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.

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