Emerging markets finance paper written on India in late 2010.

1. IBUS6007: INTERNATIONAL BUSINESS SPECIAL PROJECT
RESEARCH PAPER
Asset allocation and
investment strategies in
emerging equity capital
markets: India
Is a global macro strategy the best investment
proposition for emerging markets? India: a snapshot.
Matthew Bright
Presented to the Faculty of Economics and Business
in partial fulfilment for the requirements of a
Master of Commerce degree by coursework
The University of Sydney
Sydney, Australia
November, 2010
Keywords: Emerging markets finance, India, ‘the new normal’, asset allocation, macro investing, asset management / investment
management.

2. Is India best suited to a global macro strategy as an investment proposition?
India: a Snapshot*1
Abstract:
This paper considers India as an emerging economy after a strong short-term rebound from a
macroeconomic shock and with sound long-term growth prospects.
The focus of research houses towards the end of the decade has been on the prospective outlook for
emerging economies with projections decades ahead considering the prospects of developing middle
classes, infrastructure development and changes in consumption patterns.
In the background of this recent research focus, twenty years of emerging markets finance scholarship has
considered the perils and predilections towards investing in foreign markets with their inherent
information asymmetries, pricing inefficiencies, valuation difficulties, internal complications of
corruption and poverty and other “third-world problems”.
For investors to gain exposure to asset classes in emerging markets, typically a global macro approach is
required to develop profitable positions. Investors simply must take into consideration all of the wealth of
statistics available to them and apply their own risk premiums to countries and assets.
This paper is interested in the interaction between macroeconomic figures, equity market performance,
the relationship between international investment and market performance and the internal drivers of
markets for goods as a country, India, matures.
1
I
would
like
to
thank
the
following
academics
and
universities
for
whom
resources
were
available
in
the
form
of
cases
and
course
curricula
on
Indian
business,
including
individuals
such
as
Vikas
Kumar
at
The
University
of
Sydney,
Professor
Bruce
McKern
at
Stanford
Graduate
School
of
Business
and
The
University
of
Sydney
and
Jitendra
V.
Singh
at
The
Wharton
School,
University
of
Pennsylvania;
and
academic
institutions
offering
courses
on
emerging
markets
strategy:
Harvard
University
Department
of
Economics;
and
courses
on
emerging
markets
finance:
Yale
School
of
Management,
New
York
University,
Darden
Graduate
School
of
Business
at
the
University
of
Virginia
and
Duke
University’s
Fuqua
School
of
Business.
2

3. 1. Introduction
Current trends in emerging markets finance involve critical structural changes in the global
economy, where domestic consumption in emerging markets is evolving towards self-sufficiency
and decreased reliance on international exports to the developed world.
For India, its domestic-orientated economy and the long-term consequences of economic reform
bode well for domestic equity capital markets and the stability of foreign direct investment. This
paper considers the short-run economic performance of India as an example of an emerging
economy in a single-country setting, in examining how projected long-term growth can lead to
investment opportunities for firms now in respect of a macro investing strategy.
Time constraints limit the scope and methodologies to literature review in emerging markets
finance, Indian business and third-party proprietary research from financial houses and
consultancies on the Indian economy.2
2. Background: theoretical review, framework and research context
2.1 Emerging markets finance research in context
Over some twenty years of emerging markets finance literature, there has been ample research in
market integration and liberalisation, abnormal distribution and inefficiencies in market
microstructure and asset pricing. The literature is predominately finance-specific and
contextually, tends not to integrate topic-specific concepts of international business. Event-
specific articles often consider large macroeconomic shocks such as market failures and region-
specific financial crises.
2
A
more
thorough
analysis
would
take
into
consideration
raw
data
or
up-­‐to-­‐date
reports
from
economic
database
and
research
agencies
such
as
the
Centre
for
Monitoring
Indian
Economy
Pvt
Ltd.
(CMIE).
The
author’s
resources
were
limited
to
publicly
available
information,
information
acquired
at
no
cost
from
helpful
third-­‐parties
by
direct
approach
and
the
resources
of
The
University
of
Sydney.
3

4. 2.2 Putting international business into perspective
Indian scholars Jones and Khanna (2006) put international business scholarship into perspective
in urging for the need to explain how history matters in international business. The pair cites the
decline in the teaching of history in business schools as a possible reflection of the growth in
discipline-based teaching at the expense of the more topic-based IB department3. The core of
their argument is that a dynamic view of events in history allows us to examine long-run events
of interest, but that much of the conceptual underpinnings of current emerging markets literature
such as ‘the effects of Foreign Direct Investment on variable x’ is seriously limited in scope,
search and result. Accordingly, the author’s approach in this paper has been to integrate
concepts related to Indian business, economic and market conditions and suspended concepts
explored on a rolling basis, rather than commencing with an iron clad archetypal question.4
2.3 Investing in emerging markets
Macro investing
Macro forces have historically explained the majority of equity returns for securities in emerging
markets (Cleary, 2010). A global macro strategy directs efficient capital allocation to compelling
opportunities in international economies using macroeconomic principles to identify asset
mispricings (subject to liquidity constraints and market participant behaviour). De Brouwer
(2001) calls this a ‘top down’ approach.
Risks inherent in emerging markets
It is understood that common investment issues in emerging markets include information
asymmetry, agency conflict, adverse selection and moral hazard (Sammut, 2010). Non-market
3
Jones
and
Khanna
cite
a
personal
communication
from
IB
scholar,
Hennart,
on
the
basis
of
such
an
interpretation
of
a
business
school’s
IB
department.
4
Such
a
concept
was
explained
to
Vikas
Kumar,
Department
of
International
Business,
The
University
of
Sydney.
A
question
was
put
forward
in
the
research
proposal,
as
something
of
a
‘buoy’
and
in
order
to
provide
a
research
proposal
which
other
students
could
critique,
in
keeping
with
the
IBUS6007
course
mandate.
4

5. issues include difficulties in information access, weak contract enforcement, poor investor and
intellectual property protections, corruption and political instability (Mobarak, 2010).
Inter and intra-day volatility was compared in India for 13 years and found to be low compared
to other emerging markets (Raju and Ghosh, 2004).
Valuation Challenges in Emerging Markets
Assuming market efficiency, in asset pricing, valuation models will consider a risk-adjusted
discount, being the sum of a risk-free rate and an equity risk premium for a given market or
security. Some universal principles hold true, including the basics of discounted cash flow value.
Valuation uncertainty lies with risk premiums. Hence, practitioners and scholars alike have
devised modified Capital Asset Pricing Model (CAPM) frameworks incorporating country risks
into valuation (the international cost of capital, effectively). Considerations associated with
country risk include a country risk premium, a shift in the exchange rate and models such as the
Goldman Model take into account the sovereign yield spread. To incorporate cash flows
properly, there is the temptation to use macroeconomic factors to construct scenarios (including
forecasts for GDP growth, foreign-exchange rates, interest rates and determine how they drive
each component of cash flow). Espinosa (2005) suggests using estimated country betas in the
CAPM.
The principles of corporate finance in this area involve capturing and countering firm-specific
parameters (EPS volatility, long-run growth rate, systemic risk) with long-term yield parameters
(long-run treasury yields, interest rate volatility) and factoring in growth assumptions without
being unrealistic. The sheer number of variables computed in developing modified valuation
models and then applying them mechanically often leads to wrong results and can lead to bad
decisions (Li, 2005).
5

6. Typically a Sharpe ratio is used for portfolio management and measurement and Value at Risk
(VaR) is calculated for maximum loss over a target horizon based on horizon and confidence
level.
Asset Allocation and Investment Strategies in Emerging Markets
Stock selection in emerging markets takes into account fundamental factors, expectations and
momentum. A macro investing strategy takes into consideration a country’s fundamentals in
devising investment positions for various market instruments.
As a driver of investment strategy, valuation makes a huge contribution to asset allocation.
Kargin (2002) discusses the failure of complex, country-specific models specifically for value
investing in emerging markets. Market volatility may only bring moderate returns and
undervalued stocks may be undervalued for region-specific reasons, not easily understood by the
geographically removed investor due to information asymmetries.
General value investment principles that measure value such as low price/earnings (P/E), high
book/market (B/E) equity or high cash flow/price (C/P) may uncover opportunities in emerging
markets. Fama and French argue that the value premium is compensation for risk missed by the
CAPM and that value stocks tend to have higher returns than growth stocks in markets around
the world.
3. Methodology undertaken: data, method
Data was obtained from reliable third party sources, due to time and resource constraints and the
author’s extensive research in third party proprietary research from credible sources. The
acceptability of such methodology was assumed by the author on the basis of other successful
student-authored papers being developed in such a manner (such as Barnett-Hart, 2009).
6

7. An extensive literature review was conducted involving emerging markets finance, Indian
business and asset management and asset allocation. A general within-country analysis allows
for an isolated view of a country and its internal drivers.
4. India as an investment opportunity
4.1 Key macroeconomic indicators in India
Research houses have focused on the macroeconomic developments underpinning India’s
development. McKinsey Global Institute (MGI) makes logical sense of how India’s
macroeconomic climate interacts with a macro investing strategy with the following modified
flow-chart:
Figure 1: Modified ‘Bird of Gold’ structure
In developing this model based on its own 2007 ‘Bird of Gold’ model, revised with Oxford
Economics (OE) projections as an input, MGI proposed that India would continue to grow at an
annual rate of 7.4% through 2030 (based on a growth rate of 8.0% between 2009 and 2018,
7

8. stabilising to 7.0% between 2018 and 2030). MGI projects GDP growth to reach 9.1% in the
medium term, before slowing down to 7% between 2020 and 2030.
Against these economy-wide projections and measures, at the consumer level projected utility
growth and forecast changes in consumption preferences will drive firm profitability by
investment category and allow investors to access growth through equity capital markets.
Figure 2: McKinsey & Company analysis of India’s growth potential
Source: McKinsey Global Institute, ’India – the Growth Imperative’ research report
As a model of emerging economy growth, India has a robust future for Foreign Institutional
Investor (FII) to channel capital flows into opportunities from labour and production factors.
India’s demographics and urbanisation are favourable and its emerging middle class will drive
growth. MGI, 2007 estimates that India’s middle class will rise tenfold from 50 million to 583
million by 2025.
8

9. How Demographic Change Will Impact the Financial Sector
Projected increases in domestic savings will alter consumer behaviour in holding financial assets.
Goldman Sachs projects that the distribution of household savings into financial assets will
greatly increase household flow into equity assets and decreases in bank deposits.
Figure 4: Projected changes in household asset ratio skew
Source: Goldman Sachs, ‘India – The Assurance of Domestic Demand’
Against this background of increased household wealth and inflows to equity capital markets, it
is worthwhile considering consumption categories and patterns in India.
Figure 5: Evolution of Indian consumption categories
9

10. Historically, consumption categories have been dominated by goods (necessaries), but Goldman
Sachs projects a greater apportionment to services (necessaries and luxuries) in the next decade.
Figure 6: Projected changes in consumption bundles
As a demographic shift occurs, it makes sense that for liquid foreign capital allocation, equity
capital markets would be the logical arena for FIIs to capitalise on domestic consumption by
accessing financial instruments destined for price appreciation as consumer spending evolves.
4.2 India’s place as an emerging market in the ‘new normal’
India emerged from the global financial crisis (GFC) having expanding real GDP by 6.7% in
FY2009 (Roach, 2010), having posted impressive country output of 6.4% in 2008 and 5.7% in
2009 (IMF, 2010), amongst the highest of not only Developing Asia, but all developed countries.
Industrial production is at a two-year high after having drastically decreased from 13% in early
2007 to approximately zero in 2009 (Roach, 2010); The country generated a domestic savings
rate of 32.5% in 2009 (Roach, 2010). Inflation has returned to pre-GFC double-digit levels at
around 10% and India’s growth is projected at 9.7% in 2010 and 8.4% in 2001 (IMF, 2010).
Real GDP is projected to grow by 9.2% in 2010-2011 (CMIE, 2010).
Exports to developed markets such as the US and Europe have drastically decreased, whilst
exports to other emerging markets such as China have dramatically increased (Roach, 2010).
10

11. Key bellwethers of the Indian economy typically are manufacturing output and investment
levels, both of which have sharply increased (Khari, 2010). India’s growth in the recent period
has been driven by high domestic demand, productivity, credit growth ad high levels of savings
and investment (CSFA, 2009).
India’s post-GFC position is consistent with the country’s model espoused by Das (2006), as a
stable, consumption-driven country largely insulated from global events. Taylor’s L. K. Jha
Memorial Lecture (2010) is a good summary of the resiliency of emerging markets, including
India, over this period.
The General Regulatory Environment
Much has been written on how India’s institutional evolution through measures of reform and
liberalisation which occurred on a rolling basis in the early and mid nineties have positively
impacted the Indian economy and in particular enabled some more sophisticated and liquid
capital market development, including the development and empowerment of the Securities and
Exchange Board of India (SEBI) to regulate capital markets (salient examples include McKern et
al, 2009, Khanna and Palepu, 2005 and Zattoni, Pederson & Kumar, 2009).
The literature on India’s banking system is extensive, including on its nationalisation and
liberalisation (as an example, Chiarlone and Gosh, 2009). The topic of FDI in India has been
very well researched (such as Beena et al, 2004) and is not further discussed here.
5. Accessing macroeconomic growth through financial markets and instruments
5.1 Macroeconomics and Capital Market Behaviour in India
Montiel (2003) observes that short-run macroeconomic stability can be seen as an important
determinant for long-term growth performance in emerging economies. The snapshot of India’s
economy, post-GFC, shows a country’s robust performance after an exogenous shock. A model
11

12. of macroeconomic shocks and financial stability demonstrates the systemic effects of what
should occur with asset prices under such conditions.
Figure 7: SEBI adaptation of trickle-down effects of a shock to a country and its financial markets
Source: Government of India Committee on Financial Sector Assessment (CSFA): India’s Financial Sector, p32
Bridging theory and actual occurrence, the short-run performance of India’s capital markets and
asset prices over this period provide a positive example of behaviour under external duress.
India’s domestic equity markets grew sizeably over 2003-2009 from a capitalisation of less than
US$300 billion to over US$1 billion (Deutsche Bank, 2009). Historically, Indian equities have
been considered to be expensive based broadly on Price/Earnings ratios (CSFA, 2009), including
one a one-year forward basis or according the Greenspan formula (as discussed in detail below
the diagram).
12

13. Figure 8: SEBI model of equity valuations in India
Source: Government of India Committee on Financial Sector Assessment (CSFA): India’s Financial Sector, p231
Foreign Institutional Investors (FIIs) have broadly achieved positive net investments in Indian
equity markets, reflecting the country’s sound macroeconomic fundamentals and positive
corporate earnings. The close correlation of fund flow and P/E is an interesting phenomenon.
Figure 9: SEBI model of Net FII Inflows relative to P/E Ratio
Source: Government of India Committee on Financial Sector Assessment (CSFA): India’s Financial Sector, p232
13

14. If one considers the close relationship between Net FII inflows and P/E ratios, the relationship
can be seen as a sort of Internal Rate of Return (IRR) for the Indian corporate securities market.
It is also interesting to observe that over a blended, relatively stable decade, how a
macroeconomic shock like the Global Financial Crisis tests a country’s model and fiscal policies
through shock and recovery phases. India’s performance demonstrated a rapid rebound of public
markets, asset price recovery and sustained earnings multiples through the period.
Figures 10 and 11: Bombay Stock Exchange Sensitivity Index (red) behaviour in GFC
Source: Bain & Company, India Private Equity Report 2010, p25
Coming out of the GFC, investment in India has been quick to rebound. During the period of
January to June, 2010 FIIs invested US $6878.50 million in equity investments in the secondary
market. The primary market for IPOs has rebounded, backed by foreign underwriters such as
Goldman Sachs and Deutsche Bank, with issues including power companies such as Power Grid
Corporation of India Limited and Jindal Power Limited, state banks such as State Bank of India
and infrastructure developers including Ramky Infrastructure Limited.
The Outlook For Foreign Institutional Investment
At the same time as equity markets gain momentum, currency stability is allowing for efficient
institutional asset allocation without fluctuations distorting capital flow into markets.
14

15. Figures 12 and 13: Stock market and exchange rate performance during and beyond GFC
Source: Deutsche Bank
Key facts such as India’s equity market capitalisation exceeding the value of its banking sector
and its corporate bond market being so under-developed also bode well for foreign investors in
equity markets as equities are the choice assets to gain exposure to corporate earnings.
International Asset Allocation
Figure 14: Emerging Markets Net Private Capital Inflows / GDP
Source: IIF Research Note
A general recovery in private capital inflows into emerging markets is currently taking place. As
the West emerges scathed from the GFC, the investment community is adapting to the emerging
markets’ increases in domestic consumption and decreased export to developed markets, in asset
15

16. allocation priorities are shifting in favour of something of a towards emerging market mandates
(as considered in greater length by Kang, Nielsen, Fachinotti, 2010).
As a discrete case, cumulative fund flows to India highlight the sheer rise in FII over the first
decade of the new century.
Figure 15: FII flows to India (cumulative since Jan 2000)
Source: Chakrabarti, 2009, SEBI.
Research indicates that the vast bulk of Indian FII inflows are channelled into the equity markets,
with which capital market indices are very highly correlated, to the extent of market volatility
causing sell-offs in Indian stocks and exchange rate volatility (CSFA, 2009).
Figure: 16 Relationship between FII inflows and BSE 500 Index performance
Source: Government of India Committee on Financial Sector Assessment (CSFA): India’s Financial Sector, p302
16

17. Some Problems
A liquidity puzzle exists in India that constricts investors in channelling funds to productive uses
across the entire economy. Allen and Chakrabarti et al (2007) observe that the size of the formal
financial sector in India, measured by market capitalization and volume of bank credit, is small
in relation to the size and needs of the economy and that alternative financing sources persist
beyond the firm start-up stage.
Without a foreign footprint, foreign investors are typically limited to closed-end or open-end
funds, where foreign-domiciled investment managers make decisions on behalf of the limited
scheme.
6. Asset Management
Figure 17: Growth of the Mutual Funds Industry in India
Source: Chakrabarti (2009), adapted from Association of Mutual Funds in India
6.1 Current Issues in Asset Management
As the asset management industry evolves towards a more crowded, complicated industry, key
items on the agenda for asset managers include seizing financial opportunities associated with
17

18. demographic retirement shifts, reinventing the wholesale approach to fund structuring, business
development for the next wave of growth and driving scale to generate operating leverage
(McKinsey, 2010). Global regulatory reforms such as the closure of proprietary trading desks at
investment banks are seeing new players move into the space and niche players disappear after
years of negative returns.
6.2 Asset Management in India
Internally, pre-GFC the Indian asset management industry had grown rapidly at 47% year-on-
year since 2003, but Assets Under Management (AUM) are a mere 8% of GDP, compared to
79% in the US and 39% in Brazil (McKinsey, 2008), suggesting a dynamic opportunity pipeline.
New equity inflows and new fund offers have contributed heavily to industry development, with
growth equal between the retail and institutional segments (McKinsey, 2008). Amongst the
country’s demographic opportunities in the real economy, growth drivers will lie in distribution,
consumer understanding, and investor education (SpencerStuart, 2009).
Chakrabarti (2009) examined the asset management industry in India, including a history of
mutual funds in India, regulations and regulatory change, current industry structure and product
offerings. He observes that in spite of the mutual fund sectors recent growth nationally, Indian
population participation is still very low at approximately 3%, but still higher than retail equity
ownership, which is around 2%. Corporate assets account for over half of total assets under
Management (AUM). Performance is rather negligible in domestically founded funds, relative to
major stock market indices, but market efficiency would appear to be present, with a low number
of outliers in the risk-return profile. FIIs are seen as a discrete category of the market and are
regarded in the market as “hot money” that quickly withdraws at the hint of trouble, with
18

19. potentially destabilising consequences. FII equity investments and stock market performance are
very closely linked.
Mutual funds AUM is expected to grow 40% CAGR to be a US $302 billion industry by 2012
(KPMG, 2008). New trends in the asset management business include the arrival of real estate
securisation in the form of Real Estate Investment Trusts (REITs) and employee pension fund
development and its flow-on effects (Chakrabarti, 2009). Goldman Sachs is currently
underwriting the offer public offering of UTI Asset Management Company, India’s second
largest mutual fund.
Equity funds product development tends to focus on equity-long positions across sectors and
market caps. In accessing equities, FIIs equity funds will typically apply a proprietary investment
strategy in line with the fund or company mandate.
Investment Funds, Inception, Operation and the Indian Regulatory Framework
The asset management business officially evolved in India from the SEBI (Mutual Fund)
Regulations 1993. Historically, product marketing has not generally been aimed at Indian
investors and foreign funds have typically not elected to mobilise Indian investment with
offerings to access investment from Indian residents (SEBI, 2004).
Knowledge barriers may necessitate that investors can best access Indian ECM through open or
closed-end funds managed by third-party asset managers. Risks include liquidity and redemption
risks, geographic or sectoral concentration risks, currency fluctuations and foreign markets risks.
Integration of the geographic region and global capital markets, may dictate diversification
benefits and fund profitability, as explored in the close-end funds example by Bekeart and Urias
(1995).
19

20. Such an example is the open-end Goldman Sachs India Equity Fund launched in 2008, with the
mandate to achieve long-term capital growth from actively managed Indian equity securities.
The key metric for fund performance is the fund’s Net Asset Value (NAV) calculated on a daily
basis.
Discussion and key findings
The asset management industry in India is evolving with new product creation occurring
concurrently with demographic change and regulatory changes such as pension development.
FIIs have a strong grasp of India’s macroeconomic fundamentals and how access to equity
markets can shape investment strategies in line with fund mandates. India’s economy has
positively weathered a stress test through a challenging period and the snapshot of its economic,
taken into consideration with research houses’ long-term projections make it a positive candidate
for investment allocation from FII funds into equity markets.
Recommendations and Further Research
This paper is a good point of departure for a more extensive analysis of investment strategies that
can be applied to India based on the country’s macroeconomics forecast and growth projections.
A more extensive paper would consider the linkage between financial assets and consumer
demand for real goods and services, exploring asset allocation strategies and developing models
to overcoming the challenges of fundamental analysis in emerging economies. Further research
would also explore best practice valuation methodology used for Indian securities by
practitioners of corporate finance.
20

21. References
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publication, October 2007
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document
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to the Harvard Department of Economics, Harvard College, Massachusetts, March 19, 2009
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Cleary, D., ‘The Evolving Nature of Global Asset Allocation’, Lazard Insights Conference Call Series,
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15, 2010
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presentation, 2005
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LIII No 6, December, 1996
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21

22. Gregoriou, G. N., ‘Asset Allocation and International Investments’, Palgrave Macmillan, 2007
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Board of India (SEBI), accessed at www.sebi.gov.in/mfdp/goldmansachs.pdf accessed on 12/11/10
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January 26, 2010
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2010
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case Ref 9-106-014, August 16, 2005
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Mandate for Reform’, Stanford Graduate School of Business Case: IB-58, 09/08/05 (REV 25/08/09)
Li, W., ‘Valuation Challenges in Emerging Markets’, Emerging Markets Finance lecture session 5,
Darden Graduate School of Business, The University of Virginia
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pulling away’, company research report, 2010
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Institutions Practice, 2008
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May 2007
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Growth’, research report, April 2010
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22

23. Mobarak, A. M., ‘Doing Business in the Developing World’ Spring 2010 syllabus, Yale School of
Management
Montiel, P. J.,‘Macroeconomics in Emerging Markets’, Cambridge University Press, 2003
Poddar, T., ‘India: the Assurance of Domestic Demand’, Asia Economics Flash, June 3, 2010, Goldman
Sachs Global Economics, Commodities and Strategy Research paper.
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research paper No. 201, July 28, 2010
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Paper Series No. 8, April 2004
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