## 5. Difference Between Actual International Mutual Fund Investment and the MSCI Benchmark: Transparent versus Opaque Countries

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### Introduction
- Growth drivers of international mutual funds: technological change, privatization in emerging markets, deregulation in industrial countries in the 1980s and early 1990s, growth of institutional investors in advanced economies, and macroeconomic and trade reform in developing countries.
- Aggregate flow changes:
  - Gross portfolio flows to emerging markets 1997 to 2009: from US$132 million to around US$421 billion.
  - Portfolio flows represented about 30 percent of total gross inflows into emerging markets in the first half of 2010.
  - Emerging market hedge fund flows in 2007: US$ 9.1 billion.
  - Assets under management of emerging market funds reached unprecedented heights by 2009–2010, with record flows in 2009 and 2010 from both equity and bond mutual funds.

### Portfolio Choice, Fund Managers’ Incentives, and Consequences for Capital Flows
- Incentive structure:
  - Compensation typically linked to performance relative to benchmark indices (e.g., MSCI indices for equities, JP Morgan EMBI for bonds), creating incentives to follow peers.
- Theoretical mechanisms that can generate correlated behavior or contagion:
  - Benchmark-based compensation schemes can generate herding behavior.
  - Informational cascades: when actions are observable but private information is costly, imitation can be optimal.
  - Interaction of benchmark incentives with wealth effects, risk aversion changes, and portfolio constraints can transmit crises across countries even without common fundamentals.
  - Short-sale constraints and tracking-error concerns can make funds revert toward benchmarks, amplifying contagion.
  - Opportunistic investors (e.g., hedge funds) can potentially stabilize markets when benchmarked investors face tight constraints.
- Alternative channels for contagion:
  - Portfolio rebalancing in mean-variance or VaR frameworks, and wealth effects (models cited include Schinasi and Smith (2000), Kodres and Pritsker (2002), Kyle and Xiong (2001), Goldstein and Pauzner (2004), Yuan (2002), Pavlova and Rigobon (2007)).

### Empirical Evidence
- Aggregate patterns
  - Fund flows in and out of emerging markets are relatively volatile; volatility rose sharply about 1 ½ years before the Lehman collapse.
  - Mutual funds exhibit substantial heterogeneity; large outflows can coincide with large inflows.
  - Open-end funds withdraw more from vulnerable countries during crises than closed-end funds.
- Herding
  - Lakonishok, Shleifer, and Vishny (1992) herding measure HM described; empirical mean of HM across countries and over time found to be 7.7 percent in Borensztein and Gelos (2003a).
  - Evidence for herding is mixed and varies by country, time, and crisis episodes; herding often emerges during and after crises.
  - Herding appears more pronounced for open-end funds than closed-end funds; open-end funds’ flows Granger-cause closed-end funds’ investments.
- Momentum trading
  - Evidence supports momentum (positive-feedback) trading by mutual funds across equity and fixed-income markets.
  - Momentum appears stronger for volatile markets and during/after crises.
- Portfolio rebalancing and contagion
  - Micro-level studies show benchmark-following and tracking-error concerns explain a sizable portion of funds’ asset allocations.
  - Reverse optimization finding: expected returns implied by funds’ holdings (using historical covariances and the model) are strongly correlated with actual future returns—implying funds can be good at predicting returns.
  - Evidence that crises transmit via asset holdings of international investors (accessible vs inaccessible stocks co-movement; common “overexposed” funds index predicting contagion).
  - Portfolio shifts by developed-country-domiciled mutual and hedge funds translate into significant allocation changes in emerging markets and impact emerging market equity returns and comovement with developed markets.

### Transparency, Informational Asymmetries, Asset Allocation, and Capital Flow Volatility
- Transparency and asset allocation
  - Opacity reduces foreign investment through informational asymmetries, monitoring costs, insider trading concerns, and disclosure quality.
  - Empirical findings:
    - Foreigners invest less in firms in countries with poor outsider protection, disclosure, and governance structures.
    - Mutual funds invest more in countries with better investor protection, accounting standards, shareholder rights, and legal frameworks.
    - Global versus specialized funds differ: global funds tend to hold more assets from firms less prone to informational asymmetries.
- Transparency and volatility
  - Models indicate higher transparency should reduce herding and capital flow volatility (Calvo and Mendoza (2000); Chari and Kehoe (2003); Pasquariello (2007)).
  - Empirical findings:
    - Funds tend to avoid less transparent markets and assets; during crises funds tend to flow more from less transparent countries and herding is more pronounced in less transparent markets.
    - Less corrupt countries are less vulnerable to rating downgrades as measured by mutual fund outflows.
- Informational relative advantages
  - Evidence is mixed on whether foreign funds are informationally disadvantaged vis-à-vis domestic investors.
  - Some studies show domestic investors have informational advantages in local markets; other studies show foreign funds can outperform passive benchmarks and demonstrate timing ability.
  - Reconciliation: foreigners may be disadvantaged on local-specific information but advantaged on global factors, explaining avoidance of opaque markets while still delivering relatively good performance on average.

### Key Statistics and Measures
- Gross portfolio flows to emerging markets 1997 to 2009: from US$132 million to around US$421 billion.
- Portfolio flows represented about 30 percent of total gross inflows into emerging markets in the first half of 2010.
- Emerging market hedge fund flows in 2007: US$ 9.1 billion.
- Mean HM (herding measure) across countries and over time (Borensztein and Gelos (2003a)): 7.7 percent.
- Figure 4 — Mutual Fund Holdings as a proportion of the Total Number of Listed Stocks by Country (quintile statistics):
  - First Quintile — Average: 1.1% ; Max: 2.4%
  - Second Quintile — Average: 7.7% ; Max: 13.8%
  - Third Quintile — Average: 21% ; Max: 27.6%
  - Fourth Quintile — Average: 34.8% ; Max: 43.6%
  - Fifth Quintile — Average: 57.8% ; Max: 77.3%
- Weekly flows figure timing note: Lehman Brothers bankruptcy dated (09/08) noted in flow timing.

### Conclusions and Policy Recommendations
- Key conclusions
  - The behavior of international mutual funds is complex; simplistic characterizations are misleading.
  - International funds tend to avoid opaque markets and assets; avoidance intensifies during volatile times and funds tend to flee less transparent countries during crises.
  - Difficulty of emerging market mutual funds in overcoming local opacity does not imply they are overall informationally disadvantaged; evidence suggests relative strength in information about global factors and timing ability.
  - Portfolio rebalancing mechanisms are important in explaining contagion patterns, even absent common macroeconomic fundamentals.
  - Volatility of capital flows is to some extent driven by investors investing in emerging market funds (retail and institutional investor behavior) rather than fund-manager-level behavior alone.
  - Momentum trading is present among mutual funds.
  - There is some evidence for herding, but its quantitative importance is not fully clear; funds do not all move together uniformly.
  - Most studies suggest portfolio changes by emerging market equity funds have an impact on market returns.
- Surveillance implication
  - Monitoring exposures of large investors at a micro level is important to predict vulnerabilities and transmission of volatility across countries.
  - Consolidation of diverse sources of information on investors’ portfolio holdings can improve the ability to predict transmission channels.
- Policy implication
  - Increasing transparency — more frequent, comprehensive, and reliable information — could help emerging markets mitigate some risks associated with financial globalization.
- Research gaps
  - More research is needed on interactions among different types of international investors (mutual funds, pension funds, hedge funds), and on the interplay of differing incentives and constraints faced by their managers.

*Source: IMF staff analysis from the chapter "Difference Between Actual International Mutual Fund Investment and the MSCI Benchmark: Transparent versus Opaque Countries."*

### References .............................................................................................................

### _wp1192 - References .............................................................................................................

### Tables
- 1. Mutual Fund Flows Into Emerging Markets ..................................................................3
- 2. Global Emerging Market Equity Funds: Assets Under Management ...........................5

### Figures
- 1. Emerging Market Debt and Equity Funds: Assets Under Management ........................4
- 2. Weekly Flows Into Emerging Market Debt and Equity Funds ......................................8
- 3. Common Investors as Predictor of Contagion: The Thai Crisis ..................................13
- 4. Mutual Fund Holdings as a Proportion of the Total Number of Listed Stocks by Country ....................................................................................................................................16

*Source PDF filename: _wp1192 - References .............................................................................................................; Canonical source URL: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp1192.pdf*

### 5. Difference Between Actual International Mutual Fund Investment and the MSCI

### 5. Difference Between Actual International Mutual Fund Investment and the MSCI Benchmark: Transparent versus Opaque Countries

### Introduction
- Growth of international mutual funds has been a salient feature of financial globalization, driven by technological change, privatization in emerging markets, deregulation in industrial countries in the 1980s and early 1990s, growth of institutional investors in advanced economies, and macroeconomic and trade reform in developing countries.
- Gross portfolio flows to emerging markets more than tripled from 1997 to 2009 (from US$132 million to around US$421 billion).
- Portfolio flows represented about 30 percent of total gross inflows into emerging markets in the first half of 2010.
- Emerging market hedge fund flows in 2007 were estimated to have amounted to US$ 9.1 billion.
- Assets under management of emerging market funds reached unprecedented heights by 2009–2010, with record flows in 2009 and 2010 from both equity and bond mutual funds.

### Portfolio Choice, Fund Managers’ Incentives, and Consequences for Capital Flows
- Compensation of mutual fund managers is typically linked to performance relative to benchmark indices (e.g., MSCI indices for equities, JP Morgan EMBI for bonds), creating incentives to follow peers.
- Theoretical mechanisms highlighted:
  - Benchmark-based compensation schemes can generate herding behavior.
  - Informational cascades: when actions are observable but private information is costly, imitation can be optimal.
  - Interaction of benchmark incentives with wealth effects, risk aversion changes, and portfolio constraints can transmit crises across countries even without common fundamentals.
  - Short-sale constraints and tracking-error concerns can make funds revert toward benchmarks, amplifying contagion.
  - Opportunistic investors (e.g., hedge funds) can potentially stabilize markets when benchmarked investors face tight constraints.
- Portfolio rebalancing in mean-variance or VaR frameworks, and wealth effects, are alternative channels for contagion (models cited include Schinasi and Smith (2000), Kodres and Pritsker (2002), Kyle and Xiong (2001), Goldstein and Pauzner (2004), Yuan (2002), Pavlova and Rigobon (2007)).

### Empirical Evidence
- Aggregate patterns
  - Fund flows in and out of emerging markets are relatively volatile; volatility rose sharply about 1 ½ years before the Lehman collapse.
  - Mutual funds exhibit substantial heterogeneity; large outflows can coincide with large inflows.
  - Open-end funds withdraw more from vulnerable countries during crises than closed-end funds.
- Herding
  - Lakonishok, Shleifer, and Vishny (1992) herding measure HM described; empirical mean of HM across countries and over time found to be 7.7 percent in Borensztein and Gelos (2003a).
  - Evidence for herding is mixed and varies by country, time, and crisis episodes; herding often emerges during and after crises.
  - Herding appears more pronounced for open-end funds than closed-end funds; open-end funds’ flows Granger-cause closed-end funds’ investments.
- Momentum trading
  - Evidence supports momentum (positive-feedback) trading by mutual funds across equity and fixed-income markets.
  - Several studies document positive-feedback trading by international mutual funds and by individual investors directing money toward funds with strong recent performance.
  - Momentum appears stronger for volatile markets and during/after crises.
- Portfolio rebalancing and contagion
  - Micro-level studies show benchmark-following and tracking-error concerns explain a sizable portion of funds’ asset allocations.
  - Reverse optimization finding: expected returns implied by funds’ holdings (using historical covariances and the model) are strongly correlated with actual future returns—implying funds can be good at predicting returns.
  - Evidence that crises transmit via asset holdings of international investors (accessible vs inaccessible stocks co-movement; common “overexposed” funds index predicting contagion).
  - Portfolio shifts by developed-country-domiciled mutual and hedge funds translate into significant allocation changes in emerging markets and impact emerging market equity returns and comovement with developed markets.

### Transparency, Informational Asymmetries, Asset Allocation, and Capital Flow Volatility
- Transparency and asset allocation
  - Opacity reduces foreign investment: informational asymmetries, monitoring costs, insider trading concerns, and disclosure quality affect foreign investors’ allocations.
  - Empirical findings: foreigners invest less in firms in countries with poor outsider protection, disclosure, and governance structures.
  - Mutual funds invest more in countries with better investor protection, accounting standards, shareholder rights, and legal frameworks.
  - Global versus specialized funds differ: global funds tend to hold more assets from firms less prone to informational asymmetries.
- Transparency and volatility
  - Models indicate higher transparency should reduce herding and capital flow volatility (Calvo and Mendoza (2000); Chari and Kehoe (2003); Pasquariello (2007)).
  - Empirical findings:
    - Funds tend to avoid less transparent markets and assets; during crises funds tend to flow more from less transparent countries and herding is more pronounced in less transparent markets.
    - Less corrupt countries are less vulnerable to rating downgrades as measured by mutual fund outflows.
- Informational relative advantages
  - Evidence is mixed on whether foreign funds are informationally disadvantaged vis-à-vis domestic investors.
  - Some studies show domestic investors have informational advantages in local markets; other studies show foreign funds can outperform passive benchmarks and demonstrate timing ability.
  - Reconciliation: foreigners may be disadvantaged on local-specific information but advantaged on global factors, explaining avoidance of opaque markets while still delivering relatively good performance on average.

### Key Statistics and Measures (as reported in the source)
- Gross portfolio flows to emerging markets 1997 to 2009: from US$132 million to around US$421 billion.
- Portfolio flows represented about 30 percent of total gross inflows into emerging markets in the first half of 2010.
- Emerging market hedge fund flows in 2007: US$ 9.1 billion.
- Mean HM (herding measure) across countries and over time (Borensztein and Gelos (2003a)): 7.7 percent.
- Weekly flows figure: Lehman Brothers bankruptcy dated (09/08) noted in flow timing.
- Figure 4 quintile statistics (Mutual Fund Holdings as proportion of total listed stocks by country):
  - First Quintile — Average: 1.1% ; Max: 2.4%
  - Second Quintile — Average: 7.7% ; Max: 13.8%
  - Third Quintile — Average: 21% ; Max: 27.6%
  - Fourth Quintile — Average: 34.8% ; Max: 43.6%
  - Fifth Quintile — Average: 57.8% ; Max: 77.3%

### Conclusions and Policy Recommendations
- Lessons learned:
  - Overall, the behavior of international mutual funds is complex; overly simplistic characterizations are misleading.
  - International funds tend to avoid opaque markets and assets; this avoidance intensifies during volatile times and funds tend to flee less transparent countries during crises.
  - Difficulty of emerging market mutual funds in overcoming local opacity does not imply they are overall informationally disadvantaged; evidence suggests relative strength in information about global factors and timing ability.
  - Portfolio rebalancing mechanisms are important in explaining contagion patterns, even absent common macroeconomic fundamentals.
  - Volatility of capital flows is to some extent driven by investors investing in emerging market funds (retail and institutional investor behavior) rather than fund-manager-level behavior alone.
  - Momentum trading is present among mutual funds.
  - There is some evidence for herding, but its quantitative importance is not fully clear; funds do not all move together uniformly.
  - Most studies suggest portfolio changes by emerging market equity funds have an impact on market returns.
- Surveillance implication:
  - Monitoring exposures of large investors at a micro level is important to predict vulnerabilities and transmission of volatility across countries.
  - Consolidation of diverse sources of information on investors’ portfolio holdings can improve the ability to predict transmission channels.
- Policy implication:
  - Increasing transparency — more frequent, comprehensive, and reliable information — could help emerging markets mitigate some risks associated with financial globalization.
- Research gaps:
  - More research is needed on interactions among different types of international investors (mutual funds, pension funds, hedge funds), and on the interplay of differing incentives and constraints faced by their managers.

*Source: IMF staff analysis from the chapter "Difference Between Actual International Mutual Fund Investment and the MSCI Benchmark: Transparent versus Opaque Countries."*

### REFERENCES

### _wp1192 - REFERENCES

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*Source: _wp1192 - REFERENCES*

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