A V Rajwade: Equity markets and retail investors

WORLD MONEY

Even as the BSE Sensex crossed 8,000, some regulatory changes were announced by the Securities and Exchange Board of India (Sebi) in relation to the allotment of shares under initial public offerings (IPOs).

A few weeks ago, M R Mayya, former executive director, Bombay Stock Exchange, and L C Gupta, former member, Sebi, had contributed to the debate on direct participation of retail investors in primary issues (The Economic Times, August 16).

As a student of portfolio theory and as a practising risk management consultant, I find some of the points made by these senior and respected figures somewhat difficult to agree with. (Incidentally, if the booming market attracts the amateur, Warren Buffet, perhaps the most successful investor ever, seems to follow a different philosophy: he is happy when prices fall, as this provides him a buying opportunity.)

In the cited debate, Mayya has argued that, "all possible steps should be taken to encourage retail investors to invest directly in the primary market." With due respects, one would beg to differ.

For one thing, as the portfolio theory argues, unsystematic risk in equity portfolios can be eliminated, or mitigated, through diversification of the holdings. For this purpose, a diversified portfolio would require 20-plus stocks across different industries.

Does the average retail investor own such a diversified portfolio? Is he a long-term player, willing to cut losses if needed? The hard reality is that hardly any intending individual investor studies the offer document: he goes by the hype or hearsay.

Neither is there a good method for investment decisions. Again, having made an investment, the investor needs to follow up on the company and indeed its competitors; sectoral, macro-economic and, indeed, global trends.

Is he in a position to do so? The amateur, retail investor is perhaps better off investing in equity mutual funds, which have full-time professionals to analyse and supervise investments.

Elsewhere, Mayya argues that, "there has to be a level playing field for all the players", contradicting his earlier suggestions of the retail investor getting allotments at a 5 or 10 per cent discount to the book-built price, and also a safety net up to Rs 10,000.

Gupta also believes that, "the retail equity investors should be encouraged", but frowns upon "speculative" trading in the market. Webster's dictionary defines the word speculate as "to engage in the buying or selling of a commodity with an element of risk on the chance of profit." By this definition, every investment in equities is speculative.

But this apart, in the absence of speculative trading, liquidity may well dry up, leading to large bid offer differences and transaction costs, which will ultimately have to be borne by the investor. One is also not quite convinced that delivery-based trading would be necessarily non-speculative.

Indeed, the dividing line between investment and speculation is very thin "" and the media often glorifies successful speculators by using the sobriquet "investor".

Be that as it may, many of the changes made by Sebi in IPO regulations recently, are to be welcomed "" in particular, the stoppage of discretionary allotment. Just recall the scandals in the US IPO market at the height of the dotcom boom in the late 1990s through the discretionary allotment route.

The second major change is that, while applying for IPOs, institutional investors would also have to pay in 10 per cent of the price. What remains to be seen is whether this would lead to the institutional investor putting in applications at the last minute, in order to save the cost of depositing margins.

If so, would it hinder the price discovery process? Would the margin deter foreign institutional investors (FIIs) from bidding?

It is also a question whether variable price (so-called "French") auctions are better than the uniform price ("Dutch") auctions. For instance, in the government securities market, the Reserve Bank generally conducts variable price auctions at the time of primary issues.

Another feature of the G-Sec market is worth noting: a small portion of the issue is reserved for non-competitive bidders, the allotment being done at the weighted average auction price.

Since extending a line on the graph is so simple, some have already started talking about the index reaching the five-figure mark When bullish optimism is the rule, one often tends to forget negative factors, oil price being only one of them.

The recent rally is FII-based "" when will they start worrying about the EGS's impact on the fiscal deficit? But such possible developments apart, the market does seem fully priced and caution would probably be in order. Caveat emptor!

Tailpiece: May 17 last year witnessed a sharp drop in equity prices on fears that the increased leftist influence may scuttle economic reform. The Sensex has gone up 60 per cent since that date even as reforms have halted as feared. Sell the rumour, buy the fact?

avrco@vsnl.com