Trends in Foreign Portfolio Investments

While Foreign Portfolio Investment (FPI) has traditionally been concentrated in developed markets, new interest has been sparked by the so-called “emerging” capital markets. The emerging markets have at least three attractive qualities, two of which are their high average returns and their low correlations with developed markets. Diversification into these markets in expected to give higher expected returns and lower overall volatility.

Many individual investors, as well as portfolio and pension fund managers, are reexamining their basic investment strategies. In the last decade, fund managers realized that significant performance gains could be obtained by diversifying into high-quality global equity markets. These gains are limited, however, by the fairly high cross-correlations returns in these markets. The resulting investment strategy reflects current information. In terms of portfolio theory, adding low-correlation portfolios to an optimized investment portfolio, enhances the reward-to-risk profile by shifting the mean-variance frontier to the left. The portfolio optimization problem requires important inputs—the expected returns and the variance-covariance matrix. In principal, all of these measures should be forward-looking. That is, the returns, volatilities, and correlations should be forecasted.

An upsurge in portfolio investments in developing countries has marked the end of the debt crisis, or perhaps even helped to end it. Using the World Bank’s definition of portfolio flows as consisting of bonds, equity (comprising direct stock market purchases, American Depository Receipts (ADRs), and country funds), and money market instruments (such as certificates of deposits (CDs) and commercial paper). Broadly speaking, there are six groups of investors in the emerging markets, each having a tolerance for different degrees of risks and returns:

  1. Domestic residents of developing countries with overseas holdings and other private foreign investors, who constitute the dominant category of portfolio investors who are currently active in the major emerging markets. These investors keep abreast of developments in their country on a regular basis and monitor change in government policy. Their investments in emerging markets are motivated by expected short-term high yields. Preference is given to instruments that are in bearer form and provide returns in hard currency. These external funds termed as “Hot Money” which may or may not be beneficial to the long-term growth prospects of developing country depending on the manner in which they are invested.
  2. Managed funds (closed-end country funds and mutual funds), whose portfolio managed buy and sell shares and high-yield bonds in one or more of the emerging markets for performance-based trading purposes.
  3. Foreign banks and brokerage firms, who allocate their portfolio for inventory and trading purposes.
  4. Retail clients of Eurobonds houses who are involved in emerging securities markets due to portfolio diversification motives. They are generally interested in high-yield, high portfolio investments in the emerging markets.
  5. Institutional investors (such as pension funds, life insurance companies), who have a longer time horizon for expected gains from their portfolio and look for stability and long-term growth prospects in the market in which they invest.
  6. Non resident nationals of developing countries, who could be a potential source of portfolio investment from abroad (as opposed to flight capital).

The first three groups are active in the emerging securities markets primarily because of expectations of short-term returns and have been observed to move funds among different branches frequently. Purely speculative traders also continuously move funds between the emerging markets and the developed markets.

The lower degree of integration of the emerging markets in the global capital markets, often makes them better avenues for achieving higher yields relative to the more globally integrated developed securities markets. Since all listed companies in the Equity stock markets are not very well researched by foreign investors and their market information may be limited, there exists the potential for finding undervalued stocks which may yield high returns to potential investors. In general, P/E ratios in several Equity stock markets may be lower than those in developed markets. Therefore, one expects to see larger inflows of portfolio investments into the emerging markets from institutional investors worldwide.

The integration of international equity markets observed in recent years can be attributed to several factors:

  1. The emergence of international banking syndicates and brokerage houses which have the necessary information technology and communication facilities to be able to place large international equity issues within shorter periods of time at lower syndication and distribution fees than domestic issues;
  2. The introduction of foreign equity-based instruments, such as ADRs and GDRs, which have significantly reduced the regulatory and physical impediments that in the past hindered such investments; and
  3. The widespread practice of multiple listing of shares across different stock exchange in different countries have become widespread. The globalisation of the international capital markets has resulted in global allocation of portfolios in a relatively inexpensive manner.

It should be understood, however, that at the earlier stages of “openness” of the Equity stock markets, the return of flight capital that is observed is generally motivated by short-term speculative motives. Significant movements of such funds in and out of these markets give rise to increased volatility in stock prices as well as potential problems for domestic monetary management. Rapid increases of international reserves due to these large capital inflows have to be dealt with carefully by policymakers. These rising international reserves will strengthen the domestic currencies of the countries where these large inflows occur and have lowered inflationary expectations. Investors have observed the underutilized capacity, especially in the infrastructure sector of the emerging markets, and expect increased demand for manufactured products as a result of “impending free trade agreements.”

It is crucial for developing countries that the experiencing such large capital inflows in the short term to endeavor to continue to attract these private financing flows in the long term. Given the increasing integration of the international financial markets and the increasingly advanced communication and information technology facilities that are emerging today, the task of maintaining “financial competitiveness” in the international capital markets is a challenge that the emerging markets must face. To this end, the role of appropriate market-oriented domestic policy reforms and an endeavor to maintain a sustained growth performance in the developing countries concerned will go a long way in keeping the repatriated capital with their boundaries. From the long-term point of view it has been observed that flight capital is the last to return. This makes the task at hand for the emerging markets very challenging. If developing countries wish to attract a sustained inflows of portfolio investment from abroad rather than short-term speculative movements of funds in and out of their countries, it is crucial to address some of the major constraints that inhibit such flows. These constraints exist both on the demand as well as the supply side of Equity stock market securities.

On the demand side for emerging market securities, the most important hurdle inhibiting institutional investors abroad from investing in these markets are regulatory impediments imposed by source country governments and restrictions on investment practices imposed by the trustees of these institutions. Some governments have imposed restrictions on foreign investment by their institutional investors because they feel that possible large foreign exchange outflows may have an adverse impact on the country’s balance of payments, by institutionalizing capital flight. However, institutional investors need to be strictly monitored in the absence of a strong and transparent pension system and when pension fund managers lack a thorough understanding of the complexities of their investment in the international financial markets. The role of the domestic securities and exchange commissions and regulatory agencies for institutional investors in the emerging markets is crucial in maintaining a steady inflow of foreign capital and ensuring responsible behavior on the part of domestic institutional investors.

Tight regulation of investment decisions by institutional investors (in both developed and developing countries) is not necessary for ensuring for safety of contractual savings. In the United Kingdom, for example pension funds and life insurance companies are only expected to demonstrate that their portfolio of assets, when prudently valued, meet the requirements for technical reserves and solvency margins. This enables these institutions to appropriately manage their portfolios by ensuring flexibility in matching assets and liabilities. Excessively strict investment limits may undermine the private management of a portfolio and, in effect, result in government-directed investment. Nevertheless, pension funds and insurance companies of most developed countries are still subject to restrictive regulations on their foreign investment. These include Canada, Germany, and the Netherlands. The introduction of Rule 144A and  ADRs in the U.S. stock exchanges has considerably simplified trading in foreign equities by eliminating costly settlement delays, registration difficulties, and divided payment problems. Under Rule 144A, Qualified Institutional Buyers (QIBs) in the United States also no longer need to hold the securities they traded the private placement market for a two-year period before they can be sold. Foreign issues can now gain access to a relatively large number of U.S. institutional investors. The credit rating standards for public placements of bonds have also been relaxed.

On the supply side of the emerging market securities, institutional fund managers are concerned about the illiquidity of most of the emerging markets due to restrictions on direct entry by foreigners, the small number of players (and therefore inefficient market making), poor accounting practices, high transaction costs, and unreliable settlement systems. Almost all Equity stock markets suffer from the shortage of good-quality, large capitalization shares. This results in quick overheating (i.e. rapid increases in market capitalization) once domestic and international interest is generated in these markets due to regulatory changes or other factors. The relatively small turnover of most stock in the emerging markets also makes it difficult for large foreign investors to consider substantial portfolio investment in these markets In fact, larger institutional investors often prefer that companies they may invest in have a domestic market turnover of at least $1 million per week. Custodial services in Equity stock markets also continue to be a major constraint to increased participation by large foreign institutional investors. Another concern among U.S. institutional investors is that the management staff of the newly privatized firms may not be sufficiently concerned about enhancing the value of their company’s shares (i.e. there appears to be an “agency” problem). This will have adverse implications for attractiveness of these investments from the long-term point of view. Under these circumstances, short-term yields would be high (which may interest a different group of investors private investors and performance-based traders). Regulatory constraints and the tower level of sophistication of the capital markets in the developing countries were cited by U.S. institutional investors as other impediments to greater portfolio flows to emerging markets. U.S. institutional investors are expected to take advantage of Rule 144A and significantly increase their investment in private equity and debt offerings by non-U.S. entities.

Bookmark the permalink.