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Derivatives set up and wooing more investment great incentive for PSX expansion; taxes burden mutual funds

Interview with Mr Nasim Beg — Chief Executive, Arif Habib Consultancy

Profile

Mr Nasim Beg qualified as a Chartered Accountant in 1970 and has worked in the automobile industry as well as financial services including some time in the UAE and the UK in financial services. He has been with the Arif Habib Group for last seventeen years, having joined it to set up an asset management business. He is currently engaged in setting up its business consultancy unit and is also advising and supporting the group’s entire range of financial services activities. In addition, he actively participates on the boards of the group’s real economy companies.

PAGE: WHAT WOULD BE THE ROLE OF BROKERAGE HOUSES IN FUTURE AND HOW WOULD THEY CONTRIBUTE IN PSX?

NASIM BEG: There are two aspects. Given the fact that PSX, being an electronic platform and accessible from all major cities that have good connectivity, it is now truly location neutral. This should allow many more brokerage houses across the country to become trading members. With more brokerage houses, the number of investors should increase. However, there is a tendency to get in to cut-throat competition and offer services at extremely low commission. On the face of it, this sounds good but the low commission earnings do not allow brokerages the viability to spend on proper research; and in order to earn enough at low commission rates, the brokers tend to encourage clients to buy and sell frequently, as that allows them to make up somewhat on the low commissions. This becomes speculative trading activity, not backed by proper research; and even worse, if leverage is introduced to further multiply the value traded.

The question shouldn’t be as to what the brokers can contribute but as to how their business can be encouraged to be responsible as well as viable. The answer may lie in having mandatory research and a minimum commission level that makes, not only research economically viable but also for them to open branches and reach out to retail investors. Our initial target should be at least two million retail investors over the next couple of years.

PAGE: HOW WOULD YOU COMMENT ON INVESTMENT IN MUTUAL FUNDS BASED ON THE CURRENT SITUATION?

NASIM BEG: Mutual funds and our unique Voluntary Pension Scheme (VPS) are good saving vehicles for an average small saver, who may not have sizeable funds and neither the wherewithal nor the time to engage in research based investing. These vehicles offer various avenues in terms of asset classes (shares, fixed-income investments and very short horizon money-market investments).

In the recent years, the financial managers in our governments (federal as well as provincial), have lost sight of the nature of collective investment vehicles. The concept is that small savers pool resources and invest through a fund manager; the pool should be tax neutral, i.e., the small saver should not suffer additional taxes if he goes through this pool as compared with those who have the ability to go to the market directly.

Regrettably, both the federal, as well as provincial governments have started treating these pools of small savers as if these were taxable companies and have tried to impose an array of taxes, including super tax that only the super-rich are required to pay. Thus, if you are an investor with means, you do not suffer these taxes you going directly to the market but if you are a person with small means, you suffer these taxes going through a collective pool.

Nevertheless, small savers would do themselves a favour going through mutual funds and VPS, as they will get professional help in doing so.

PAGE: YOUR VIEWS ON CHINESE INVESTMENT IN PAKISTAN STOCK EXCHANGE:

NASIM BEG: I have not been in favour of any foreign strategic stake in PSX but I am amongst the minority and now look towards making the best of it. The reason that I have not been in favour of foreign strategic stake is on two accounts, firstly the stock exchange is a very important constituent of a capitalist economy, which we are. The primary function of the exchange is to provide a conduit for national (as well as foreign) investments to flow to industry, trade and commerce; which in turn become the backbone of the national economy. In other words, it is the pipeline for capital flows; would I like our other strategic assets such as oil and gas pipelines, railways, national airlines, airports, defence production etc. to be under the management and control of foreigners? I think not.

My second issue is that there is a flawed line of thinking that we should not re-invent the wheel and just mimic what the more developed economies have done in developing their exchanges, thus we need a strategic partner who has already been through the learning and is now developed to an optimal level.

My issue with this line of thinking is that I do not agree with the assertion in the capitalism has been well served by the financialization of the economies. We have seen as to how disastrous the financialization has been in the most developed of the economies.

What I hear many market colleagues talk with excitement about is the hope that new products will be introduced. These new “products” are derivatives and other leverage mechanisms.

The perceived need is twofold, firstly to provide hedging tools and secondly to provide liquidity. So, the question is who needs to hedge? Not a small saver who takes a long-term investment view of investing in shares and is not speculating; this investor needs to be guided not to put any emergency reserve funds in the market, as the investor may need access to those funds without notice and would not wish to make a distressed sale, especially if the market prices have taken a dive for any unforeseen reason.

The non-emergency funds invested in shares can be sold when the market prices have recovered from any temporary shocks, thus it would not make sense paying hedging costs for such investments. A speculator would of course like access to tools that allows the speculator to pass on the downside to some other speculator; thus, the hedging tools are desired by speculators and not investors.

This brings us to the second need, which is liquidity. This is based on the well-established observation that a market place, where there is a lot of buying and selling (liquidity), offers the best price discovery and the lowest impact cost.

“Price discovery” is best understood by an example, if there are a very few buyers or sellers, one may not get a fair price as the buyer or the seller on your other side may either push up the price if you are buying, or may offer too low a price if you are selling but if there are many buyers and sellers, someone else is likely to offer you a better price.

As regards impact cost, it is closely related to the liquidity issue but specific to a particular share that isn’t traded too often. If the share of a company is not traded too frequently, the buyer is likely to impact the price upwards when trying to buy shares of that company and similarly, downwards when trying to sell. However, if speculators become active in that company’s shares, then the impact cost is likely to be lower; and if a speculator comes to the market with borrowed money, the speculator will buy or sell even a larger number of shares; thus, the impact cost will be further reduced.

However, both these perceived justifications are based on flawed premises. If we are looking for large numbers of buyers and sellers, we need to attract a much larger number of investors to the market; our present 200,000 or so don’t even begin to compare with the 50,000,000 in India. Leveraged speculation is used as a substitute to achieve increased trading but this has a direct bearing on price volatility, which in turn is counterproductive, as it drives away small savers.

There is an additional collateral damage, the unsuspecting small savers, every now and then, get attracted to the stock market when stories of wonderful returns and price run-ups start going around; these run-ups normally take place in a low interest rate environment, which creates leverage-driven speculative bubbles

Regrettably these small savers driven by speculative greed under such exuberant circumstances, especially when investing in fixed-rate instruments is not very attractive, get enticed to buying shares at these unsustainable levels and suffer the inevitable consequences.

Thus, the small savers learn these bitter lessons shy away from investing in shares.

As regards the impact cost, the fact is that if a small saver invests in shares, with a long-term investment horizon, rather than for short-term speculation, such an investor will not suffer the impact cost as materially as a day — trader or speculator would; as an example, if the investor wants to buy a share in well-run companies, where the shares are tightly held by sponsors and very few shares are available in the market, there would be an impact cost in buying such shares but not so when selling as it would be sought after. In such cases the impact cost amortised over ten years would not be significant enough to concern oneself about.

In trying to protect the investor against the myth of a high impact cost, we end up keeping him totally away by encouraging leveraged speculation, hoping to create a lot of activity but actually creating volatility scaring the investor away; thus, one prefers fixed-rate investment, getting a far lower return.

The solution lies in increasing the number of investors. If we had two million, i.e., ten times the current 200,000, the liquidity would increase; and for trying to address the thinly traded stocks, the listing rules must require a larger free-float of companies that wish to list. The exchange has already initiated some measures in this regard. Nevertheless, if these are sought after shares, which very few people want to sell, there will be a higher price in the market.

PAGE: WHERE DO YOU SEE PSX MOVING IN NEXT COUPLE OF YEARS?

NASIM BEG: I assume the question is about the future of the exchange and you are not asking me to predict the Index and share prices. As I see it, the historical influence of brokers will diminish further. Hopefully, it will not result in a total absence of the wise counsel of some of the well-respected and experienced members.

At the same time, we are likely to see efforts to enlist many more brokers across the country. This should have a positive impact. We might start seeing entry of Chinese portfolio investors. Fresh liquidity inflows will drive up prices unless we increase the current free-float and bring in new listings.

Bringing in new listings has several challenges but having said so, if there is money in the market chasing a few shares, it will allow new issuers to get good value, which is likely to be a great incentive. Many market participants expect the new management to bring in derivatives. I have already expressed my view about this but if the exchange is successful in arranging these products, it should help brokers and the exchange to earn more on account of trading activity in these products. This may help brokers to extend their outreach across all major towns.

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