Dissecting the relationship between the PSX and investment in Pakistan

The stock market is an eminent investment horizon with participants ranging from individual retail investors to institutional investors, including commercial banks, mutual funds, hedge funds, and insurance firms. Besides, the public-listed companies also trade in their stocks. This makes the Pakistan Stock Exchange (PSX) a key indicator of the country’s investment landscape. Hence, it is vital to understand the relationship of the returns of PSX’s benchmark index, KSE-100, with some dissimilar assets for the sake of composing and managing a well-diversified portfolio.

An optimal risk portfolio is the one with the least volatility. It is possible when the Sharpe ratio is maximised as per the Markowitz Portfolio Theory. But, how can the investors do so? Investors need to stock up on those assets in their portfolio which help reduce both the unsystematic and systematic risk.

Unsystematic risk is security or industry-specific and can be curtailed through diversification. On the flip side, systematic risk is the vulnerability of the KSE-100 returns in the wake of national or international events of sizeable magnitude. Such risk can only be hedged or, in case of an economic slump, waned by investing in safe-havens.

The segregation of a hedge, diversifier, and safe-haven is intricate to understand. It demands a thorough analysis of historical returns to learn whether a particular asset is inversely, positively or uncorrelated with the other one. In this case, let us assess the investment attributes of assets, including gold, crude oil Brent, crude oil WTI, and currencies like US dollars, Great Britain pounds, Japanese Yen, and Euro in relation to the KSE-100 index.

Gold and crude oil are considered to ameliorate the efficient frontier’s risk to return trade-off. There has been innumerable research aimed at classifying these assets. Some academics believe that gold can only act as a safe-haven against USD and GBP exchange rates, while others assert the safe-haven property in case of a steep plummeting oil price. The common denomination from the literature is that gold and crude oil’s investment credentials depend on the country, time, and the investor’s nature, which could be either risk-averse, risk-neutral or risk-loving. In this case, we assume the investor to be rational and risk-averse.

An analysis of the historical five-year returns portrays that crude oil’s presumed property as a safe-haven does not hold in the case of both Brent and WTI. This is partly owing to the recent plunge in spot and forward prices due to an overwhelming excess supply. Crude oil WTI remains an asset that facilitates diversification in the portfolio with a weak positive correlation of 0.01 with the KSE-100 index. In contrast, crude oil Brent can hedge systematic risk in precarious times with a correlation of -0.07. Gold can also not be concluded as a safe-haven. However, it can be classified as an asset suited to withstand market risk for PSX, like a rise in the policy rate.

In the case of currencies, GBP and USD turn out to be uncorrelated with the stock market. They are a safe-haven for a Pakistani investor, reflecting why people hoard such foreign currencies amidst a financial turmoil. The Japanese Yen is traditionally considered to be the safest currency. In Pakistan’s case, it is close to but not completely uncorrelated with the equity market. Hence, it is an appropriate choice to hedge the market volatility.

Pakistan has managed to cling on to the MSCI emerging market index since its elevation from the frontier market status in 2017. PSX, since then, orchestrated a dismal show with -15.34% and -8.41% annual returns in 2017 and 2018, respectively. However, the tables have swiftly turned, and the PSX is spiralling upwards with 9.90% and 7.41% returns in 2019 and 2020. This year the KSE-100 has already embarked on a northwards journey.

With a further upsurge anticipated in the PSX, investment will soar in the forthcoming time. An all-equity Pakistani investor must add those assets which makes the portfolio cash in on the bull and put up with the bear.