Defining the Asset Class Where Does Microfinance Belong in the Investment Universe
Strangely, key features of the microfinance investment universe have led some specialists to classify this asset class as money market plus. Key features that mis-leadingly suggest such a definition include: little or nil volatility, like money market instruments; predominately short term, with an average duration of 18 months, seldom exceeding the 36-month short term limit;4 the cash nature of the business with a high transaction turnover due to short duration; and the low default record. For example, Dexia and LACIF, relatively large MFIFs, have never recorded any loss from an insolvency of an investee. IGF experienced several losses on loans to small MFIs (as a result of guarantees being called by banks), but its shareholders have never suffered a capital loss.5
2 LIBOR is the London Inter-Bank Offered Rate. LIBORx2 = twice the LIBOR rate.
3 Previously known as the Association for Investment & Management Research, based in Charlottesville, Virginia. The CFA Institute is an international, non-profit organisation of more than 70,000 investment practitioners and educators in over 100 countries. Its mission is "To lead the investment profession globally by setting the highest standards of education, integrity, and professional excellence."
4 In contrast, the Lehman Emerging Market Bond Index, which includes over 100 issuers, had an average duration of 3.7 years with an average annual return on its global composite index of 7% from March 1998 to mid-2004.
5 The average tenor (maturity) is 19 months for Dexia's Micro-Credit Fund and for LACIF loans in Latin America, 18 months limited to 24 months. A recent loan of US$ 2.5 million made by LACIF had a 3 year maturity. A trend towards much longer maturities is discernable, best illustrated by BlueOrchard. The initial Dexia fund it started had a maturity cap of 3 years, according to Luxembourg regulations. The second responsAbility Global Fund it took over in 2003 from a group of Swiss banks allows maturities of up to 5 years. And the 2004 collater-alised debt obligation (CDO) fund agreement concluded with the US OPIC offered maturities as long as 7 years. Such lengthening will have a direct impact on duration and MFIF portfolio sensitivity within the next three years. Marking-to-market will be unavoidable.
Box 2. Where Does Microfinance Investment Fit?
There are four major investment classes:
• Conventional - listed securities, bonds and money markets.
• Alternative - hedge funds, private equity/venture capital, real estate, etc.
• Mission-oriented investments - with sustainable development, environmental, social, religious or other value constraints.
The first three, listed above, primarily seek financial performance that is either relative (compared against benchmarks) or absolute (avoiding losses and maximising returns).
• Ethical, mission oriented seeking value satisfaction - feeling good by helping people -before financial returns. The return can only be relative to a mission; measurement must take into account the benefits left on the table, or how the investor's financial concession is recycled into tangible benefits (financial, material, social, etc.), making asset allocation even more difficult to achieve in an efficient way for institutional investors.
Where does MFIF belong in the investment universe?
The micro fund management asset class is mission-oriented and belongs to the alternative asset class in the high yield end of the over-the-counter issued debt and equity market.
MFIF instruments are indeed distinct from conventional OECD money market instruments. The money market plus approach is also flawed because it ignores the risk of emerging money and bond markets where:
• Macro-volatility of local markets is highly dependent on international interest rates. Moreover, local markets, which MFIs increasingly tap for funding, are very inefficient.
• Tropical weather (storms, hurricanes, floods, etc) can have devastating effects on financial markets and on MFIs.
• MFIs' foreign currency exposure can threaten solvency. Funding locally generated by depositors is growing, but this increases MFIs' exposure to local systemic risks.
• Steady increases in maturity and duration are starting to introduce liquidity pressure in the market, making it difficult for an MFIF to pull out or liquefy its exposure prior to maturity.
The MFIF industry has the following characteristics: It has a high-yield fixed income stream (including the guarantee market but excluding funds invested in equity). It is based mainly on low grade issuers of promissory notes, CDs (certificates of deposit) and guarantees in emerging markets. The asset class is closer to entrepreneurial finance than to conventional corporate finance. It is part of the unlisted world of private equity markets and small to medium enterprises (SME). When it stakes start-ups it is close to venture capital. It is an alternative asset class.
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Box 3. Ten Key Differences Between Two Types of Risk | |
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Credit Risk |
Fiduciary Risk |
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• Asset intermediation |
• Systems/processes |
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• Fixed income revenue in symmetry with client interest |
• Variable fee revenue in asymmetry with client interest |
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• Economic cycles |
• Capital market cycles |
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• Shown ex-post on balance sheet |
• Shown ex-ante on P&L |
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• More downstream |
• More upstream |
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• Medium-term inertia |
• Short-term inertia |
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• More quantitative |
• More qualitative |
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• Results centred |
• Best practice centred |
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• Excludes fiduciary governance |
• Includes corporate governance |
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• Banking regulation |
• Securities regulation |
Another feature of the industry is fiduciary behaviour in packaging MFIF products in ways that often tend to be confusing, if not misleading. For example, "social development" for marketing reasons may simply justify a lower return than could normally be expected on this asset class. MFIF operations may indeed have a social dimension and impact, but the investments should first and foremost be essentially financial, unless investors are willing to leave some of their gains on the table. In that case, funds should qualify as "ethical," which denotes zero returns or a return equal to the rate of inflation.
Given the definition of alternative asset classes, the return should be stated in absolute terms against a benchmark. In other words, if a benchmark is negative, it would not be enough to beat the benchmark by posting a smaller negative performance (as is the case with so many so-called actively managed conventional funds). MFIFs should always record a positive return with no drawdown unless a default is recorded. Management should be active, seeking to create value rather than trying to replicate an index. The only alternative would be a passive approach with funders co-investing alongside funds. However, this is not recommended; if things go wrong, a serious accountability problem arises.
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