Side effects
regulations protect but do they serve?
Even well-intentioned market regulations have side effects that end up disadvantaging investors.
Mutual Fund Total Expense Ratios
Asset management is a scale business. Beyond a certain AUM, costs plateau and margins increase. To make sure that investors benefit from these scale advantages, SEBI sets a ceiling on the expense ratio of a fund based on its AUM1.
This works great when the markets are trending up and the fund is ramping up assets. However, what happens in a down market or if there is some sort of controversy in the management of the fund and investors head for the exits?
When AUM begins to shrink, the fund manager is well within their right to increase expense ratios, and most of them do. Investors vote with their feet and exit the fund. As more AUM flees, the more the fees ramp up, making it all the more difficult for the fund to outperform its benchmark. Investors who choose to remain end up paying more for less.2
The capital gains tax hit makes this scenario a double whammy. So, investors face a dilemma - they can either stay and bleed slowly or exit with a deep cut.
This is the very opposite of rewarding patience and “staying the course” when it comes to investor behavior.
Categorization of Mutual Funds
Another piece of regulation that leads to some weird market distortions is the one that mandates the market-cap based universe from within which funds can pick stocks3.
Twice a year, AMFI is tasked with categorizing the universe of stocks4 into “large/mid/small” and funds with specific market-cap mandates are allowed to invest in only the corresponding set of stocks.
This ends up tilting funds towards pro-cyclical portfolios and against value stocks.5 This is particularly true in the large-cap space as stocks in out-of-favor industries get kicked out and large-cap-only funds cannot buy them until they get back in again.
Regulation crafted with the intention of forcing fund managers to do what it “says on the tin” disadvantages an entire investment style and leads to most funds having similar factor tilts.
Regulations - there is no effect without side-effects.
Markets this Week
A lot of companies will be announcing earnings this month (calendar).
Not a great start to the year…
… with Mag7 getting dumped.
More here: country ETFs, fixed income, currencies and commodities.
Links
Research
Migration Policy and the Supply of Foreign Physicians (NBER)
In the United States, rural and low-income communities have difficulty attracting and retaining physicians, potentially adversely impacting health outcomes. With a limited supply of physicians completing medical school at US universities, foreign-born and educated physicians provide a potential source of supply in underserved areas. For international medical school graduates (IMGs) the terms of the commonly used J-1 visa require a return to the home country for two years following employment in medical residency. The Conrad 30 program can produce a sustained increase in physicians at the state-level and in underserved communities.
Lifetime Memories of Inflation (NBER)
The recalled experiences of inflation by individuals are closely related to their forward-looking expectations about inflation.
Diversification Is Not A Free Lunch (SSRN)
We demonstrate that diversification is only a free lunch under uncertainty and ignorance. Using expected returns, diversification reduces returns.
Investing and Economics
Don’t take closing the gap between rich and poor countries for granted (ft, @michaelxpettis, carnegieendowment)
Is the west talking itself into decline? (ft)
In India, the road to enter bankruptcy court is now 7,000 companies long (livemint)
American Companies Are Going Broke Gradually, Not Suddenly (bloomberg)
Bitcoin ETF Issuers Clear Major Hurdle on Path to SEC Approval (bloomberg)
Having a highly addictive vice like mobile sports gambling sitting in your pocket all day is a real problem. Since 2018, $220 billion has been wagered in legal sports books, with the annual total increasing by an average of 22% year over year. And with all that easily accessible gambling, addictions have increased.
China-India trade tensions may continue in 2024, but Beijing doesn’t want to rock the boat (scmp)
India is not attracting enough manufacturing through China Plus One strategy, says Raghuram Rajan (thehindu)
The US assesses that corruption within the People’s Liberation Army has led to an erosion of confidence in its overall capabilities. US assessments cited several examples of the impact of graft, including missiles filled with water instead of fuel and vast fields of missile silos in western China with lids that don’t function in a way that would allow the missiles to launch effectively.
US Intelligence Shows Flawed China Missiles Led Xi to Purge Army
Democratic institutions aren't sufficient in themselves to keep the wealthy few from concentrating political power. (the-american-interest)
Odds & Ends
Even fair coins tend to land on one side slightly more often than the other. flipped coins land with the same side facing upward as before the toss 50.8% of the time. (scientificamerican)
'Rich Dad, Poor Dad's' Robert Kiyosaki Says He's $1.2 Billion In Debt Because 'If I Go Bust, The Bank Goes Bust. Not My Problem' (yahoo)
Flowers Are Evolving to Have Less Sex (nytimes)
Meme of the Week
For example, the base TER of Franklin India Prima Fund - Direct went from 0.79% in Feb-2019 to 0.91% in July-2021. It trailed the midcap index by ~7% (annualized) during that period.