Whenever we think or speak about the markets, we refer to the investors, issuers and the intermediaries. In this paradigm all investors are considered a homogeneous breed, with convergent interests.
But inherently there are at least three distinct investor behaviours that are embodied in different classes of investors, namely, hold-to-maturity, trading, and strategic investors. Indeed this classification differs from the traditional way of distinguishing them as retail and institutional investors.
Retail, being the more trading type, has usually provided the momentum and thus the liquidity for the more patient and bulky institutional investors. That symbiotic relationship has served to find an acceptable equilibrium in the past.
However, with the emergence of private equity and hedge funds, and with the blurring of activities of the banks from being mere credit advancers to a wider set of investment banking, the character of institutional investors has changed fundamentally to embrace all three types of investor classes mentioned above.
With the broadening of the investor classes, the traditional expectation of behaviour between retail and institutional is no longer valid. Both the behaviours and the regulations surrounding these investors vary significantly enough to look upon them as different market participants. This change in composition might give us clues to understand the higher volatility in financial markets in recent times, both in India and globally.
Trading investors would include hedge funds, mutual funds and most retail investors. Hold-to-maturity players include insurance and pension funds, and strategic investors include sponsors, private equity players and banks.
Banks are included as investors both because they are as much investors as lenders and also because apart from artificial regulatory treatment, there is no fundamental difference between lent and invested assets; both are equally subject to credit and market value risks.
Strategic investors usually stay invested in an asset for the long term and do exit for strategic reasons. While they straddle trading and holding strategies, they evaluate the performance of their investments, with the intention of correcting in case they are not happy with the performance.
Hold-to-maturity investors essentially are driven by long-term liabilities that they have to nurse and, therefore, seek investments which will allow them the best value for investments that are locked in to long-term maturities.
These tend to be more weighted to fixed income assets, rather than equity and they have little or no interest in the management of the underlying assets or operations. They usually participate in corrections at the time of maturity only.
Since trading investors are driven entirely by monetary considerations, they actively evaluate their investments with the intent of exiting if they are not satisfied with the performance. Though investors have been rigorously classified by their behaviour pattern, it is fair to state that individual investors might have all behaviours attached to them in varying degrees, with one behaviour being predominant.
This classification will help us understand the increased volatility in the global financial markets. As opposed to a homogeneous investor class, we now have large investments led by hedge funds essentially playing in the market as tradable funds.
The market might not appreciate the impact these heavy hitters have, as they have merged into the traditional classes of traders. Similarly the strategic class has now been fortified by the presence of the private equity breed, who are making the investments a lot more accountable and, in a sense, less stable than the erstwhile gang of sponsors (or promoters) and bankers who supported them.
Thus, we have a lot more triggers for change and even though the market changes less frequently due to their efforts, they change sizably when these elephants decide to dance.
The changing nature of banks as they realise they are as much part of the investment markets as anybody else has also significantly contributed to the phenomenon, as they have not only not moved to stabilise the market in the traditional role that they have played, but also been opportunistic to trade markets as they sense opportunities.
These interventions have systemically increased both the velocity and the amplitude of change. The market now has decidedly more trading impulse than the stabilising nature of the predominant hold-to-maturity investors of the past.
The fact that regulations are fashioned around institutions and not their behaviour adds to the markets' inability to understand fully what is going on. For instance, mutual funds and hedge funds behave similarly, except mutual funds have lot more transparency and rules around their behaviour.
While assets of mutual funds are known, those of hedge funds are not. Hence the market's ability to predict flows or trades are often miscalculated leading to sharper corrections than before.
Similarly, regulations require mark-to-market provisions on some assets and some institutions, while similar assets with other institutions are not required to have the same provisions.
Credit exposure in loans held by banks does not require these provisions, but they attract it, if held as bonds by the banks and mutual funds. However, the same bonds held by non-banks including hedge funds, insurance companies and pension funds, do not require mark-to-market provisions. This in itself induces differential behaviour. Similarly, prudential norms limit asset-wise exposure by some players, while others have greater flexibility.
Despite greater volatility, the broadening of the investor classes has been a boon to the world, as it has accelerated investments, made the markets more competitive and competent and allowed for more options.
Regulation aimed at restricting this expansion will be futile and regressive. Markets will be better off accepting the presence of a greater variety of investors and their investment strategies and making their assumptions about volatility and asset allocation.
There might be a need to re-evaluate a number of classical models including value-at-risk, betas and risk- return trade-offs to reflect the larger weight of trading outcomes rather than ultimate investment outcomes.
Regulators might want to more carefully explore the interface between regulated and unregulated entities to see if any prudential norms or disclosures need to be tightened. Instances of this could be banks that float hedge funds or investment vehicles that attract differential regulatory norms, monitoring end use of bank lending/investments, right mark-to-market provisions for regulated entities dealing with assets with market value fluctuations, disclosures to estimate aggregate leverage in the system, and understanding sources of capital into regulated entities with a view to estimating leveraged positions, if any.
Global flows will increase and the trading impulse will intensify, escalating volatility even more. Investors' classes are set to widen even more with sovereign wealth funds also adding colour.
Regulators, with primarily domestic jurisdiction, are less likely to be able to suppress volatility. Markets are, therefore, well advised to factor both the increased trading propensity by weightier funds into their models and allow for increased size and faster rate of change in their values.
The writer is Managing Director, Standard & Poor's, South Asia.
