Activities involved in Fund Administration:

The main activities involved in the life cycle of the fund are:

• Gathering assets and
• Managing the assets and deciding on how to spend the money.

Many fund managers consider tasks that does not fall into one of the two categories as a candidate for outsourcing. According to an article on wikipedia, “Fund administration is name given to the set of activities that are carried out in support of the actual process of running a collective investment scheme, whether the scheme is a traditional mutual fund, a hedge fund, Pension fund, unit trust or something in between”. Many KPOs such as S.G. Analytics provide the following services with Fund Adminstation:

• Calculation of the Net Asset Value (NAV) including the calculation of the funds income and expense accruals
• Corporate actions and cash reconciliations
• Daily accounting, recording and maintenance of all investment activities including multi currency accounts

The above list is just a summary of the task involved in Fund Adminstration.

Security Issues:

There are a huge number of security issues while outsourcing a financial activity which was summarized neatly in the blog post titled, “Outsourcing Financial Activities”. An important point mentioned by the blogger is, “Security issues are vital and should be given ample thought and time during the discussions. Financial activities form the keystone for the success of a company, hence look out for certification such as ISO 27001″. This certification thus becomes necessary while looking out for candidates worthy of outsourcing any financial activities.

Sovereign Wealth Fund Size

Where does this money come from?

The foreign reserves of countries are typically in dollars, euros, or yen. However when a country accumulates more reserves than it feels isnecessary for immediate purposes, it usually creates a sovereign fund to manage those resources. Some countries such as Kuwait and the United Arab Emirates (UAE) have created SWFs to diversify their revenue streams as their revenue streams rely heavily on oil exports and are vulnerable ups and downs of the oil market. The SWFs thus is used as a shield by these countries against oil-related risks. According to this article in investopedia, “The amount of money in these SWF is substantial. As of May 2007, the UAE’s fund was worth more than $875 billion.  Still, the holdings of such funds remain quite concentrated and seems to follow the 80-20 rule as with the top five funds are accountable for about 70 percent of total assets in SWFs.

What is the future of SWFs?

The future of the SWFs is summarized beautifully by Simon Johnson, the Economic Counsellor and Director of the IMF’s Research Department, in his article, The Rise of Sovereign Wealth Funds. According to this article, “Sovereign wealth funds are major state-owned players of the 21st century. Hedge funds, while becoming more prominent in this century, are in some sense a throwback to the end of the 19th century, when large pools of private capital moved around the world with unregulated ease—and generally contributed to a long global boom, rapid productivity growth around the world, and a fair number of crises. What happens when the 21st-century state meets the 19th-century private sector? The outcome remains to be seen.”

History and the Religious Flavor to Saving:

Our forefathers have been for years highlighting the importance of saving in gold. This was taken a step further, when festivals were celebrated by the buying of gold. This form of regular savings accumulated over the years and acted as a suitable protection against financial storms.

Importance of having a blend of Savings and Investments:

Barack Obama has been recently quoted to have said, “At the end of the day, the best way to bring our deficit down in the long run is not with a budget that continues the very same policies that have led to a narrow prosperity and massive debt. …. It’s with a budget that leads to broad economic growth by moving from an era of borrow and spend to one where we save and to one where we save and invest”. This is a classical quote from a great visionary that he is.  The quest for optimum growth is the primary source of  the invention of the various financial instruments we  come across in our day to day lives. These include insurance, mutual funds, and even the stock market.  Financial valuation has its source in mathematics and over the years it has become one of the primary contributors for the research in mathematics.  These models have only one goal, i.e.,  optimization of these instruments to maximize their returns.

Save in a Bank or Spend?

These words by Keynes might be correlated to the trends observed by financial researchers and KPOs which motivated my previous blog post on markets and chaos theory. However, one observation that should not miss the eye is the conflict between saving and growth. Can savings in banks, and government bonds chop the wings of growth? In India, savings was given a higher priority from ages and during this period the growth rate of around 3.5%, commonly known as the Hindu Growth rate,  was observed. The insecurity arising due to the droughts, the wars fought with its aggressive neighbors and lethargy in the guise of socialism were some of the reasons why savings were encouraged by the intellectuals. The intellectuals have morals which are in a different league and their ideology has withstood the test of time. However, many criticise these very morals when economists chalk strategies which are high in morals as they are considered to hamper growth. A classical example of this is the lost decades of Japan. A classical example of the other side of the spectrum was observed in India from the late 90′s where the habit of savings was being  replaced with the credit card mentality of the west. Financial analysts and researchers have also observed that this time period seen a massive growth in virtually all sectors. The careless spending and current financial chaos has left many with a huge financial burden in the form of housing loans, car loans and unpaid credit card bills. Somehow a feeling that utopia exists somewhere between the spectrum of savings and growth but zooming into this spectrum is going to be a non trivial task which could be similar to zooming into the Manderbolt Set. This might need the help of mathematicians who are not blinded by the past strategies of the economist whose failure has affected virtually every life in this planet. However, they can achieve their goals only if “We the People” start using our “Buddhi“.

Such views are not only being shared by financial analysts and bloggers but are also being activelt written by columnists. All of them converge on one point that the greed and myopic vision of the visionaries heading the large financial institutions coupled with false assumptions made in their mathematical models are the root cause of the current financial chaos. It is sad that this behavior was made publically available half a decade ago but was largely neglected due to the apathy and laziness of some economists.

Why are these KPOs in great demand?

Leading KPOs such as S G Analytics have over the years been highlighting the potential of the untapped resources in our country, especially the talent pool in the area of financial research. Every year a large number of highly qualified mathematicians and business graduates pass out from some of prestigious institutes, however a large pool of this talent is yet to be tapped by the industry. The time constraints in carrying out cumbersome tasks are a boon to the KPO industry especially those working in the financial sector.

These KPOs have mastered the art financial research and to a few financial researchers, they are to the financial industry what pipeline assembly was to the Ford Motor Company before the second world war.

What do these KPOs offer to their clients ?

A wide range of services including, Financial Research, Sector Research, Fund Analysis, Thematic Research and Fund Administration are offered by the KPOs. As in the case of any service industry, most ofhese services are customer centric, however a few processes may be common across the customers.

Short Selling

Short Selling: An Example

The practise of short selling was first observed in 1609 and has been banned by many markets before the 19th century.  An example of short selling is as follows. Alice borrows the 10 shares worth $5 each of company X from Bob for a day. Bob has decided not to sell the 10 shares for another 6 months as he speculates that the share price will go up. Alice should ensure that she returns 10 shares of company X to Bob by the end of the day. Alice sell the 10 shares for  $50 ($5 each) at the begining of the day as she knows that some bad news shall bring the price down to $3. As she predicted, the price falls to $3.50, and she buys the share for $35. She gives $5 to Bob and keeps $10 to herself.

Hedge Funds and Short Selling:

Short selling is on of the techniques used by hedge fund manager to hedge the risks involved in their long term investments. The wikipedia article on hedge funds gives a nice example of hedge funds and how short selling is used. The importance of investment data becomes really critcial while predicting the price ranges of securities, hence KPOs have entered into the business of sourcing financial data

BRIC: Brazil, Russia, India, and China

Growth Prospects of India and China:

According to KPOs India and China have shown the maximum promise especially in the area of Microfinance. This blog post by S G Analytics, highlights the astronmical or should I say economical growth rate of 43%. There is about 52 billion USD worth of credit that needs to made available in this market and only few investors have dared to enter the arena of microfinance.

Role of KPOs

Over the years KPOs operating from India such as S G Analytics have concentrated their resources in pursuing the evolution of the Indian and Chinese markets. Such exposure is vital in evaluating the prospect of microfinance firms to ensure that these firms are not exposed to non-recoverable risks.

Some of the key challenges faced by the investors investing in microfinance are

1. Need for broader suite of products
2. Regional diversification
3. Market consolidation and entry of FII

Mining Online Data:

Mining online data requires a lot of artifical intelligence and a flair for the mathematical tools used to get something meaningul from the data. The problem is partially solved by storing the data in custom databases the data as data presentation is a critical component of data mining. Once the raw data is stored in a structured format, a user interface is required to ontain the required subset of the data required for the mathematical analysis.

Mining EDGAR data

The problem is aggrevated when the data is present offline in the form of financial statements. Such data has to be first converted into a structured form in some database. This is a non trivial task as offline data is usually heavily unstructured and many a times requires multiple iterations if the data is poorly presented.

Mining and Presenting the Data:

Mining and Presenting Offline and Online Data

KPOs have lately mastered the art of not only mining the data and storing them in structured and custom databases but also in providing some user interfaces to easily access this data. This activity is a real timesaver for many financial researchers who previously had to manually mine the data.

The deflationary Spiral

Deflationary Spiral: A whirpool to be avoided

The bad news is that deflation may result or be a symptom of  a deflationary spiral, where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price.  The Great Depression was is a classical example of such a deflationary spiral. According to financial analysts and KPOs such as S G Analytics, a deflationary spiral is usually triggered by higher interest rates. These high interests result in a fall in money supply and a consequent a  fall in demand for goods. The fall in demand results in an increase in inventory and thus a fall in production and thus a fall in stock prices

KPOs revealing the hidden treasure:

In such situations many cash rich companies might have an attractive E/V and some might fall in the negative EV category. Financial researchers and KPOs consider some critical times in these times as the right time to invest. A detailed analysis of the funds and the sectors reveals the hidden treasure which is worth investing. These analysts burn the midnight oil while analyzing such data which only a few realize and put to optimum use.

KPO: The Intellectual sibling of BPO

In simple words KPOs operate at a much higher level in the intellectual value chain and hence the job satisfaction, intellectual stimulation, and the results provided by the KPOs are far superior compared to those of BPOs.

The Number Crunching Game:

In case of the financial sector, a small number of KPOs are mushrooming that assist in Equity research, Sector research and Fund analysis. These KPOs have mastered the mathematical tools used in the Financial Analysis, more specifically getting the best of the various financial instruments present in the market.

KPOs: Need of the hour

The fast paced lifestyle depends heavily on the  need for flexibility, drastic reduction in time required to ‘go to the market. Furhter, the economies of the developed nations such as the U.S.  have always been fueled on innovation in the finance, healthcare, pharmaceutical, biotechnology and intellectual-property rights.  The KPOs are expected to enhance the efficiency of such sectors and thus in a long run create further jobs and avenues of research.

The market for KPO is huge and some KPOs predict that the market is worth $10 billion by 2014,  growing at a CAGR of 20% from 2003.

An Example:

Imagine an investor Alice buys a CDS from the Big Brother Bank. The reference entity of this CDS is the loan taken by Bob. Alice will make regular payments to the Big Brother Bank which the Big Brother can use to give Bob. If  Bob defaults by not repaying the loan installment then Alice receives  a one-off payment from Big Brother Bank followed by the termination of the CDS contract. I came accross a nice illustration by nowandfutures.com that gives a nice overview of CDS.

CDS Overview

Mistake of treating a CDS as Insurance:

The article on credit default swaps, shows how the net exposure can be neutralized. However, this practice was not followed by some of the insurance majors such as AIG. This is considered by many financial researchers as  the source of the current credit crisis

A Surgeons Knife

Like many financial instruments the CDS is like a surgeons knife. If comprehensive analysis and detailed study of the swap is done then problems such as those encountered cannot happen else they can be used as tools for large scale destruction.

Is the EV a good indication of the health of the organization?

The EV works for most of the organizations, however it might be misleading for a few sectors. There can be organizations that have a negative EV and yet be profitable. Such companies are exposing their
cash reserves for a penny. But are their cash reserves make such organizations a good buy? As pointed out in the blog by a KPO called S.G. Analytics,  the banking sector cannot be evaluated like other sectors. Further, the analysis done by SG Analytics shows that only in the Financial sector a significant number of companies (38) in East Asia, followed by 34 in North America (US) fall in the negative EV category. A simple research shows that a significant amount of cash is deposited at the central banks in the form of cash reserve ratio (CRR) and the statutory liquidity ratio (SLR). However, in the current economic downturn the market capitalization of many financial institutions have shrunk and have become trivial compared to the total cash held by these banks.

Are analysts and KPOs of any help?

The cash reserves that make the stocks of such banks tempting may many a times be a mirage as the current economic downturn may spiral the good loans to go bad and might play a spoilsport by eating up most of the cash reserves. Thus, the moral of the story is predicting the EV of the banks is a non trivial task and should be better left to analysts and KPOs like SG Analytics.

What is mark to market ?

Suppose Alice bought 5 shares of company X at $10, the book value of the shares (depending in the accounting principles) is $50. Now if the stock value trades at $15, then the mark-to-market value of the share
is $75, which is far higher than the book value. However, if the share price fell to $5 then, the mark-to-market value is $25.

What is margin buying?

Other securities are typically used as a collateral while borrowing from a broker to buy shares. This form of buying is called margin buying.

Alice buys a share in company X for $10, using $2 of her own money, and $8 borrowed from her broker. The net value (share – loan) is $2. The broker might set  a minimum margin requirement of $1. Suppose the share goes down to $8. The net value is now $0 (net value ($2) – share loss of ($2)). In this situation, when the margin
posted in the margin account is below the minimum margin requirement, the broker or exchange issues a margin call. Alice will either have to sell the share or repay part of the loan (so that the net value of her
position is again above $1). When the market begins to slide downwards, individuals might start selling their shares to cover their margin positions, thus can result in crashes similar to the ones that happened in 1929.

Impact of mark to market and margin buying.

When even a single company in financial distress starts selling its assets to raise capital to meet regulatory requirements, the market-bottom prices it sells out for become the new standard for the valuation of all similar securities held by other companies under mark-to-market. This results in a downward death spiral for financial
companies large and small. So it seems that the financial analysts and researchers working at S.G
Analytics have identified the crux the cause of financial meltdown in their blog.

The Price to Earning Ratio (P/E )

The price earning ratio is, as the name suggests, P/E where P = Price Per Share and E is the annual Earnings per share. Thus, as the units of P/E is the number of years, the P/E ratio is a nice indicator of the number of years of earnings that are required to get the purchase price of the stock. The component P is the value of the stock price while buying the stock however financial analysts such as S.G Analytics have various ways of computing E. The traditional value of E is computed as the earnings per share for the recent 12 months period.
For e.g. if the stock price of a company is $10 and the earnings (dividends) over the recent 12 month period is $1, then the P/E = 10/1 = 10 years.

How to identify companies that performed badly last year but have good prospects this year?

The P/E is a good indication of the past performance of the company however given the current economic scenario it is not a good indicator of which stocks have a potential to perform well. There are metrics like the T-Model, that take into account the growth rate but computing such metrics is better left to the financial analysts and fund managers. However a simple metric that can take into account the growth is by using the potential earnings per share given the growth potential of the sector. This is exactly what is done while computing the forward EPS. In case of forward EPS, the expected earnings per share is the E in the P/E ratio. Thus, the forward EPS is many a times referred to as the estimated price to earnings by financial analysts.

A word of caution

Over the years a stock’s P/E is used as a good indication of how much investors are willing to pay per dollar of earnings. As the P/E takes into account the earnings per share it gives a much better indicator of a stock’s value than the market price alone. However, there are many reasons for a forward EPS to be high/low which are many a times heavily dependent on the market sentiments.

Types of Derivatives:

The most widely used derivatives are

1. Forward Contracts – is a formal agreement  between any two parties to buy/sell an asset at a fixed time in the future. For example, Barney who is planning to shift from New York to Paris in 6 months time agrees to sells his car to Fred for $1000.  This money is exchanged in 6 months time irrespective of the market condition and fluctuations in the market
2. Futures contract – is a contract, traded in a futures exchange,  to buy/sell at a specified date in the future at a price specified today
3. Swap contract – is a derivatives where two parties agree to exchange one cash flow for another.

The  credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument goes into default.  Many consider the lethal combination of NINA (“No Income No Assets), falsified information of borrowers income, and CDS as the primary causes of troubles of many large insurance firms such as AIG and the foreclosure spiral that has engulfed the housing sector.

Further Reading:

A nice articled titled, “Barnyard Basics of Derivatives”, gives a crisp overview of how derivatives work. Lately these instruments like all other financial instruments have come under sharp criticism, however to be fair, like all mathematical tools, derivatives have their own set of pros and cons.

Mining Data:

The submitted forms are freely available on the SEC website. For example, the form submitted by General Motors corp is available at the following link. As you can see, filing such forms and getting some useful data from such forms is a non-trivial tasks. Many KPOs such as S.G Analytics have currently mastered the art of not only filing such forms but also mining them for investment research. The need for number crunching has also enabled analysts to make the parsed data available for research. However, as in the case of raw data, the outcome of this research is heavily dependent on quality of the organization conducting this research.

Conclusion:

A significant drawback of the EDGAR system is that the data is highly stripped down difficult to read compared to annual reports. Many companies have their annual reports available online, however for those who do not have them, the investors have to rely on other sources of data. Thus, the process of sourcing the quality data for financial research has become a lucrative business for KPOs operating from India such as S G Analytics.

The activities involved in the M&A process includes
1. Screening of the investments and divestitures
2. Due Diligence
3. Analysis of the Regulatory Risk

Screening of the investments and divestitures:

This process involves identification and analysis of the investment and disinvestment opportunities. This is a  cumbersome process and involves the analysis of the financial health of organization and mining the past financial records. For example in the case of an electronic goods manufacturer, the analysts would be interested in the year, location, items produced, worker count, and the number of items produced at each plant along with the plan capacity.

Due Diligence:

The process of due diligence during a M&A includes identification and assessment of the business risk.

Analysis of the Regulatory Risk:

A key roadblock in many big mergers is the possibility of a monopoly of the merged entity. Regulatory bodies do not allow mergers that result in the merged entity having a monopoly over the entire market. For example, the regulatory bodies would oppose the merger of Google and Yahoo as their combined market would result in the merged entity having a monopoly over the internet search market.

Thus one of the key activities which is creation of a detailed pitch book for the investors should not be done by only those who have mastered the art of managing mergers and acquisitions.

Over the years the financial organizations bank have always picked the top cream of not only the Management Institutes but also technical institutes. They were once envied for their fat pay checks and high service charges. This senseless greed and violation of trust  that resulted in large scale manipulation of the financial instruments has been blamed for fueling the current financial storm. As a result of this greed many of their clients had to bear the brunt of this storm. The financial health of their clients is slowly requiring them to trim down to austerity. This may turn out to be a boon for the KPO industry as many clients are slowly demanding more for the same value. This is bound to make the think-tank of these companies to reconsider the organization and composition their work force. KPOs are confident that the cost cutting measures taken by the think tank shall make them the most suitable candidates for a healthy chunk of their business analytics and financial research. Further, as in the case of the investment banks, the legal process outsourcing is also gathering steam.

It is hard to disagree that greed is one of causes for the current credit crisis however non-altruism is also considered to be the driving force behind innovation and economic growth.  KPOs are now awaiting for the time where the a good amount of this research work shall be outsourced.

How microfinance works:

The wikipedia entry on microfinance is nice read. The following diagram from the wikipedia entry gives a comprehensive summary of the various goals achieved by a family of microfinance products ranging from insurance plans to long term loans.
Why is it attractive?

According to KPOs such as S.G Analytics, currently about 250 million people in India which includes small and marginal farmers need about 52 billion USD worth of microfinance credit.  Further the customer base  covered by microfinance is growing at a Compounded Annual Growth Rate (CAGR) of about 43%. These numbers need to be taken with a pinch of salt due to the absence of regulations and regulatory rules in the microfinance sector. Lately a couple of microfinance firms have plans to raise more than Rs 300 crores.
A wolf in sheeps clothing:

The greed of some microfinance firms is clearly reflected in their huge interest rates, as a result of which microfinance appears to be a camouflage for the pawn brokers.

” There are 10^11 stars in the galaxy. That used to be a huge number. But it’s only a hundred billion. It’s less than the national deficit! We used to call them astronomical numbers. Now we should call them economical numbers.” — Richard Feynman.

Various meanings of economical:

The word economical has many meanings, one such meaning is  “of pertaining to the national or regional economy”, another meaning is “guarding against waste of unnecessary expense or avoiding waste”.  Sadly the current financial crisis seems to be following the definition given by Richard Feynman more than 2 decades ago!

What is currently economical?

The article on investment opportunities shows that investment opportunities only in the infrastructure sector is about 1500 billion dollars which is 15 times the number of stars in the galaxy. These numbers which were once considered astronomical are now been talked of routinely as economical numbers. Crunching such numbers is relished by economists, applied mathematician and applied physicists who are many a times considered the fore-fathers of the financial mathematics stream. The current financial turmoil seems to be following the butterfly effect.  In these situations what is coming next can only be predicted by financial analysts who are scholars such as Feynman who once quoted,

“Physicists like to think that all you have to do is say, these are the conditions, now what happens next?”