John Rea
Investment Company Institute
Summary
Over the past decade, developing nations have increasingly used debt and equity securities in place of bank loans to finance the expansion of their economies. As a result, securities of emerging countries have become an important asset class for private investors, including U.S. mutual funds.
In the process, concern has arisen that foreign investors generally, and U.S. mutual funds specifically, might be sources of "hot money." In other words, according to this theory, portfolio managers and shareholders might run at the first sign of trouble in a developing economy, and thereby further disrupt its capital markets during a period of financial stress. Although such actions by mutual fund investors or fund portfolio managers have not occurred in U.S. financial markets, some have suggested the high volatility of emerging markets, coupled with the newness of their capital markets, makes them more sus-ceptible to destabilizing investment flows relative to U.S. capital markets.
In order to shed light on this issue, this article considers the pattern of investments in emerging markets by U.S. mutual funds during the 1990s. More specifically, it tracks the net flows of new cash to U.S. emerging market equity funds from 1991 through early 1996 and the portfolio investments in 23 emerging countries by 13 large U.S. emerging market equity funds from 1993 to 1995. The principal findings are summarized below:
For the period 1991-96, shareholders in U.S. emerging market equity funds did not redeem shares in large volume during periods of foreign market weakness. In fact, the net inflow of new cash continued during some periods in which equity prices in emerging markets moved sharply lower. In other periods of market downturns, such as the Mexican peso crisis in late 1994, outflows were small and short-lived, and inflows resumed even as equity prices declined further.
During the 1993-95 period of high volatility in emerging markets, portfolio managers from a sample of large U.S. emerging market equity funds generally did not shift investments between countries in a manner that would exacerbate price swings. Indeed, for the period examined, the managers quite frequently bought shares at times when share prices were falling and sold in rising markets. Moreover, when portfolio liquidations of securities in falling markets did occur, they typically were small relative to the size of the positions taken.
Background
In the past decade, less developed countries have made considerable progress in establishing and strengthening domestic capital markets. As a result, the share of world market capitalization accounted for by emerging markets grew from 3.7 percent in 1986 to 10.7 percent in 1995.
Over the same time, U.S. investors have come to view securities issued by companies in emerging nations as a new and attractive asset class. These securities typically offer higher potential investment returns and represent opportunities for further portfolio diversifi-cation, as returns on these securities have low correlations with those in developed markets. U.S. investors accordingly have increased their portfolio exposure to developing nations.
For example, in 1995, about one third of U.S. holdings of foreign securities were in less developed countries.
U.S. mutual funds shared in the trend toward increased overseas investing. Assets of international and global mutual funds grew from just $16 billion in 1986 to a record $285 bil-lion in June 1996, of which about 10 percent was in emerging markets funds.
Another $27 billion was invested in international and global closed-end funds in 1995, with approximately $15 billion, or 56 percent, identified as invested in emerging market funds. The increased presence of U.S. mutual funds in emerging markets has raised concern about their potential to destabilize financial markets in developing economies. This concern has two dimensions. One is that mutual fund shareholders might redeem their shares abruptly, forcing mutual funds en masse to liquidate securities and, in the process, placing downward pressure on securities prices. The second is that, even in the absence of share-holder redemptions, fund portfolio managers might suddenly reallocate investments on a large scale from one country to another, causing securities prices to fall sharply in the coun-try subject to the liquidation.
This article examines the record in the 1990s for evidence of instability in emerging financial markets by focusing on both shareholder flows and portfolio activity of U.S. emerging market stock funds.
The examination is confined to this period because only recently have emerging market mutual funds become significant investors in developing economies.
As recently as the end of 1992, assets of emerging market equity funds represented only 3 percent of the value of equity in emerging markets available for foreign ownership, whereas this figure had reached nearly 10 percent by the end of February 1996.
Moreover, prices of equities in these markets exhibited considerable volatility during the period, providing an excellent backdrop in which to analyze the extent to which shareholder flows and fund port-folio investments coincided with sharp movements in equity prices.
Shareholder Investment Activity in Emerging Market Funds
The measure used to examine the investment patterns of shareholders in emerging market equity funds and their responses to market developments is the net flow of new cash to these funds - that is, sales of mutual fund shares to investors (other than through reinvested distributions) less redemptions plus net exchanges by shareholders. Apositive value of net flow indicates that shareholders on balance made new investments in emerging market funds, thereby providing cash for the funds to purchase additional securities. Anegative value indicates that shareholders on balance withdrew cash, thereby reducing the resources available for investments in emerging markets. The monthly net flow for U.S. emerging market equity mutual funds is used for the analysis.
For the period January 1991 through February 1996, the net flows of new cash from shareholders to emerging market equity funds accounted for much of the growth of the assets of these funds. Virtually all of the asset growth for the five-year period came from the net flow into these funds rather than from asset appreciation, even though the total return on emerging market funds was a healthy 16 percent per annum. Importantly, at times, new cash flows to these funds ran counter to movements in share prices in these markets, and thus helped to maintain the level of investment in these funds and offered stability to these markets.
Emerging market equity funds experienced monthly inflows from January 1991 through February 1994. The monthly inflows were substantial, ranging from 2.4 percent to 27.3 percent of the preceding month’s assets. Moreover, the persistence of the inflows occurred even when monthly returns in emerging markets turned negative. For example, the IFCI composite index of equity prices in emerging markets declined 16.5 percent between April 1992 and September 1992, yet emerging market funds experienced an inflow in each of the five months.
This period included the month of June when the IFCI index fell 10.3 percent but the inflow of new cash was 27.3 percent of assets at the end of May. For the entire five-month period, the cumulative inflow was 60 percent of assets at the end of April.
Since the end of 1993, mutual fund investors have, on occasion, withdrawn funds from emerging markets when securities prices declined, but the outflows were generally small relative to the price swings. The first such outflow in the sample period occurred in March 1994 when securities markets worldwide experienced heightened volatility owing to a tightening of monetary policy in the United States. Given the 10.1 percent decrease in the IFCI index in March, the outflow was modest, amounting to only about 4.3 percent of assets. Furthermore, the outflow was short-lived - inflows resumed in April, even though stock prices in emerging markets continued to drift downward through June of that year.
In late 1994 and early 1995, emerging market funds again experienced outflows, but they were remarkably small in view of market developments. The IFCI index of emerging market equity prices dropped 3.3 percent in October 1994. This negative return was followed by a small outflow in November that amounted to 1.1 percent of assets at the end of October. The Mexican peso crisis in late December accelerated the downward movement in the IFCI index, which fell 22.5 percent over December 1994 and January 1995. Despite the sharp drop in securities prices, the two-month outflow in December and January was less than that in November. Inflows resumed in February, and in April alone exceeded the sum of outflows between November and January.
The IFCI index of emerging market equity prices continued to decline through March 1995 and, as a result, posted six consecutive monthly decreases on the way to a cumulative 29.1 percent drop between September 1994 and March 1995. The cumulative outflow in November, December, and January, however, amounted to only 2.4 percent of average assets for the three months. Moreover, when combined with inflows in February and March, emerging market equity funds experienced a cumulative outflow over the five months of only 1.4 percent of average assets.
A final round of outflows occurred between August 1995 and November 1995. During this period, the IFCI index of emerging market equity prices declined about 7.6 percent, but as in two previous periods of falling securities prices, the magnitude of the outflow was small, amounting to 2.7 percent of assets.
Despite the outflows that occurred at a few points during the two-year period from March 1994 to February 1996, shareholders continued to invest substantial amounts in emerging market equity funds. The cumulative net inflow during this period was $8.3 billion or 44 percent of assets at the beginning of the period. Not only did the investment occur during a period of substantial volatility, but it also occurred in the presence of a 15 percent decline in the IFCI index.
Thus, the weight of the evidence from the examination of shareholder activity suggests that mutual fund investors have taken a long-term view to investing in emerging market funds. Over the five-year period, shareholders made substantial new investments despite considerable short-term volatility in returns. Although investors tended in the past two years to redeem small portions of their holdings as markets weakened, subsequent invest-ments more than offset redemptions. These responses of shareholders in emerging market funds to market developments and their long-term investment horizon are very much in line with other evidence of general mutual fund shareholder behavior.