AN UNDERSTANDING OF THE STRUCTURE AND FUNCTIONING OF THE MARKET:
Investment banks are an important part of the Financial Market, providing for a special segment of various banking operations that guide individuals or organizations financially in raising capital and also provide financial consultancy as and when required[1]. For newly formed organizations, they act as intermediaries. The chain of investment banking is universal and is perhaps the most complicated mechanism that deals with finance and trade.
These investment banks and financial intermediaries in the market offer various elaborate financial services, such as mergers and acquisitions advisory, trading securities and proprietary trading, restructuring that needs guidance to improve company structures to make it more efficient and profitable, and issues dealing with Initial Public offerings or IPO[2]. These functions are especially important for boosting the economy of a nation since they help provide financial stability for organizations and individuals who are not capable of self-reliantly commencing a business. They also help in improving structures of companies such that the attraction for investors and investor confidence increases infusion of capital when necessary. The very nature of this market is based on the goal of earning profit which helps the sector effectively contribute towards the consequent growth of players in the market[3].
One major benefit of investment banks is that they assist organizations go public with sharp planning and initial capital investment[4]. Given these functions performed by financial intermediaries, the markets are greatly influenced and driven by these investment banks, and it becomes necessary for the governments of countries to ensure that these intermediaries do not take undue advantage of this value they hold to the detriment of investors and customers.
The concept of investment banking is fluid and relevant all over the world and it becomes important to have a statutory State-controlled Regulating Authority to form a proper set of guidelines which will ensure that none of these functions are marred by malpractice, and will prevent any sort of malicious activity by the investment banking sector. These Regulatory Authorities also have to create and facilitate the required opportunities and pathways necessary for this sector to flourish with genuine approach, especially since the profit motive is a primary objective that must be considered when such policies and guidelines are enforced.
There is a clear distinction between the governance of financial intermediaries and their operational conduct and culture, and one may take priority over the other in cases where these organizations attempt to maximise profits. In such situations, the interests of investors may take a backseat and the accountability and responsibility that is a consequential part of the sector must be monitored and guaranteed by Regulatory Authorities[5].
In India, this function is performed by the Reserve Bank of India which is solely vested with the power to regulate major financial institutions and instruments in the country. It is assisted by SEBI or the Securities Exchange Board of India which is a necessary regulatory authority for listing and functioning of investment banks and financial market intermediaries, and is primarily associated with the various security markets in India.
AN UNDERSTANDING OF VARIOUS INVESTMENT STRATEGIES:
An investment strategy has been defined as the behavior, decision and market assumption that investors or investing organizations exhibit about the market at large[6]. This means that every idea or business investment decision that an investor may have about the market in which they invest in can be regarded as an investment strategy. This can include ideas as to what kind of investment is suited to that particular market by analyzing the market for potential competitors and then deciding as to what kind of strategy may work out. Investment strategies play an especially important role when it comes to investing in the alternative funds market such as the hedge fund market.
This is mainly because conventional modes of investment and their related strategies may not work in the alternate market as these funds offer different rates of return and react differently to market conditions, both internal and external. As a result, investors have to consider different kinds of action plans so as to invest successfully in such markets[7]. An investor must analyze the market so as to understand the risk that is associated with that market and the associated rates of return that usually come with such market risk.
An example of this is that an investment strategy in a hedge fund market is characterized by the position of stocks and securities in that market[8]. Based on the position of such stocks or securities, an investor or a hedge fund firm might devise an appropriate investment strategy for the same. Such a strategy involves a very small use of the firm’s working capital[9]. This is because the firm also needs to set aside a percentage of the working capital for the running of the firm’s day-to-day expenses and the business.
Some common investment strategies that firms or investors apply are as follows[10]:
- The Long/Short Equity strategy: This was first popularized by Alfred Winslow Jones in 1949. This strategy is used even today by many firms. The objective behind this strategy is quite simple. No business has a guaranteed winner or a loser. So as a result, an investor or a business uses this ploy to their advantage.
Under this strategy, an investor invests in a commodity which has the potential to rise in its value and uses it as collateral in order to sell a security with the intent of buying it. This combination when used by an investor/businessman or a firm generally increases more opportunities for stock specific profits thereby reducing market risk. A long/short equity maybe used in two competing companies in the same industry after looking at the value of these companies.
- Market neutral is another strategy where the firm or investor uses both the long and short equity strategy of investment, except both these strategies are equal and do not target any market as such, thereby maintaining a market neutral approach. This strategy can be seen as a less risky option when compared to the long short equity strategy; however the rate of return is also expectedly lower.
Firms go with this method because when dealing with long and short equity options, the investor or the firm do not typically hedge the entirety of their long market value and this option has a relatively longer and a bigger market exposure. Also, if this method were to be used in this scenario, then that portion which is not hedged may fluctuate amid market volatility. Hence the market neutral is preferred.
- The merger arbitrage method is considered to be riskier as compared to the market neutral method. The returns from this method occur after a takeover has taken place, which is also why this method is regarded as an event driven strategy. In the case of a share-exchange transaction, the hedge fund firm may buy the target company’s shares and sell the buying company’s shares in the open market and purchase it at a lower price, in a ratio which is found in the merger agreement. This is however subject to certain points such as: regulatory approval, that the company’s financial position does not change significantly and a favorable vote by the company’s shareholders.
This method is risky because planning a takeover is one thing, but there may-be externalities that could prevent such a merger from taking place. Such companies could place conditions on such a merger which could prevent such a merger from taking place. There could be a situation where the social, technological or political environment may prevent such a merger from taking place. As with any merger the party which participates in such a merger should be aware of the potential risk which could be associated with such a merger.
- A convertible arbitrage is an example of a hybrid security that involves a bond that pays interest at regular intervals and at the time of maturity, the principal is paid back. This bond is known as a straight bond and this bond is combined with an equity option. Under this method, the managers try to maintain a neutral position where the bond and the stock cancel each other out amid market changes. Managers and investors must preserve this neutrality by short selling and increasing their hedge in case the price goes up.
This method is dependent on market volatility, especially in situations in which the volatility is high or low. An unfavorable situation occurs when the market volatility goes out of control, in case of problems in the economy.
- Event Driven is another strategic method employed in the case of the hedge fund market in situations in which the strength and activity in the economy is high and more corporate and industry related events take place. Under this type of method, hedge fund firms often tend to buy those firms that are riddled in debt and have financial problems. Investors who invest in these firms should also be able to shoulder some risk and show patience as well.
THE TRUE BEACON CASE STUDY:
This case study helps analyze the performance of a particular hedge fund firm that was founded in Bangalore. It will help determine how financial market intermediaries can function under the guidelines of Regulatory Authorities, such that they maximize profits while protecting investor interests.
True Beacon is an asset management firm based in Bangalore and is a relatively new firm that has managed to outperform stock exchanges such as NIFTY50 despite the harsh economic situation that had been created due to the COVID 19 Pandemic[11]. The annual year’s results of the firm’s flagship fund were announced recently and True Beacon beat the NIFTY50 benchmark by about 26.6%[12]. In addition to this, the firm also recorded annualized returns of about 29.7% between September, 2019 and August, 2020[13].
The most fascinating aspect that has contributed to this performance is the composition of the firm’s financial model and its method of operations. The firm’s main objective is to attract foreign investment into India and in order to achieve this; it employs a unique financial model wherein under its revenue model it does not charge any management fees or any standing amount[14]. However, they charge a 10% performance reward in the case of any profits or gains. This unconventional model was the vision of its founder and CEO, Nikhil Kamath.
The objective behind setting up the firm was to eliminate all kinds of entry or exit loads[15]. Its model, thus, ensures that the investors are charged twice for the returns that they get[16]. The firm focuses on proprietary investment products and offers services such as portfolio management and capital market services among others to investors. In order to facilitate more foreign investing, the firm has also set up a foreign portfolio investment company based in Mauritius called True Beacon International where the main function is to garner greater foreign investment by serving individuals with a high net worth as well as ultra-net worth[17].
The firm is a category III AIF based firm that employs a hybrid investment strategy and by using, the firm places more emphasis on long equity and less on short term equity, using about 65% of its capital for the long and large cap only equity and about 35% for the short term equity[18].
This is clearly a good investment decision as the long and large cap only equity is hedged first whereas the short term equity is used to generate active return on investment during smaller and shorter cycles. As a result, even during major market instability such as the market unrest caused by COVID-19, the firm may most likely make gains. This hybrid model has worked incredibly in their favour and has made them gain significantly during the pandemic, protecting investors from market risks.
CONCLUSION:
Based on all of the studies conducted, it is clear that financial intermediaries such as investment banks are an essential source of growth in the financial market. Therefore, policies made by regulatory authorities should not be so strict that opportunities become restrictive and challenging for companies to meet their capital and profit motives.
However, while analyzing the regulatory mechanisms in India in light of the functioning of other prominent regulatory bodies around the world including The Federal Reserve Board and Securities and Exchange Commission (SEC) and Bank of England and Financial Services Authority (FSA), it is clear that the policies and norms set by the RBI and SEBI are based on the nature of the Indian economy and give the authorities absolute power to dismiss a bank from its practices if any substantively disruptive irregularities are found and not rectified. While the regulations are strict, they become necessary to avoid any sort of financial crisis. In an attempt to minimize this risk and constantly monitor the sector, these Authorities haven’t been able to focus enough on caving a suitable pathway for the sector to flourish such that there is mutual benefit for intermediaries and investors.
In such circumstances, True Beacon has proven that an unconventional approach to investment strategies can also help firms meet investor needs while maximizing profits.
[1] Mukabana, J, “Money Market Fund Reforms. BIS Investment Company Reforms”, 2014, p. No. 31, San Diego: BIS
[2] Joshua Rosenbaum, J. P., “Investment Banking: Valuation, Leveraged Buyouts, and Mergers and Acquisitions – Valuation Models”, 2009, New York: Wiley.
[3] CUTS Centre for Competition, Investment & Economic Regulation, “Investment Policy in India – Performance and Perceptions”, 2003
[4] Porter, M.E. and M.A. Kramer, “The Big Idea – Creating Shared Value”, 2011, Harvard Business Review. January edn
[5] APEC-OECD Integrated Checklist, “Regulatory Reform: Addressing Regulatory, Competition Policy, and Market Openness Policy Issues”, 2005
[6] Ewelina Sokolowska, “The Principles of Alternative Investments Strategies”, p 55-79, Investment Strategies of Hedge Funds
[7] ibid
[8] Dheeraj Vaidya, “Hedge Fund Strategies”, Wall Street Mojo, https://www.wallstreetmojo.com/hedge-fund-strategies/
[9] ibid
[10] Neil O Hara, “The Various Strategies of Hedge Funds”, Investopedia.com, 25th February, 2020 https://www.investopedia.com/articles/investing/111313/multiple-strategies-hedge-funds.asp
[11] ANI, “Asset Management Firm True Beacon’s Flagship Fund Records 26.6% Outperformance Of Indian NIFTY50, Despite Covid-Induced Turbulence”, September 10, 2020 http://www.businessworld.in/article/Asset-management-firm-True-Beacon-s-flagship-fund-records-26-6-outperformance-of-Indian-NIFTY50-despite-Covid-induced-turbulence/10-09-2020-318981/
[12] Ibid
[13] “True Beacon forms FPI entity to attract overseas investment into Indian capital markets”, 2020, https://economictimes.indiatimes.com/markets/stocks/news/true-beacon-forms-fpi-entity-to-attract-overseas-investment-into-indian-capital-mkts/articleshow/77997821.cms?from=mdr
[14] Supra, refer footnote no. 11
[15] Abhik Sen, “All My Money”, Fortune India, September 3rd, 2020 https://www.fortuneindia.com/venture/all-my-money/104694
[16] ibid
[17] Supra, refer footnote no. 13
[18] Supra, refer footnote no. 15
YLCC would like to thank Dylan Sharma for his valuable inputs in this article.
