory changes in
time.
The capital market industry itself needs to be well regulated. Low-quality institutions can be counter-productive to
deepening the market. This includes increased roles to Self-Regulating Organizations (SROs), as well as fast action
on any malpractices so that investors’ faith is not shaken.
Manpower supply is worth mentioning as an end-note. This includes leadership who bring insights of what works
and what may not, as the markets expand. It also includes advisors with client relationships, and analysts with
research skills and institutional relationships.
B-School faculty with industry-experience, who train the next generation of management graduates, are also
included here, as are data analysts who can mine business intelligence to assist strategic decision making.
Trainings in soft skills, as well as product training, is necessary.
I will conclude by saying that competition is high. A lot of countries, and asset classes within each country, are
fighting for foreign and local monies. Countries who do not act fast to put necessary rules and facilities in place will
lose out.
Nifty future on Singapore Exchange is an example, which has taken away trading market share from NSE’s Nifty
future because NSE has been slow to respond.
Every market has its own unique challenges, irrespective of its stage or maturity. Investments into expanding the
market’s capacity can be calibrated at a realistic pace to test the market and reduce upfront risk. However, the
investments cannot be frozen totally, as competition will not wait.
– The author, Sourajit Aiyer, works with a leading capital markets company in Mumbai. All views are his own.
Related
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This entry was posted in In Depth, Views and tagged Asia, capital markets, emerging markets, ETFs,frontier
countries, frontier economies, frontier markets, funds, India, institutional investors, investing in bonds, investing in
equities, investing in stocks, portfolio, private equity, retail investors, securities,stock markets, stocks on January 5,
2015 by Antonia Oprita.