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The Curious Case of SPACs (as published in The Edge on January 15, 2021)

1/15/2021

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By Emir Hrnjic

The COVID-19 pandemic triggered a massive uncertainty in global markets and the U.S. Fed responded by cutting interests rate to 0.25 per cent. As investors started chasing higher yielding investment opportunities, the somewhat–obscure concept of a Special Purpose Acquisition Company (SPAC) came back to the spotlight. In 2020 alone, roughly 250 SPAC initial public offerings (IPOs) raised U$83 billion – roughly equal to funds raised by conventional IPOs. Moreover, SPAC IPOs in this banner year raised more capital than all previous SPAC IPOs combined. Even 2021 started with a bang raising roughly U$8 billion in first two weeks – on a pace to double the record of capital raised in 2020.

Recently, Asian investors started jumping on a bandwagon. For instance, SPACs sponsored by Asia–based Antony Leung, Richard Li, CITIC Capital, Maso Capital, and Malacca Straits have raised more than U$2.5 billion, while Singapore–based Vickers Venture Partners, Japan–based Softbank, and Hong Kong–based Provident Acquisition recently filed to raise almost U$1 billion via SPAC IPOs. Even the Singapore Exchange is considering allowing SPACs’ listing due to their popularity.

Furthermore, more than a dozen SPACs are holding talks with South-east Asia’s startups about potential mergers. For instance, Bridgetown Holdings approached Tokopedia – South-east Asia’s largest e-commerce platform, while Traveloka – South-east Asia’s largest online travel app – announced that it is going public with a SPAC as a possible option. Moreover, reports revealed that other Asian unicorns such as Grab, Gojek, and Bukalapak have all been recently approached by SPACs.

While Goldman Sachs declared that SPACs in 2021 could even exceed capital raised in 2020 and Reuters reported that SPACs “arm up for Asian unicorn hunt”, investors are getting reacquainted with these alternative financial vehicles.

SPACs 101

Known as a “blank check company” with no business operations, SPAC is formed to raise funds via IPO with an intention of acquiring a promising private company within two years. When a private company is acquired by a public firm, it automatically becomes public. Hence, SPACs provide the public an easy access to a mature private equity (PE) investments, while being more transparent than PE, but less transparent than conventional IPOs.

Since investors do not know eventual acquisition target at the time of raising capital, SPAC resembles a flipped IPO process from demand–supply perspective. In a traditional IPO process, investment (company going public) is known and underwriters are looking for investors. In SPAC, on the other hand, lead sponsors find investors first and, then, search for investment (company to go public). 

After raising capital, SPAC sponsors promise to identify an acquisition target within two years. If they fail to find a target within two years, most SPACs return money to investors. Even if they find an acquisition target, the SPAC shareholders have flexibility to opt out and redeem their shares before the acquisition.

Also known as De-SPACing, SPAC’s acquisition automatically makes a private company public and thus resembles a flipped RTO from the private–public perspective. While RTO represents the process of private company acquiring a public company, SPAC achieves the same outcome via the process of a public company acquiring a private company. 

On the other side of the table, acquisition target has to negotiate with only one party (SPAC) unlike a typical IPO company that deals with multiple parties including underwriters, lawyers, and auditors. 

SPAC IPOs VS. CONVENTIONAL IPOs

Natural question arises how SPAC IPOs made such dramatic inroads into well–established world of conventional IPOs.

SPAC proponents claim that the phenomenon of pricing a typical IPO below their market price – so called IPO underpricing – incurs an unnecessary (opportunity) cost for the company going public, also known as “money left on the table”. The IPO underpricing averaged over 20 per cent this year. 

In extreme cases, IPOs leave even more money on the table as in recent cases of DoorDash and Airbnb which soared 86 per cent and 115 per cent on the first day of trading, thus leaving billions of dollars on the table. 

They also argue that SPAC enables investors to avoid IPO underwriting fees that typically go as high as 7 per cent.

Other factors include reduced underwriters’ ability to conduct traditional IPO roadshows during pandemic. Since SPACs are established by reputable sponsors who then search for additional investors through personal networks, there is no need to conduct traditional IPO roadshows.

Moreover, the quality and reputation of SPAC sponsors have drastically improved over the years and institutional heavyweights such as Goldman Sachs, Citigroup, and Deutsche Bank jumped on the SPAC wagon. The improved quality of sponsors, institutions, and their networks greatly contributed to a SPAC boom. 

Additionally, many view SPAC as an accelerated IPO without strict regulatory scrutiny that accompanies a typical arduous IPO regulatory process. SPAC accelerates the process of capital raising as there are no operations, assets, or financial data. The entire process can be completed in several weeks, instead of several months. This efficiency reduces completion risk, especially in volatile markets. 

Finally, some spectacular success stories boosted the popularity of SPACs and attracted even more investors. For instance, DraftKings’ valuation quadrupled, while Virgin Galactic’s price jumped 150 per cent in several months after the SPAC acquisition. 

SHORTCOMINGS OF SPACs

In contrast, shortcomings and hidden costs of SPACs are numerous.

A recent research study documented that the median SPAC held only U$6.67 per share by the time of the merger – down from U$10 at the IPO stage. This drop was mostly due to dilution of SPAC shares as sponsors were rewarded with 20 per cent of the acquired company – akin to a “finder’s fee”. 

Another research study documented that the average SPAC IPO in the first decade of 2000s lost roughly half of its value over four years, while higher SPAC sponsors’ ownership was associated with worse performance. Similarly, the operational performance of SPACs was inferior to industry peers and conventional IPOs.

Finally, research found that SPAC–acquired firms were traditionally small and levered firms with low growth opportunities, consistent with the notion that SPAC acquisitions attracted firms to go public in difficult times.

A former SEC Chairman, Arthur Levitt, stated “I have never found any [SPAC] attractive. No matter what the reputation or what the sponsor might be. […] They are the ultimate in terms of lack of transparency.”

Notwithstanding the banner year for SPACs, opponents warn that SPAC is inherently inferior capital–raising method. A potential reversal in market enthusiasm may come from increased opposition of target companies, opaque nature, or inferior post–performance. 

SPAC sponsors try to convince investors that these statistics derive from SPACs of old era, while new SPACs are bigger, better, and higher quality. Nevertheless, investors should do their own due diligence and do not rely on any sponsors’ promises. After all, sponsors’ incentives are very different than theirs. 


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Shortcomings and Hidden Costs of SPACs (as published in The Business Times on December 23, 2020)

1/15/2021

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By Emir Hrnjic

As COVID-19 pandemic devastated global economy and created an unprecedented uncertainty in global markets in 2020, an alternative financial vehicle known as Special Purpose Acquisition Company (SPAC) flourished as an innovative capital–raising method. In 2020 alone, almost 250 SPAC initial public offerings (IPOs) raised more than U$81 billion – more than all previous SPAC IPOs combined.

While most SPACs are sponsored by investors in the United States, Asian investors started catching up. For instance, Antony Leung, a former Hong Kong financial secretary and Blackstone executive, launched a U$1.5 billion SPAC. Additionally, SPACs sponsored by Richard Li, CITIC Capital, Maso Capital, and Malacca Straits – all based in Asia – have raised more than U$1 billion. More recently, Singapore-based Vickers Venture Partners started a process of raising U$100 million through a SPAC IPO.

When news broke out that Bridgetown SPAC backed by Asian-based Richard Li and American–based Peter Thiel approached Tokopedia regarding potential merger, SPAC’s price soared by more than 30 per cent. The largest e-commerce platform in Southeast Asia, however, remained non-committal about the merger. Soon after, the Indonesian giant backed by Alibaba, SoftBank, and Temasek hired investment banks Morgan Stanley and Citigroup to advise them about going-public process and announced that it is considering traditional IPO.

While Forbes claimed that the “SPAC boom of 2020 is probably the biggest Wall Street story of the year”, business press paid very little attention to shortcomings and hidden costs of these alternative financial vehicles.

SHORTCOMINGS AND HIDDEN COSTS OF SPACs

Notwithstanding historical popularity of SPACs and record-breaking amounts of capital, recent research study from NYU and Stanford does not support the popular argument that SPACs are a cheaper way of going public. In fact, the study documents that SPAC costs are opaque and exorbitant as the median SPAC share value starts at U$10 at the IPO stage, but the median SPAC holds only U$6.67 per share by the time of the merger.

This drop is mostly due to dilution of SPAC shares as sponsors are given 20 per cent of the acquired company as a reward for their efforts in finding a target company. This is akin to a “finder’s fee” in return for leveraging their brand equity for fundraising for the SPAC. While the return to sponsors mostly comes from this reward, the resulting dilution represents the cost to other SPAC shareholders.

Furthermore, investors in SPAC may have different incentives and investment horizons which may not appeal to an acquisition target. For instance, IPO investors may have longer horizons because they invest in the IPO company. SPAC investors, on the other hand, may not be vested in the future of the acquired company.

A former Facebook executive, Chamath Palihapitiya, became the poster boy of SPAC boom, when he sponsored SPAC that later acquired the Virgin Galactic. Since the innovative company like Virgin Galactic will likely take a long time to generate the profit, long-term commitment of initial sponsors assumes oversized importance.

For instance, when Virgin Galactic aborted a recent test flight, its shares fell as much as 6 per cent. More importantly, Chamath Palihapitiya sold 3.8 million shares worth U$98 million, thus sending bearish signals to the market.

Another research study from University of Exeter dubs them “poor man’s private equity funds” because, on average, SPACs substantially underperform comparable companies. The average return in four years following the SPAC IPO is negative 51.9 per cent, significantly worse than an average return of 8.5% by comparable IPO companies. Similarly, SPACs considerably underperform the competitors based on accounting measures such as operating margins and return on sales.

Moreover, SPAC performance is worse when deals are completed just before the deadline for a SPAC acquisition suggesting that SPAC managers become desperate to do any acquisition when facing the impending deadline. Performance is also worse if the deal barely meets the minimum transaction value. 

The overall research evidence is consistent with the notion that SPAC acquisitions attract firms to go public in difficult times. SPAC–acquired firms have lower growth opportunities, higher leverage and smaller size and thus lower quality than traditional IPO firms.

SLOWING DOWN

SPAC opponents claim that the boom will likely slow down. As retail investors start entering the market en masse, they argue that investor enthusiasm may lead to unsustainable overvaluations. 

Moreover, reduced regulatory scrutiny is a double-edged sword. Although the IPO process can be long and arduous, it was designed to provide transparency, thereby providing sufficient information for investors to make sound financial decisions. Comparatively, the SPAC acquisition process is more opaque, as investors are relying on the brand equity of the SPACs’ sponsors as opposed to carrying out due diligence by themselves. 

While less due diligence allows accelerated IPO process and reduces completion risk, it may fail to uncover potential accounting irregularities. For instance, the electric truck manufacturer Nikola’s stock price skyrocketed to U$93.99 before falling to U$27 due to alleged false statements about its technology.

Finally, target companies are increasingly uneasy about being acquired by SPACs as evidenced by a recent example of Tokopedia. For instance, former Google executive who founded Upstart, said that “SPAC feels like reaching the next level of a video game and handing the joystick to somebody else. It’s an acquisition of [the] company despite how it might be described.”

Notwithstanding the 2020 boom in SPACs, the fear remains that boom will turn into a market bubble and eventually burst. Myriad factors can contribute to the eventual slowing down such as reduced investor sentiment, increasing opposition of target companies, accounting misdeeds, eventual poor performance, or regulatory intervention.
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Wirecard: The Rise and Fall of a Fintech Giant in Asia (as published in The Business Times on Sept 24, 2020)

9/24/2020

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By Paul Condylis and Emir Hrnjic
 
News broke recently that fintech company Railsbank has agreed to acquire its competitor Wirecard UK’s remaining assets, clients, and a number of employees. Moreover, Wirecard sold its operations in Brazil and advanced the process of selling its North American operations.
 
Once the darling of the fintech industry, Wirecard is now in a predicament.
 
In a dramatic turn of events, on June 18, 2020, auditing firm EY refused to sign off on its financial statements and Wirecard admitted that roughly €1.9 billion in two Philippine banks did not exist. Within several days, the CEO was arrested for alleged fraud, the company filed for bankruptcy protection, and Wirecard’s share price collapsed from more than €100 to less than €2.50.
 
In the largest auditing scandal since Enron, the Financial Times reported that EY did not do even basic auditing procedures such as confirming with the banks that they held large amounts of cash in Wirecard’s trustee accounts.
 
Even German Finance Minister was aware of potential market manipulation at Wirecard a year and a half ago, but he, too, failed to act.
 
But how did a tiny German payment processing company manage to enter such a competitive business and develop at such a spectacular rate?
 
Asian Expansion
 
After starting a subsidiary in Singapore in 2007, the company grew rapidly in the Asian market due to acquisitions of small Asian mobile payment companies.
 
Wirecard entered the fringes of the market serving merchants with less-than-stellar reputation such as pornographic websites and online gambling that conventional banks avoided due to high risk and small margins. Wirecard managed to disrupt the payment processing market due to its ability to charge less than its main competitors and willingness to onboard riskier customers.
 
Moreover, as conventional banks licked their wounds after the global financial crisis in 2008–2009, Wirecard and other fintech companies started processing electronic payments faster than banks and chipping away their market share.
 
Finally, the fintech companies started heavily investing in powerful machine learning models capable of offering better risk management and fraud detection as well as creating powerful databases of their customers.
 
After rapid expansion in Asian mobile payment business, the Asian business started earning almost half of the group’s revenues.
 
What Is Next?
 
Even after the parent company filed for bankruptcy protection in Germany on June 23, the subsidiaries proceeded with their business activities.
 
Germany’s financial regulator BaFin stated that they would “continuously review whether insolvency applications also have to be filed for subsidiaries of the Wirecard Group.” On June 26, the British financial regulator FCA suspended the activities of Wirecard’s UK-based subsidiary but lifted the restrictions three days later.
 
Closer to home, the key concern is how Germany’s parent’s bankruptcy affects the Singapore subsidiary. While the trustee did not rule out that Wirecard subsidiaries may have to file for insolvency, theoretically, businesses of Wirecard’s subsidiaries should be judged on their own merits.
 
In fact, the Monetary Authority of Singapore (MAS) said on June 30 that it is closely monitoring the operations of Wirecard’s entities in Singapore. They “have complied with MAS’ directions to hold customers’ funds in segregated accounts with banks in Singapore,” thus ensuring that the funds are safe from the German parent’s bankruptcy.
 
Since Wirecard has very few tangible assets, the risk is that its business will lose substantial value if clients start switching to competitors.
 
Moreover, FT reported that Wirecard’s main 100 customers accounted for more than half of its genuine sales.
 
Notwithstanding the fact that some Wirecard’s transactions were fictitious and Wirecard may not have as many customers as claimed, Wirecard’s market share in Singapore is likely sizable.
 
Customers Jumping Ship
 
Unfortunately, German parent’s bankruptcy likely spooked the customers of Wirecard’s subsidiaries in Singapore.
 
Wirecard entered a payments agreement in March to process transactions made via the GrabPay e-wallet used by more than 600,000 merchants in the region. That partnership was put on hold immediately after the news of German parent’s bankruptcy.
 
Just a few days later, Visa and Mastercard announced that they are considering revoking Wirecard’s ability to process payments on their networks.
 
Bloomberg and Business Times reported that many other Wirecard’s clients started leaving the company immediately after the scandal broke.
 
Moreover, Wirecard’s competitors started aggressively poaching Wirecard’s customers by offering them attractive custom-tailored packages and expedited migration.
 
The first customers to jump ship are likely the safest businesses that should be easily onboarded by competitors. As Wirecard’s safest customers keep switching, the remaining portfolio will become riskier. As the remaining portfolio becomes riskier, Wirecard will have harder time to retain competitive pricing and the downward spiral is inevitable.
 
Notwithstanding the fact that subsidiaries did not file for bankruptcy and may not have been involved in the accounting and auditing misdeeds, Wirecard’s remaining business is in serious trouble.
 
The payment processing business is mostly a business of trust and if the trust is lost – business is gone. If Wirecard customers believe that Wirecard will go bankrupt, it will likely go bankrupt as a self-fulfilling prophecy. In the best-case scenario, Singapore subsidiary will be acquired just like its counterparts.

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How Safe is Your Online Shopping? (as published in The Business Times on September 1, 2020)

9/1/2020

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By Gordon Clarke and Emir Hrnjic

The Wirecard scandal has revealed that even major companies involved in online payments may be disastrously unreliable and even enable illegal transactions such as money laundering. 

In fact, Visa and MasterCard allegedly had their suspicions about Wirecard since 2015 after they realised that the company had high levels of stolen card purchases and reversed transactions. 

The internal file from 2017 shows that Wirecard processed payments for a variety of controversial and potentially illegal businesses. 

In fact, sceptics are warning that there might be more scandals ahead due to unscrupulous accounting practices, poor auditing controls, and technical security failures.

ONLINE PAYMENTS

While online payments have been exponentially growing for decades, the global pandemic has given it an unexpected boost. According to 2019 e-Conomy Southeast Asia report, the six largest Southeast Asian markets recorded S$600 billion in online payments last year, while they were projected to exceed S$1 trillion by 2025. Moreover, in the last few years we have also witnessed rapid growth of instant payments using e-wallets and account–to–account transfers initiated on the mobile handset. 

The COVID-19 pandemic has accelerated this trend. Online purchasing soared due to worldwide lockdowns whereby people remained confined to their homes for months. Moreover, Bain & Company now expects digital payments to account for 67 per cent of total transaction values in 2025 – 10 percentage points above their pre-pandemic prediction. 

With online shopping regarded as a norm, we have become desensitised to allowing the storage of our payment details by merchants and processors, whose security is likely inferior to that of financial institutions. While our credit card details are deposited all over the web, companies we trust have failed to keep our data safe. 

According to Statista, over 164 million sensitive records were exposed in 1,473 data breaches in the United States alone last year, while fraud cost the world economy over US$5 trillion overall, according to Crowe. 

The question arises on how safe our online shopping experience is and how service providers can protect us.

FRAUD DETECTION

In the card payment business, fraud defences include on-line authentication, chip card security using the international EMV standard, the CVV figure on the back of the card, the “3-D secure” approach, as well as encrypted messages and databases at banks. 

For instance, in Singapore, where the limits on instant payments and contactless card payments are increasingly high, the main defence against fraud is the instant SMS warning to the cardholder when an unusual transaction occurs. However, this does not work as well for overseas issued cards which must rely on notoriously unreliable cross-border SMSes.

Card payment transactions are relatively well protected, but instant account–to–account payments have very few of these facilities. There is clearly a need for heightened vigilance on the part of service providers, merchants, as well as others who accept digital payments. 

Most merchants, payment service providers (PSPs) and payment system operators use machine learning algorithms to detect suspicious transactions. Two other actions that would certainly minimise fraud risk are security monitoring systems and tokenisation.  

MONITORING SYSTEM AND TOKENISATION

The first step in securing data and systems is to control the technology perimeter of the organisation for both processing services and PSPs. This includes setting up a monitoring system, often called a security operations centre (SOC), which is often a physical box containing the necessary software. The SOC contains machine learning algorithms that learn the normal patterns of data and system behaviour in a company or network and instantly flag deviations from historical patterns. 

The SOC also requires IT staff to be well–trained to act appropriately upon the monitoring alerts.

The monitoring system should detect attempts by external agents to log in to the company’s system, which are surprisingly frequent. Some intrusions result in the planting of malware which can sit quietly in a system for months, gradually learning how valid payment messages are authenticated while informing its controllers. Then, it suddenly sends massive payments abroad as in the well-known attack on Bangladesh Bank a few years ago. 

The monitoring software, however, should spot the communications made by the malware, identify it using an extensive library of malware signatures, isolate the problem, and, finally, alert the IT team to remove it. 

But all this is to no avail if someone on the inside is colluding with criminals or being coerced to manipulate the systems and substitute false destination accounts – also known as mule accounts – when payments are being sent. According to US publication Digital-First Banking, up to one in five account openings at present could be fraudulent.

The best solution to this is tokenisation (not to be confused with the “tokenisation” in the crypto industry), where all databases and messages contain a token that looks like a real account number instead of the actual account numbers. Widely used in the cards industry, for example in the ApplePay and Google Pay schemes, the token also carries instructions (“domain controls”) which allow transactions to be executed only under a very specific set of circumstances. These may include a specific day of the month, or only once, or only for bill payments, or countless other specifics. Using tokens makes mule account substitution frauds extremely hard, even from the inside.

In an ideal world, payment companies and merchants would make it so difficult for fraudsters that the benefits from a lucrative sting – which may take months of time and effort as well as lot of investment – would simply not be worth the risk of being caught.

However, we are far from that utopia, and the risks to customers and their service providers are real and large. The exponential growth of online purchasing and a further dramatic increase during the COVID-19 crisis are making the protection even more urgent.


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E-commerce is set to boom driven by COVID-19 (as published on CNA on Aug 17, 2020)

8/17/2020

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​Commentary: E-commerce is set to boom driven by COVID-19  
Brief: COVID–19 crisis may provide the impetus to creative destruction as seen during the dotcom bubble burst, says Emir Hrnjic. 

SINGAPORE: A fear of the uncontrollable spread of the COVID-19 virus compelled governments around the world to lock down cities and close national borders. 

Ever–diminishing consumer demand led to a near collapse of industrial production and a complete shutdown of service industries. As the crisis triggered massive layoffs, unemployment reached double digits.

At the early signs of trouble, stock markets plummeted. Major indices such as S&P500, Japan’s Nikkei Index, and Singapore’s Straits Times Index started dropping on Feb 19 and lost approximately 30 per cent of their value in a month. 

As the pandemic spread, most major economies faced unprecedented recessions. According to the OECD Economic Outlook, the world is headed for an almost 13 per cent decline in global gross domestic product (GDP) in the first half of 2020. 

Closer to home, Singapore’s GDP fell by 41.2 per cent in the second quarter of 2020, while the government projected as much as a 7 per cent decline of annual GDP. 

As the global situation looks extremely bleak, observers wonder if there is a silver lining. 

CREATIVE DESTRUCTION

Austrian Economist Joseph Schumpeter argued that economic growth relies on daring entrepreneurs, evolving institutions and innovative technologies. Without daring entrepreneurship and innovation almost all businesses fail. 

Moreover, major crises reveal true survivors – businesses resilient enough to weather the most challenging conditions. It is often in such extreme circumstances and the excessive volatilities, that we witness creative destruction. 

Creative destruction is based on the principle that the existing system needs to be challenged so that innovative products or services can replace the outdated ones. Effectively, the existing equilibrium gets disrupted, market dynamic changes, and routine practices get transformed. 

Typically, innovative solutions spring to life. As innovative technologies replace existing technologies, the resources are more efficiently reallocated by the market, thus allowing economies to grow. This economic progress is chaotic and often unpleasant and thus the moniker “creative destruction.”

Indeed, we witnessed creative destructions in action many times before.

DOTCOM BUBBLE

When the dotcom bubble burst 20 years ago, the Nasdaq index plummeted by almost 80 per cent. Moreover, a majority of dotcom companies quickly ran out of cash and went bankrupt. Unsurprisingly, doomsayers predicted the end of the internet era.

Even though the dotcom era witnessed a glut of bankrupt companies, massive layoffs, and a wipe-outs of market values, some of the capital was invested in a very high throughput backbone for the internet. That initial infrastructure has enabled the development of companies that have changed the business models of modern era. 

Moreover, the existing equilibrium got disrupted, market dynamic changed, and routine practices got transformed. 

Finally, crisis revealed true survivors. Indeed, companies that had survived the dotcom bubble and had a spectacular growth include Amazon and Google – some of the largest companies in the world. 

COVID–19 PANDEMIC

Similarly, the global COVID–19 pandemic triggered plunges in market indices, widespread bankruptcies, and worldwide recession. Yet, the destruction often creates space for innovative players and thus this COVID–19 crisis may provide the impetus to creative destruction. 

The question becomes, “What will be destroyed and what will replace it?” Some industries such as airlines and tourism are very difficult to forecast. Yet, the theory of creative destruction implies a complete shake-up and major innovations in these industries. 

It is easier to predict industries such as e-commerce.

Since the invention of the internet, the online sector has been consistently chipping away the market share from brick-and-mortar stores. 

According to the US Commerce Department, online sales beat general merchandise stores for the first time in February last year. 

According to eMarketer, US e-commerce sales are estimated at approximately US$700 billion in 2020 - 14.5 per cent of total US retail sales - compared to slightly above US$600 billion in 2019. The e-commerce share of total retail sales is estimated to reach 15.5 per cent in 2022. 

Unsurprisingly, Amazon’s stock price soared by 66 per cent and eBay rose by 55 per cent since the beginning of the year. 

Closer to home, the internet economy in six largest Southeast Asian markets with a population of 570 million surpassed US$100 billion last year, according to the 2019 e-Conomy Southeast Asia report. 

While internet economy in most countries was growing at 20 per cent to 30 per cent, Indonesia and Vietnam grew over 40 per cent a year.

By mobile internet usage, four Southeast Asian countries rank in the top 10 in the world. Driven by a high mobile internet penetration rate, young consumers, and an increase in disposable income, Southeast Asia’s online sector is expected to hit US$300 billion by 2025, while e-commerce sector was projected to be worth US$150 billion by 2025. 

The study reported US$600 billion in online payments last year, while gross transactions were projected to exceed US$1 trillion by 2025. 

Indeed, online purchasing soared due to worldwide lockdowns and people’s inability to do the shopping in brick-and-mortar shops. In fact, according to Accenture, the COVID-19 crisis caused a shift in Singapore consumers behaviour and thus spurred Singapore’s digital economy to earn additional US$500 million annually, while some businesses saw up to three times their normal growth. 

The COVID-19 pandemic will provide further impetus for the growth in digital payments. Bain & Company projected digital payments to account for 67 per cent of total transaction values in 2025 – up 10 percentage points from their pre-COVID-19 prediction. 

The COVID–19 pandemic has caused loss of human lives and destroyed jobs, but there is a silver lining to the crisis. 

The ensuing creative destruction will likely spur innovation, as innovative technologies will replace existing technologies and thus resources will be more efficiently reallocated by the market.


Emir Hrnjic is an adjunct assistant professor at National University of Singapore (NUS) Business School and a co-founder of Block’N’White Consulting. The opinions expressed are those of the writer and do not represent the views and opinions of NUS.
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Should government bailouts restrict stock buybacks? (as published on Channel NewsAsia on July 27, 2020)

7/27/2020

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Should government bailouts restrict stock buybacks?
By Emir Hrnjic

Much depends on governments’ specific objectives for the bailouts and whether supporting the stock market is a key goal, says NUS Business School Emir Hrnjic.

SINGAPORE: Amid the COVID-19 pandemic, governments have allocated trillions of dollars to businesses and financial institutions to boost the economy and prop up share prices.

In this, regulators are calling for emergency assistance to companies to come with strings attached, particularly with respect to potential stock buybacks. Most notably, influential US Senator Elizabeth Warren proposed a permanent ban on stock buybacks for all companies that accept emergency federal funding.

A recent article in the Harvard Business Review argued stock buybacks made companies vulnerable in an inevitable economic downturn when their cash flows dry up. The article reported that S&P 500 companies spent US$4.3 trillion on buybacks over the last decade, roughly half of their net income. 

Notably, the six major US airlines spent about US$47 billion buying back their own stock in the last decade. Cynics noted the money spent on buybacks might have been put to better use in the current crisis when the same six firms asked for a combined US$58 billion in federal assistance. 

MORE BUYBACKS IN ASIA

While stock buybacks have traditionally been concentrated in the US, they are increasingly popular in Europe and Asia. Japan reported US$52.5 billion of buybacks in 2018. 

Softbank announced doubling its buyback plan to 2.5 trillion yen (US$23.5 billion) in April, sending its stock soaring by almost 40 per cent, despite posting an annual operating loss of 1.35 trillion yen. 

Closer to home, while the Straits Times Index lost almost a fifth of its value in a month of March, SGX reported that total share buybacks for Singapore–listed stocks in just that month – roughly half a billion Singapore dollars – almost matched the total amount of buybacks for the entire last year. 

While buybacks in Singapore were dominated by DBS, UOB and OCBC, the US Federal Reserve ordered the country’s largest banks to suspend their stock buyback programs.

BUT MANAGERS’ AND SHAREHOLDERS’ INCENTIVES ARE ALIGNED

As lawmakers weigh whether emergency assistance should come with stock buybacks restrictions, observers wonder whether this stand is restrictive or justified. 

The answer depends on whether we believe in laissez-faire capitalism. The phrase laissez-faire capitalism simply means that governments stay away from the workings of the free market.

In laissez-faire capitalism companies should be investing in projects expected to provide a rate of return higher than their cost of capital. If firms run out of such projects, they should return cash to shareholders in the form of dividends or stock buybacks. So stock buybacks are in the best interest of the shareholders.

From the perspective of the overall economy, firms with no profitable opportunities return cash to shareholders so they can invest in other profitable opportunities. 

In principle, buybacks could help the economy by reallocating the resources to the best possible use. However, the problem may arise in a crisis if investors who sell their shares during a buyback choose to hoard the cash and do not reinvest in the economy.

Furthermore, since buybacks reduce the number of outstanding shares, they automatically improve many valuation ratios such as earnings-per-share. While economists argue the effect of artificially inflated valuation ratios should have no effect on valuation, an increase in share price is a well-documented consequence of stock buybacks.

Critics point out managers conduct stock buybacks for selfish reasons such as to boost the value of their own stock holdings and stock options. Nevertheless, stock buybacks should be seen favourably as managers’ and shareholders’ incentives are aligned. 

GOVERNMENT INTERVENTION

On the other hand, when governments are involved in markets, the key question becomes why they help companies. If governments’ main objective is to help improve shareholder wealth by propping up share prices, supporting stock buybacks using federal money may be justified. 

However, if their objectives include supporting investments in the real world, boosting the economy, or slowing down rising unemployment, stock buybacks help very little. 

Stock buybacks do not invest in the real world, do not create positive externalities, nor do they slow down rising unemployment. Stock buybacks only help augment shareholders wealth and they may boost positive market sentiment that could spill over to the real world. 

Theoretically, rising shareholder wealth may have a positive impact on consumption and thus the real economy (also known as wealth effect). However, the research study by Karl Case, John Quigley and Nobel Laureate Robert Shiller found “at best weak evidence” of a stock market wealth effect.

Given the above, if companies are calling for emergency assistance, then governments around the world need to carefully consider their objectives for acceding to these requests for bailouts. If the reason is to prop up the stock market, the stock buybacks are a useful way of investing the bailout money. 

On the other hand, if the reason is to prop up the economy and stop skyrocketing unemployment, lawmakers should be calling for conditions attached to buybacks. 

Stock buybacks using shareholders’ money may be the right thing to do, but stock buybacks using taxpayers’ money is probably not.

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The curious case of Wirecard (as published in the Straits Times on July 26, 2020)

7/26/2020

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The curious case of Wirecard
By Paul Condylis and Emir Hrnjic
 
On June 18, global fintech company Wirecard admitted that large parts of its Asia business were misrepresented and that €1.9 billion (S$3 billion) in cash reported on their financial statements did not exist. 

Five days later, the company filed for bankruptcy protection from creditors, and Wirecard’s share price collapsed from more than €100 to less than €3.

In the largest auditing scandal since Enron, Wirecard’s auditing firm of more than ten years did not carry out even basic auditing procedures such as checking directly with banks to confirm that Wirecard held large amounts of cash in these banks. 

While most experts will focus on deciphering dubious accounting practices and puzzling auditing failures, this article will focus on three non–auditing issues. 

None of these issues were indicators of potential fraud, but combined, they start to look suspicious. Admittedly, however, everything looks obvious in hindsight.

REGULATORY CRACKS

Before the earth-shattering scandal last month, Wirecard was a global fintech company with its headquarters in Germany. It started in 1999 by helping websites collect payments from customers. 

More specifically, it operated on the fringes of electronic payment processing business servicing online gambling companies and pornographic websites. 

While traditional payment processing companies stayed away from these sectors due to high risk and small margins, Wirecard filled the gap. 

As the past two decades witnessed a plethora of businesses moving online and away from traditional cash payments, this darling of the fintech industry experienced spectacular growth. In 2018, Wirecard became a payment processing giant worth almost €25 billion and was included in the prestigious German blue-chip index – the DAX.

After Wirecard acquired XCOM in 2006, the renamed subsidiary was licensed to issue credit cards and handle money on behalf of merchants. 

Thus Wirecard became a fintech hybrid with banking and non-banking operations.

These hybrid fintech firms are not subject to the same regulations as banks and financial firms. If a company does not meet the typical threshold of 50 per cent of its business in lending and taking deposits, it is not scrutinised like the banks. 

Hence, while Germany’s financial regulator BaFin regulated Wirecard’s banking arm, it did not regulate its payments processing business, which fell through regulatory cracks. 

REVERSE TAKEOVER

Founded in 1999, the company was listed in 2005 via a reverse takeover of a defunct call centre group which was publicly listed. 

A reverse takeover or a reverse merger is the process of going public via a back-door listing. In short, the private company buys shares of a public company and takes control. So, effectively, the private company becomes a publicly traded one. 
This allows the private company to transfer its business operations into the public entity and bypass the complex process of going public via initial public offering (IPO) – a much more common method for going public. 

Compared with IPO, reverse mergers happen at much lower costs, in much shorter time and with few regulatory requirements and little overseeing. Also known as back-door listing, this unusual method avoids the intense scrutiny and regulatory procedure of a typical listing via IPO. 

Several academic studies documented that reverse merger firms are typically smaller, less profitable, and riskier than IPO firms, consistent with the notion that reverse merger is a way for smaller and less developed firms to become publicly listed. 

Notoriously, a boom in reverse mergers of China–based firms in the United States ended due to a series of financial scandals in 2011, when more than 20 of such companies were delisted and as many as 42 out of 150 were accused of fraud.

PRICE MANIPULATION VERSUS PRICE DISCOVERY

Short sellers expressed concerns about the company as early as July 2014, but every time they were met with accusations of price manipulation. 

For example, when the Financial Times reported claims of forged documents in Wirecard’s Asia headquarters in January last year, oddly, BaFin launched a probe into the FT reporting and an alleged attempt at share price manipulation. 

In an unprecedented move, BaFin imposed a ban on short selling of Wirecard’s shares a month later. Even though BaFin banned the short selling of banks during the global financial crisis in 2008 due to concerns of price manipulation, this was the first time that Germany’s watchdog banned a short selling of a single company. 

In 2016, short sellers under the pseudonym Zatarra published money-laundering allegations against Wirecard. Again, BaFin started investigating accusers for alleged price manipulation. 

Soon after, critics of Wirecard started receiving “spear-phishing” emails in an online bullying attempt. 

Finally, Wirecard hired KPMG to conduct a special audit, but the auditors were not able to clear the company. 

Despite short sellers’ allegations of Wirecard’s transgressions since 2014, it was not until June 2020 that EY, its auditor of more than ten years, refused to sign its financial statements due to fraud concerns. 

It was only in June that BaFin stopped blaming whistleblowers, journalists, investors, and short–sellers and started probing Wirecard. 

The example of Wirecard shows the value of short selling when viewed from the perspective of price discovery and not price manipulation.

The non–auditing issues should have given rise to suspicion among investors and, especially, Germany’s financial watchdog. 

While investors and BaFin may not go back in time for a do-over, at minimum, they can pay more attention to similar concerns in future. 


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Fraud Detection Using Machine Learning Amid Covid-19 crisis (as published in Business Times on July 21, 2020)

7/21/2020

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Fraud Detection Using Machine Learning Amid Covid-19 crisis
By Paul Condylis and Emir Hrnjic

Online shopping and the quest for ever-increasing convenience resulted in the scattering of our credit card details across various websites. Over time, we have become desensitised to providing our payment details and, effectively, passed the responsibilities of storing and protecting our personal and transaction details to e-commerce companies. 

Unfortunately, many companies have failed to keep our data safe and secure. According to Statista, over 164 million sensitive records were exposed in 1,473 data breaches in the United States last year. 

The exponential growth in e-commerce attracted even more aggressive growth in illicit activities. Southeast Asia’s e-commerce market will likely exceed Google’s prediction of US$200 billion, driven by a high mobile internet penetration rate, young consumers, and an increase in disposable income.

At the same time, fraud cost the world economy over US$5 trillion in 2019. According to AppsFlyer, APAC’s fraud is 60 per cent higher than the average global rate, while South East Asia is the heaviest hit region, especially Indonesia, Malaysia, Thailand, and Vietnam.

Recently, the international law enforcement agencies warned of a spike in fraud related to the COVID-19 pandemic, and The Straits Times reported that victims in Singapore have lost S$41.3 million in the first quarter of this year, nearly a 30 percent increase. Unfortunately, it seems that 2020 will turn out to be a bumper year for fraudsters around the world. 

Fraud Detection and Machine Learning

In order to protect the customers, banks and retailers have deployed large-scale fraud detection pipelines that scan transactions in real-time. For a long time, fraud detection has relied upon rule-based expert systems to detect illicit activities. Traditional experts analysed transaction logs, identified fraudulent patterns, and implemented hand-coded rules to flag those activities. The rules were as simple as blocking the transactions from a compromised credit card number to more sophisticated rules such as flagging transactions that deviate from the credit card’s historical patterns. 

Over time, as transaction volumes have exponentially grown, thousands of increasingly complicated fraud–detection rules emerged and this approach became intractable. Fortunately, machine learning can easily scan millions of transactions to enable real-time fraud detection. Machine learning is a procedure that enables a computer to learn from data how to perform a certain task. Once a computer learns the task to a sufficient level, human experts are no longer needed. 

Indeed, fraud detection algorithms based on past purchase behaviour have matched accuracy of human performance at identifying anomalous transactions. Meanwhile, the experts’ role evolved to analyse and understand larger issues such as new global fraud trends. 

Covid-19 Pandemic

But what happens when purchase behaviour suddenly changes? And therein lies the rub. If machine learning algorithms rely on learning from historical data, a rapidly changing environment and fast-evolving patterns will wreak havoc on the predictions and forecasts. 

The world has drastically changed since COVID-19 wrecked the global economy. Predictably, fraudsters have taken advantage of the uncertainty in the rapidly evolving environment and changed the patterns and targets of attack. For instance, traditional strategies of ticket fraud (i.e. reselling tickets purchased with stolen card information) have migrated, and fraudsters are increasingly turning to well-orchestrated scams directly defrauding unwitting consumers. 

In such an environment, machine learning algorithms must be retrained on new data and quickly redeployed. However, as changes are unfolding in real-time, algorithms have far less data to learn from and adapt to changing fraud attack vectors. Slow moving trends underpinning increasingly irrelevant historical data must be unlearnt and machine learning engines must accurately predict newly evolved tendencies using limited data. Moreover, the impact is compounded by having less validation data to judge the effectiveness of machine learning algorithms. 

As fraudsters changed the patterns and targets of attack forcing experts to retrain and quickly redeploy machine learning algorithms in a rapidly evolving environment, automatic retraining of machine learning algorithms on new data and thwarting fraud attacks become paramount.

Only companies that have significantly invested in talent and robust big-data pipelines are well placed to cope with the current situation. Have the companies you have trusted with your data been so diligent? Maybe it is time to check your bank statement.
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The future is digital (as published in Asia Asset Management, July 2020)

7/3/2020

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The future is digital 
Digital currencies may one day challenge US dollar supremacy
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Interest in digital currencies has been boosted by recent developments such as China’s pilot rollout of the digital yuan and a shift in Facebook’s plan for its Libra cryptocurrency.

While consumers may still associate blockchain technology closely with the speculative and volatile nature of bitcoin, significant advances in the use of distributed ledger point to a more promising outlook for digital currencies.

Dr. Emir Hrnjic, an adjunct assistant professor of finance at the National University of Singapore and a co-founder of Block’N’White Consulting, provides insight into central bank digital currencies and private cryptocurrencies and the potential impact on financial markets and investors in this question and answer with Asia Asset Management (AAM).

AAM: What do you see as the benefits and costs of central bank digital currency (CBDC)?

Hrnjic: The actual CBDC has yet to be properly launched. The People’s Bank of China (PBOC) achieved the first milestone by rolling out a pilot test of CBDC in four cities. We still do not know all the details.

Nevertheless, a CBDC needs to be properly designed and enable scalability, accessibility and privacy. The challenge is to design a CBDC with the convenience typically provided by financial intermediaries, not by central banks. PBOC tried to combine these by designing a two-tier system: the central bank will create the digital currency and then large financial institutions and the four largest state-owned banks will distribute it.

A properly designed CBDC will help target money supply and enable central banks’ access to money demand data. However, a CBDC will also enable central banks to trace individuals’ transactions. While this may help the battle against illicit transactions, it will also permit encroachment on consumers’ privacy.

The PBOC will probably institute limits on the frequency and amounts of anonymous transactions to try to strike a balance between preserving privacy and halting illicit transactions.

AAM: How do you see distributed ledger technologies being utilised by central banks in the next five to ten years, and what would the implications be for financial markets and investors?

Hrnjic: This is a million-dollar question. The future of blockchain technologies depends on many unknown variables and everyone is really making at best an educated guess at this point. A recent study by the Cambridge Centre for Alternative Finance prophesised that a third of central banks will have active applications within a decade.

Moreover, a study by the Bank of England in 2016 concluded that a properly designed CBDC may strengthen the transmission of monetary policy changes. However, the study also warned that any mismanagement of transition from physical to digital cash could pose a major threat to financial stability.

Despite many potential challenges, the Bank of England’s study concluded that CBDC issuance “could permanently raise GDP [gross domestic product] by as much as three percent and could substantially improve the central bank’s ability to stabilise the business cycle”.

AAM: Do you think the coronavirus pandemic may have helped push digital currency developments forward?

Hrnjic: Many changes across the world happened simultaneously as a consequence of Covid-19 [the disease caused by the coronavirus] and it is very hard to disentangle the impact of the pandemic versus numerous other seemingly related contemporaneous events.

Nevertheless, during the Covid-19 pandemic, communities socially distanced and observed strict hygiene measures. Since earlier research suggested that physical money carry up to 3,000 types of bacteria, money in a physical form became less desirable than digital money. Even the World Health Organisation warned that bank notes may carry the coronavirus for several days and advised the use of contactless payments.

While contactless payments and digital currencies are not the same, this is consistent with the notion that Covid-19 helped push digital currency developments forward.

Even the early versions of the US stimulus bill unexpectedly included the development of the digital US dollar to disburse stimulus payments. Eventually, the digital dollar did not make it to the stimulus bill, but the mere attempt seemed very intriguing. While a proposed digital dollar would have not used blockchain, it would have bypassed intermediaries by creating government-run digital wallets for all Americans.

AAM: Do you believe the digital yuan will have a significant impact on the dollar in coming years?

Hrnjic: One can argue that the launch of the digital yuan may pose a distant threat to the US dollar’s supremacy. Indeed, a recent Foreign Affairs article argued that the failure to “develop a competitive American alternative could significantly hinder the United States’ global influence” despite the fact that nearly 90% of international transactions were settled in US dollars, whereas RMB controlled only 2% of the market.

Nevertheless, China has worked on its CBDC since 2014 and its next emphasis will likely be on improving the domestic banking and payment system. While rolling out a pilot test of the digital yuan represents a major milestone, and China may have the ambition to unsettle the global monetary system in the distant future, it seems that this process will likely be slow and deliberate.

AAM: What can you tell us about Facebook’s recent pivot away from launching its Libra currency?

Hrnjic: Libra was initially designed as a stablecoin fully backed by a basket of bank deposits and treasuries denominated in five major international currencies. After strong pushback from regulators around the world, Libra was recently revamped.

Revamped Libra will comprise several stablecoins – each backed by a single currency such as the US dollar or British pound – separate from the Libra coin. Libra coin will simply be a digital composite of some of these coins.

In another major change, the Libra Association will vet any wallet launched on the network. While the first Libra White Paper vowed to transition Libra to a permissionless system, revamped Libra backed out of this promise.

Although Libra’s initial idea was to become a global digital currency with permissionless network and censorship resistance, revamped Libra significantly scaled back. While attempting to satisfy regulators, it seems that Libra has lost its soul.

AAM: What is your opinion about Libra’s potential to act as an alternative for currencies of countries with high inflation such as South Africa?

Hrnjic: Libra should have a stable exchange rate due to its backing by five major international currencies and thus it could be very useful in certain countries as well as in cross-border transactions. For example, populations in many developing nations have access to mobile networks and high mobile phone ownership rates, which offer potential for Libra to improve financial inclusion.

This could be especially useful in countries with high inflation or unstable banking systems as well as for cross-country remittances. Hence, Libra can expand access to capital and help people in developing countries get involved in the global economy.

This may be of great importance to countries such as India, Philippines and Indonesia with large remittances from their diaspora and a high fraction of underbanked people.

AAM: Do you believe private cryptocurrencies may pose a big risk to CBDCs?

Hrnjic: Despite the fact that private cryptocurrencies are facing intense regulatory scrutiny, especially in the US, Libra may eventually challenge the digital yuan’s global dominance.

Indeed, Libra could partially replace some sovereign currencies, especially in countries with high inflation, an unstable banking system and a large underbanked population.

Moreover, the potential dominance of any private cryptocurrency in a specific country would undermine the monetary policy of that country. If private cryptocurrency started replacing local currency, it would cause the local currency’s depreciation and thus higher inflation.

In this respect, the effect of cryptocurrencies would be analogous to dollarisation – the impact of the US dollar on local currencies in some developing countries. For example, the population in countries such as Zimbabwe or Cambodia use the US dollar due to a lack of trust in local currency.

AAM: What are the main takeaways regarding CBDCs and private cryptocurrencies.

​Hrnjic: CBDCs and private cryptocurrencies may partially replace fiat currencies relatively soon, but not in the near future. If that happens, the impact on financial inclusion would likely be positive for both private and government-backed cryptocurrencies. That should be of enormous interest to policymakers in countries such as India, Philippines and Indonesia with large diaspora and tens, if not hundreds, of millions of underbanked people.
However, the impact of private and government-backed cryptocurrencies on monetary policy diametrically differs. CBDCs are likely to strengthen the transmission of monetary policy and help in targeting money supply.
​
On the other hand, dominant private cryptocurrencies would severely undermine the effect of monetary policy. Furthermore, they could also lead to diminishing the relevance of some fiat currencies, the loss of their value, and high inflation.
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Did Islamic equity funds outperform? (as published in The Star on June 19, 2020)

6/20/2020

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Did Islamic equity funds outperform?
By BEN CHAROENWONG and EMIR HRNJIC
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decade long performance

AS the Covid-19 virus reached pandemic proportions, national borders closures and country lockdowns led to diminished consumer demand and a collapse of industrial production and service industries. The crisis led to financial distress among small and medium enterprises (SMEs) and sparked massive layoffs. In matter of weeks, unemployment rose to double digits.


Large companies were not immune to the pandemic either (no pun intended). While Boeing and major US airlines pleaded for more than US$100bil in federal funding to stay afloat, several well-known companies including Hertz, Thai Airways, and JCPenney filed for bankruptcy.

As the Covid-19 pandemic ground international trade almost to a halt and wreaked havoc on national economies, stock markets plummeted.

The S&P500 started dropping on February 19 and lost almost a third of its value in a month. Only after the Fed committed to lend trillions of dollars and US Congress allocated more than US$2 trillion in federal emergency assistance to American companies and financial institutions did the American stock market reverse the free fall and partially recover.

Almost simultaneously, dominos started falling in Asian markets. Along with the collapse in the US stock market, the Japanese Nikkei Index and Singapore’s Straits Times Index lost roughly 30% of their values, while Hong Kong’s Hang Seng Index dropped by almost 20%.

As the global economy reached the brink of total collapse, Morningstar Research reported that in March 2020 investors withdrew US$326bil from mutual funds across the world.
 
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Islamic equity funds

In the midst of the unprecedented mayhem, an often-overlooked area of niche investing stands out – Islamic equity funds.

Islamic equity funds avoid non–halal activities such as conventional finance, alcohol, gambling, pork related products, and adult entertainment, as well as tobacco, weapons, arms, and defence manufacturing. Additionally, the screening criteria requires investing in companies with low debt ratio, low cash and interest-bearing items, low accounts receivable and cash, as well as low revenue from non-halal activities.

Originally targeted to Islamic investors, these funds appeal to non-religious investors as well. Notably, shunning sectors associated with weapons production would appeal to the broader investors’ base, especially with the general trend towards environmental, social, and governance (ESG) investing. Furthermore, their conservative nature may be attractive to long-term investors as well.

Covid-19 crisis

During the Covid-19-induced market panic through March, the MSCI World Index lost over 30%, while the MSCI World Islamic Index lost 20%, thus resulting in a relative outperformance of 10%. As the Islamic index fared better than the rest of the market during the crisis, one might argue that Islamic equity funds offered some protection from downside risk to investors.

Remarkably, while the pandemic triggered massive declines of assets under management (AUM) across the world, in-flow into Islamic funds in certain countries picked up. According to the Fitch ratings agency, Islamic funds in Saudi Arabia experienced an increase in AUM by 3%, thus surpassing Malaysia as the largest market for Islamic funds in the world.

Nevertheless, it is still too early for a victory lap since the Covid-19 crisis has been around for a relatively short time and thus corresponding outperformance of Islamic finance index provides relatively few data points to support meaningful conclusions.

Global financial crisis

Even though some analysts were quick to attribute the outperformance during Covid-19 to luck, we find a consistent pattern during another major market downturn – the Global Financial Crisis (GFC) from 2008 to 2009.

While outperformance of Islamic indices during the Covid-19 crisis could have been due to short-term fluctuations, longer data surrounding the GFC provides the ground for more robust experimentation to examine the relative performances of the Islamic versus conventional global indices.

In the six months around the failure of Lehman Brothers, the MSCI World Index lost 42.6%, while the MSCI World Islamic index lost only 12.4%, resulting in an outperformance of over 30%.

Another prominent measure of performance over a decade–long horizon around the GFC – from the Dow Jones Global index’s inception in October 2006 through December 2016 – indicates that a US$100 investment in the Dow Jones Global index would yield US$123.96 while an equivalent investment in the Dow Jones Global Islamic index would yield US$144.99, roughly a 20% improvement.

Part of the difference in the performance in the period surrounding the GFC stems from Islamic funds’ avoidance of conventional financial institutions and the embrace of Islamic financial institutions, making them inherently more defensive and better able to withstand adverse economic conditions.

Notoriously, Bear Stearns, Lehman Brothers, Merrill Lynch, and other behemoths of financial world either filed for bankruptcy or were acquired to escape insolvency.

Their shareholders lost hundreds of billions of dollars. None of these conventional financial institutions were syariah-compliant and thus were not included in Islamic funds.

An IMF study by Jemma Dridi and Maher Hasan suggests that Islamic banks outperformed conventional banks during GFC due to smaller investment portfolios, lower leverage, and avoidance of financing or investing in the innovative (and risky) instruments that wrecked conventional banks.

Surprisingly, Islamic AUM was only US$15bil in 2008. While it grew almost five-fold to US$70.8bil in 2017 according to the Malaysia International Islamic Financial Center, projections are even more optimistic going forward – to approximately US$216bil by 2024.

Conclusion

Islamic equity funds can provide some protection from downside risk as evidenced by their outperformance in two high-profile crises. This is partially due to a limited exposure to highly volatile stocks such as conventional financial institutions. These return characteristics should appeal not only to Islamic investors, but to the broader public as well.

Moreover, Moody’s 2020 Investors Service’s report predicted expansion of Islamic assets by 3% to 4% per annum in the short to medium term. The report states that the demand for Islamic asset management is rising due to “large Muslim populations, supportive legislation and growing investor demand for syariah-compliant products.”

We expect this wake-up call to further boost the development of the Islamic asset management industry and thus expand the existing investable universe.
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