The hype around institutional investors is finally getting some attention..(lessons for India)

I mean it should not have taken so long for World Bank to figure limitations of institutional investors. Seeing and analysing their performances for instance in SE Asian countries (or Latin American or African ) should have given enough evidence that things are not as per expected. Infact far off it. But then it needed a crisis in their own homes to realise what is going on. Till 2007, even having such talks was just a crime.

WB’s leading finance scholars discuss the role of institutional investors. They say the expectations are way off the mark. The focus of the article is on institutional investors without specifying domestic or foreign. But is can easily be extended to FIIs as well:

Developed and developing country policy makers alike have promoted institutional investors as a pillar of their financial systems. Responsible for managing retirement savings, institutional investors are expected to invest for the long term, follow market fundamentals, and provide liquidity to countries and companies overlooked by other actors in financial markets.

Earlier this month, however, Lead Economist Sergio Schmukler systematically debunked these myths during the course of his presentation at the June Policy Research Talk. The Policy Research Talks are a monthly event held by the research department to foster a dialogue between researchers and their colleagues across the World Bank.

Research Director Asli Demirguc-Kunt, who hosted the event, argued that “policy makers often think that many of the shortcomings of financial systems can be fixed by promoting institutional investors.” She explained, “Their development is seen as leading to the expansion of capital markets, the extension of the maturity structure, and all sorts of other good things. Today we are going to compare these expectations to the data, and see if they are met.”

Given their size, the ability of institutional investors to live up to these expectations is critical. As of 2013, institutional investors based in OECD countries had nearly $100 trillion under management. The role of institutional investors has grown substantially in emerging markets as well, with equity and bond markets nearly quadrupling over the last two decades.

Schmukler and his colleagues’ research shows, however, that not only do institutional investors not invest according to expectations, but sometimes even behave counterintuitively. Drawing both on global data and country examples, he demonstrated that institutional investors exhibit herding behavior, pass over assets with better risk-adjusted returns, and invest pro-cyclically, thereby increasing economic volatility.

They point to this example of Israel:

The case of Israel provides a particularly stark example. In 2009 MSCI—a major supplier of investor indices—announced that Israel would be upgraded from its emerging markets index to its world index. But when the upgrade became effective a year later, Israel experienced a sudden and massive reversal of capital flows, with a nearly $2 trillion net outflow.

Schmukler explained this counterintuitive behavior in terms of a benchmark effect created by the desire of institutional investors to not let their portfolios deviate too far from either an index or from the portfolios of their competitors. He cited the “incentives for asset managers, who are rewarded for investing in low-risk vehicles that mature over a short period.” 

Similar hype was generated in India too. India was to enter into some global benchmark like MSCI and this was seen as another indicator of India’s arrival on global marketplace. It was ironical that a country which does miserably on most humanity related indicators continues to celebrate as ephemeral things as inclusion in some global benchmark. Neverthless, we now know that much of it was just hype and created more damage for Israel.

But then if we remove the FII story from India, the hopes and expectations crash by half. It is the huge noise around FII and their role in stock markets which keeps India interested in FIIs and FIIs interested in India. As FIIs are big global players, the positive vibes from them keeps India humming in global marketplace. They decide which policies are good or bad and have become highly influential over the years. Just keeping them happy has become the mantra.

The point is not to demean role of FIIs completley. But be realistic with expectations. Neither everything is good about them nor is everything bad about them. Like most things in life there is a yin and yang to these investments as well. However, the pre-crisis era just looked at one side and kept pushing developing countries to have more and more of such flows.

Interesting and realistic times..

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