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Wednesday, Dec 27, 2006

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If markets are efficient...

S. Balakrishnan

Financial markets are all about valuations. What is the right price of a share, bond, currency or commodity? The very raison d'etre for the round the clock, frenetic and frenzied activity in financial markets all over the globe is differences in perceived value. Buyers think the asset or liability is cheap, while sellers hold the opposite view. But what is true value? Can both be right? (If time is stretched long enough, perhaps).

The theory of efficient markets provides the answer. At any given time, all prices reflect full and true value. So there is really no undervalued or overvalued opportunity in the market.

Just a gamble

In effect, market players are only gambling on what the next move will be. And that will depend on incoming, new information or data (to which prices will adjust). Equilibrium will reign till something new crops up to disturb it.

Why, then, do prices fluctuate from moment to moment? Take any market and one finds trading volumes have grown massively in the last decade or so. This shows that efficient markets are high in theory but thin in practice. The academic response to this is that it is all `noise' - much ado about nothing. Research suggests that there is no surefire technique to outperform the market on a sustained basis.

Inconsistent show

This is proved by the inconsistent performance of mutual funds over a sufficiently long time horizon. Outsized gains in some years are offset by subpar results in others, leaving the overall return, at best, near that from investing in the index, or ironically below (in 70 per cent of the cases, an American study shows). And the 30 per cent (of the funds), which beat the index, varies from time to time, even year to year. The `star' fund manager is a mythical creature.

India is not immune to the implications of efficient markets. The quicksand of market volatility has led to quite a few casualties in performance, with one-time high flyers now turning in a poor show.

As has been said in this column earlier, an investor would have multiplied his capital about 5.5 times in the last four years — a compounded annualised return of 60 per cent — by just sticking to the Sensex basket. No entry, exit loads, management fees and administrative expenses. At best, a handful of funds might have put out a better display. Alpha fees for below beta (market) results.

The business of managing mutual funds is a lot more profitable than the funds themselves and explains the innumerable fund themes and mad rush to start new funds and asset management companies.

There is assured value for all in the mutual fund value chain except the poor investor!

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