Are India’s financial markets getting efficient?

I always keep thinking about the nature of efficiency in Indian equity Markets. Where are we placed? Are markets getting efficient or inefficient?

The usual wisdom is that equity markets are getting efficient by the day. This is because the infrastructure (regulations, technologies etc) needed to these markets more effcient has become much better. The trading is on electronic exchanges where arbitrage can be snapped in a fraction of a second. The people can see the various trades on their computer screens from anywhere across India.

However, we have other side of the story which tells me that markets might actually not be getting efficient at all. One good indicator is to see the performance of active finds vs passive funds (index/ETFs).  If markets are getting efficient one shouldn’t see active funds beating passive funds by huge margin and atleast the margin should be shrinking over the years.

As this story shows, passive funds have been increasing in India. But this analysis (and even this debate) says, active funds continue to beat the passive funds. Some might say that most of these analysis don’t point to the risk adjusted, expense adjusted return. Even if we discount all this, I think we should be seeing active funds outperform indexers over the years.

Another point is this story from Mint. which says the cost of fund managers has been increasing at about 300% and Indian fund managers might get the same salaries as those in London, Singapore etc. Now, if the markets are getting efficient we should see the salaries declining as arbitrage opportunities are at best getting limited and is not worth the cost.

So, which side do we lean? Towards efficient or inefficient side? If they are efficient, then active funds shouldn’t outperform. Why do fund managers get such huge salaries? Basically for outperforming markets. Does it mean we have many Buffets in India?

Raghu Rajan in his speech identifies 4 sources of alpha:

  1. One comes from having truly special abilities in identifying undervalued financial assets—Warren Buffet 
  2. Activism- This means using financial resources to create, or obtain control over, real assets and to use that control to change the payout obtained on the financial investment like a Venture fund, etc
  3. Financial entrepreneurship or engineering—investing in exotic financial securities that are not easily available to the ordinary investor, or creating securities or cash flow streams that appeal to particular investors or tastes. Of course, if enough of these securities or streams are created, they cease to have scarcity or diversification value, and are valued like everything else. Thus this source of alpha depends on the manager constantly innovating and staying ahead of the competition.
  4. Finally, alpha can also stem from liquidity provision. For instance, investment managers, having relatively easy access to finance, can hold illiquid or arbitrage positions to maturity: if a closed end fund is trading at a significant premium to the underlying market, they can short the fund, buy the underlying market, and hold the position till the premium eventually dissipates. What is important here is that the investment managers have the liquidity to hold till the arbitrage closes.

Rajan said the first three are difficult and most likely fund managers are retorting to fourth and could lead to a problem in stressful times. His prophecy was quite true  as the subprime crisis showed.(read my post here)

So, there are three questions- If markets are getting efficient, 1) How fund managers are generating alpha in Indian MF industry?
2) If they are not generating alphas, why such huge salaries? 
3) Should these salary levels be regulated?  

Or we can simply say, Indian financial markets are not getting efficient and there are still arbitrages and asymmetries to be profited from.

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6 Responses to “Are India’s financial markets getting efficient?”

  1. Business » Are India’s financial markets getting efficient? Mostly Economics Says:

    […] Get the entire post from here. […]

  2. The use of Quant Mutual Funds in India « Mostly Economics Says:

    […] funds are not treated at par in India. This also brings me back to a point I have made earlier- Are our markets getting efficient? If they are we should perhaps be seeing active funds being converted to a passive fund, not the […]

  3. Mc Cain Says:

    I think that proper steps should be taken to make the financial market strong and if no preventive measures would be taken then the market would crash.

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  4. The US incentive practice catching up in India « Mostly Economics Says:

    […] loose out (for whom Mfs are designed) and big ticket investors make assured returns. I had pointed earlier that fund managers in India are getting paid the same amounts as in London […]

  5. The Wall Street Culture that led to crash « Mostly Economics Says:

    […] am wondering whether the expense ratios have fallen or declined over the years. Looking at the way MF managers are paid in India (see this as well)  it should only be rising. Moreover, we hardly have any discussion in India […]

  6. lead generation opportunities Says:

    lead generation opportunities

    Are India’s financial markets getting efficient? | Mostly Economics

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