The Role of Mature Market Mutual Funds in Emerging Markets: Myth or Mayhem?1

Contributor Notes

Author’s E-Mail Addresses: long@imf.org, asy@imf.org

The expansion of the global mutual funds industry has been characterized by growth in mature as well as emerging markets. This has clearly contributed to the development of local securities markets in emerging market economies, which in turn, has been key in attracting investment inflows from overseas funds. A major concern, however, is that large foreign investors could significantly disrupt the stability of local capital markets in the event of a market shock, with systemic implications for the real economy. Our estimates suggest that while local investors remain the more important group in terms of market share, the influence of foreign funds cannot be discounted. Asset allocation decisions by mature market funds- both dedicated and crossover-in aggregate, could affect emerging markets. In particular, European mutual funds appear to play a much bigger role in emerging markets than their U.S. counterparts.

Abstract

The expansion of the global mutual funds industry has been characterized by growth in mature as well as emerging markets. This has clearly contributed to the development of local securities markets in emerging market economies, which in turn, has been key in attracting investment inflows from overseas funds. A major concern, however, is that large foreign investors could significantly disrupt the stability of local capital markets in the event of a market shock, with systemic implications for the real economy. Our estimates suggest that while local investors remain the more important group in terms of market share, the influence of foreign funds cannot be discounted. Asset allocation decisions by mature market funds- both dedicated and crossover-in aggregate, could affect emerging markets. In particular, European mutual funds appear to play a much bigger role in emerging markets than their U.S. counterparts.

I. Introduction

The increase in global assets under management (AUM) in recent years has been characterized by growth in institutional investors’ assets, in both mature and emerging markets. The retail sector has also played an increasingly important role in channeling funds to asset managers for investment. The expansion of the mutual fund industry is largely attributable to the proliferation of investment opportunities globally, as countries have continued to liberalize their capital markets, reduce trade barriers and demutualize. The growing middle class in many mature and emerging market economies is also expected to support the expansion of mutual fund sales in the future. From an institutional perspective, the privatization of pension systems and increasing market penetration of the insurance industry—especially in emerging markets—is also expected to increase the demand for mutual fund products.2

A mutual fund can be defined as an investment company that combines the assets of investors—individual and institutional—and collectively invests those assets in stocks, bonds and/or money market instruments. Investors invest in a mutual fund by purchasing shares issued by the fund, which then uses the cash raised to invest in portfolios of stocks, bonds and other securities. Mutual funds also tend to continuously offer new fund shares to the public. Mutual funds are “open-end” investment companies in that they are required to redeem outstanding shares at any time, upon demand, and at a price determined by the current value of the funds’ net assets, known as the net asset value (NAV). There are generally four types of mutual funds: equity, bond, hybrid and money market.3

In emerging markets, the exponential growth in the local mutual fund industry has clearly contributed to the development of local securities and derivatives markets, which in turn, has been key in attracting investment inflows from overseas funds. More importantly, the greater depth and liquidity of local markets has reduced reliance on external funding. Mutual funds in emerging markets tend to invest locally, as they are, in many cases, “captive” due to investment restrictions or are simply averse to investing offshore. Thus, policymakers have tended to focus on the role of mature market mutual funds—which clearly dwarf the local ones in size—in these emerging markets. The biggest concern is that asset reallocation decisions by these foreign investment funds could significantly disrupt the stability of local capital markets, in the event of a market shock, with systemic implications for the real economy.4

In this paper, we estimate the importance of mature market mutual funds in emerging equity and bond markets, vis-à-vis local mutual funds, and assess their potential impact on market stability. In this context, we also consider the importance of the investor base, namely, crossover versus dedicated investors. Finally, we provide an assessment on the issue of portfolio optimization by mature market mutual funds in their emerging market asset allocations. Our findings suggest that asset allocations by mature market funds into emerging markets, while not inconsequential, are still much less important than the holdings of domestic investors. Mutual funds in mature European markets appear to play a bigger role in emerging markets than their U.S. counterparts, with greater potential to influence local markets. Meanwhile, the portfolios of European funds appear to be more optimal than those of their U.S. counterparts, although both still exhibit home bias in their allocations.

The paper is presented as follows: Section II provides a broad overview of the developments in the industry, followed by a discussion on asset allocation trends in Section III. In Section IV, we estimate the allocations by dedicated and crossover mutual funds from mature markets into emerging markets, and discuss the stability implications of these and other local market investors. Section V provides a brief discussion on the diversification benefits achieved by U.S. and European investors, followed by the conclusion in Section VI.

II. Global Industry Overview

The net assets of the global mutual fund industry has grown more than six-fold since 1990, to $14 trillion at the end of 2003 (Tables 1A and 1B). Notably, the mutual fund industry in emerging markets has grown sharply over this period, by more than 19 times its size in 1990, notwithstanding the financial crises that has beset some of these markets since the mid-1990s. Despite the surge in total net assets, however, mutual funds in emerging markets still only represent less than 5.7 percent of total global net assets (Figure 1), with emerging Asia accounting for 3.7 percent of the global total.

TABLE 1A

Mutual Funds: Total Net Assets*

(In billions of U.S. dollars)

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Sources: Bloomberg, Federation of Malaysian Unit Trust Managers, Investment Company Institute, Monetary Authority of Singapore, Securities and Exchange Commission of Thailand, Superintendencia Bancaria and Superintendencia Valores of Colombia.* Funds of funds are not included; home-domiciled funds except for Hong Kong SAR, Korea, New Zealand and Singapore, which include home- and foreign-domiciled funds. ** As at September 2003.
Table 1B.

Mutual Funds: Growth in Total Net Assets

(In percent)

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Sources: Bloomberg, Federation of Malaysian Unit Trust Managers, Investment Company Institute, Monetary Authority of Singapore, Securities and Exchange Commission of Thailand, Superintendencia Bancaria and Superintendencia Valores of Colombia.* Funds of funds are not included; home-domiciled funds except for Hong Kong SAR, Korea, New Zealand and Singapore, which include home- and foreign-domiciled funds. ** As at September 2003.
Figure 1
Figure 1

Mutual Funds: Total Net Assets by Market

(In billions of US dollars, end of period)

Citation: IMF Working Papers 2004, 133; 10.5089/9781451855524.001.A001

Sources: Investment Company Institute, Securities Commission of Malaysia, Securities and Exchange Commission of Thailand.

In aggregate, equity mutual funds are clearly the most popular within the industry, with 43 percent of total global net assets as at the end of 2003, or $5.9 trillion (Figure 2). Money market funds are next in size, with 24 percent of the total net assets. Indeed, the trend over time shows continuous growth in global money market fund aggregates, in contrast with equity funds, which have tended to be more “volatile.” Similarly, bond funds have continued to post positive growth in net assets since 2000.

Figure 2
Figure 2

Global Mutual Funds: Total Net Assets by Fund Type

(In billions of US dollars, end of period)

Citation: IMF Working Papers 2004, 133; 10.5089/9781451855524.001.A001

Source: Investment Company Institute

Significantly, U.S. mutual funds alone make up 53 percent of the industry’s total global net assets, which is some 1.6 times the size of the industry in all the mature European markets combined, and 8.5 times that of its mature market counterparts in the Asia-Pacific region. U.S. investors had placed some $7.4 trillion in 8,126 mutual funds as at end-2003, compared to $6.4 trillion invested in 8,244 funds at the end of 2002. The anticipation of a strong economic recovery and improving corporate profitability saw equity fund assets rise 37 percent to $3.7 trillion in 2003, from $2.7 trillion in 2002.

The increasing popularity of mutual funds in United States is clearly supported by the investment profile of domestic households since the 1980s (Figure 3). Almost half of all households were owners of mutual funds by the end of 2003. These investors made $668 billion of net purchases of financial assets in 2002, up 21 percent from $554 billion the previous year. They were net buyers of mutual funds ($164 billion), bonds and bank deposits, albeit net sellers of directly held stocks.

Figure 3
Figure 3

U.S. Household Ownership of Mutual Funds

Citation: IMF Working Papers 2004, 133; 10.5089/9781451855524.001.A001

Source: Investment Company Institute

III. Trends in Asset Allocation

Allocations to different asset classes tend to differ across countries and regions (Tables 2A and 2B), depending on market infrastructure, availability of instruments to invest and hedge, liquidity of market, as well as risk considerations. For instance, mutual funds in United States hold the largest proportion (44 percent) of their net assets in equities, while funds in Latin America are predominantly invested in fixed income instruments (68 percent). Allocations by European mutual funds appear to be evenly balanced between equity and bond funds.

TABLE 2A

Mutual Funds: Total Net Assets by Fund Type, 2003

(In billions of U.S. dollars)

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Sources: Investment Company Institute, Monetary Authority of Singapore, Securities Commission of Malaysia, Securities and Exchange Commission of Thailand.* As at end-2002.
TABLE 2B

Mutual Funds: Net Assets by Fund Type as Proportion of Total Net Assets, 2003

(In percent)

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Sources: Investment Company Institute, Monetary Authority of Singapore, Securities Commission of Malaysia, Securities and Exchange Commission of Thailand.

As at end-2002.

In terms of global allocations, while international mutual funds do have some presence in emerging market local currency bonds and equities,5 few markets generally meet their investment criteria, which may include ease of exit, an attractive tax structure, along with clearing and settlement considerations. The issue of investability, where foreigners are prohibited from purchasing, or restricted to a limited fraction of, a given company’s stock, has also excluded foreign investors from any significant holdings in emerging markets. That said, as the emerging market asset class becomes more mainstream, mutual fund managers are pushing more local market instruments and promoting hybrid mandates,6 that are incidentally becoming popular amongst European investors seeking to diversify their holdings.

In United States, surveys of fund managers indicate that they too are planning to increase their holdings of emerging markets instruments—both equities and bonds—in their portfolios. This is in contrast to investor preference over the past decade, with domestic equity funds increasingly dominating those of foreign equity funds up to 2000 (Figure 4).7 Net new cash inflows into all U.S. equity funds peaked at $310 billion in 2000, of which $260 billion were allocated to domestic funds and the remainder to foreign assets.

Figure 4
Figure 4

U.S. Equity Mutual Funds: Net New Cash Flows

(In billions of US dollars)

Citation: IMF Working Papers 2004, 133; 10.5089/9781451855524.001.A001

Source: Investment Company Institute

Interest in emerging market equity funds has been growing in Asia, in line with the global economic recovery and the perceived ‘undervaluation’ of Asian assets. Hong Kong SAR and Singapore are unique within the emerging markets in that they represent regional asset management hubs, with funds largely sourced from and invested overseas. In Singapore, there has been substantial growth in the asset management industry since 1997, with AUM growing by 65 percent to about $200 billion at the end of 2002.8 Some 70 percent of funds are sourced externally—from United States, Europe and the Asia-Pacific region, while investments into overseas markets account for 82 percent of funds (Figures 5A and 5B). In Hong Kong SAR, 63 percent of AUM of around $200 billion are sourced from overseas, with the balance sourced from local investors. Of this amount, 76 percent are invested abroad; the remaining 24 percent, which is invested locally, represents almost $48 billion of assets under management or around 30 percent of GDP.9 In contrast to these two markets, the opposite is true of Korea, another important market for mutual funds, where net assets totaling some $134 billion (or 26 percent of GDP) are largely held in local securities. About 87 percent of AUM by investment trust management companies (ITMCs) is allocated to local fixed-income instruments, with the rest placed in equities.10

Figure 5A
Figure 5A

Singapore: Sources of Discretionary Funds by Region, 2002

Citation: IMF Working Papers 2004, 133; 10.5089/9781451855524.001.A001

Source: Monetary Authority of Singapore
Figure 5B
Figure 5B

Singapore: Investment of Discretionary AUM by Region, 200

Citation: IMF Working Papers 2004, 133; 10.5089/9781451855524.001.A001

Source: Monetary Authority of Singapore

Within Eastern Europe, the mutual fund industry has grown rapidly in both Hungary and Poland, with net assets of about 5 and 4 percent of GDP, respectively. The industry is extremely competitive in Hungary, partly owing to the lack of up-front fees, while the growth of the industry in Poland was prompted by the approval of the “Belka tax,” a tax on bank deposits that caused a sharp shift of retail funds away from the banking system. These funds were initially allocated to fixed income mutual funds, and more recently to equity and hybrid funds.

Latin America’s mutual funds industry is the second largest in emerging markets after Asia, with net assets of $221 billion. Of this amount, Brazil’s mutual funds represent $172 billion (or 78 percent) of total net assets, with 59 percent of this amount allocated to bond funds (Table 2B). The mutual fund industry in Mexico has grown relatively quickly, despite lasting scars from the peso crisis in the mid-1990s. During 2000–03, the total net assets of Mexico’s mutual funds grew rapidly and have predominantly been invested in fixed income instruments (Figure 6).11 Similarly, mutual funds in Colombia have concentrated exclusively on fixed-income instruments, concentrated in medium- and long-term government bonds.12

Figure 6
Figure 6

Mexico: Net Asset Values by Fund Type

(In percent of GDP)

Citation: IMF Working Papers 2004, 133; 10.5089/9781451855524.001.A001

Sources: FundPro and WEO* NAV as at end-June 2003

IV. Dedicated and Crossover funds in Mature Markets

An important development in changes to the emerging market investor base has been the ascendancy of “crossover” relative to “dedicated” investors (Figure 7).13 The difficulty arises, however, in the definition of “dedicated” versus “crossover” investors for emerging markets. Broadly defined, a dedicated investor is one whose performance is measured against an emerging markets asset benchmarks, such as the Emerging Markets Bond Index (EMBI) or the Morgan Stanley Capital International (MSCI) indices. Crossover investors are the main institutional investors in instruments such as investment-grade debt and mature market high-yield securities. They tend to invest in emerging market assets to improve returns, and are thus more opportunistic. Crossover accounts tend to move in and out of a particular asset class, while dedicated investors usually reallocate within the asset class.

Figure 7
Figure 7

Emerging Markets Investor Class

(In percent)

Citation: IMF Working Papers 2004, 133; 10.5089/9781451855524.001.A001

Source: PIMCO

Traditionally, the categories of crossover equity investors include global equity funds (which invest primarily in equity securities traded worldwide, including U.S. companies) and international equity funds (which invest primarily in equity securities of companies located outside United States). Dedicated equity funds include emerging market funds (which invest primarily in companies based in developing markets around the world). Meanwhile, regional equity funds (which invest in companies based in a specific part of the world, and may comprise both mature and emerging markets), could represent either dedicated or crossover accounts, albeit more benchmark indices are available for the former.14 Within the fixed income universe, crossover investors include global bond funds (which invest in debt securities worldwide, and may invest up to 25 percent of assets in companies located in United States) and international bond funds (which must invest at least two-thirds of the portfolio outside United States). Emerging market bond funds invest primarily in the debt of less-developed regions.

The improving credit quality in emerging markets, as evidenced by the numerous credit upgrades in 2003, has instilled confidence in traditional high-grade crossover investors. For instance, recent institutional mandates to invest in emerging debt are widely considered a stable source of funds, as they are generally seen as longer-term, strategic allocation decisions. As more emerging market sovereigns receive an investment grade rating over time, and an increased proportion of global investment portfolios are committed to these countries which are included in core benchmarks, capital flows to these countries are expected to become less volatile. Already, more than 40 percent of the Emerging Markets Bond Index Global (EMBIG) is represented by investment grade issuers.

Overall, institutional inflows are viewed as a more stable source of assets under management, compared to the retail flows which have been fuelling the growth of emerging market bond funds over the past year. The less sophisticated retail investors are seen to be more likely to pull out their investments quickly during a market event. For instance, most European institutional investors are said to prefer to follow buy-and-hold strategies unless their views on a country turn excessively negative. Additionally, the large size of some portfolios, high transaction costs and lack of liquidity in emerging markets prevent excessive trading, and practically ensure that fund managers adopt a buy-and-hold approach, which sometimes makes tactical asset allocations in emerging markets rather difficult.15

The stability of the crossover base for emerging market assets remains uncertain, as it has yet to be tested by a major market shock in recent years, following the emerging market crisis of 1997–98. While analysts have noted that the increase in crossover investors has corresponded with increased market volatility, these investors tend to buy and hold assets despite their display of opportunistic behavior vis-à-vis emerging market assets. This is evidenced by their support for Brazilian assets after the 2002 crisis.

Given the size of the mutual funds industry in mature markets, relative to the emerging countries, it is not surprising that asset allocations by the former into the latter have been of some concern for policymakers. Notably, the potential for these mature market mutual funds to exacerbate market volatility, in the event of a market shock, may be significant.

U.S. crossover funds in both equity and debt asset classes have clearly benefited from new net flows from retail investors in 2003 (Figure 8). On balance, equity funds have been more attractive, compared to bond funds, with international equity funds in receipt of net cash inflows of almost $14 billion for the year, while dedicated emerging markets equity accounts posted net inflows of almost $5 billion. The size of international-type equity mutual funds in United States was 17 times that of debt mutual funds in 2002.

Figure 8
Figure 8

U.S. Mutual Funds: Retail Net Flows

(In billions of US dollars)

Citation: IMF Working Papers 2004, 133; 10.5089/9781451855524.001.A001

Source: AMG

Indeed, allocations to mutual funds with the mandate to invest in equities outside of United States are not insignificant. In 2003, the total net assets of all (long-term) U.S. crossover and dedicated emerging market funds amounted to $518 billion out of the $3.7 trillion in all equity funds, or about 14 percent.

Dedicated investors have 100 percent allocation to emerging market securities, so that the total net assets of dedicated investors in emerging markets in a particular country k could be calculated as:

(1)AD,k,t=i=1n1Di,k,t ,

where AD,k,t is the total net assets allocated by dedicated equity funds in country k to emerging market equities at time t, and Di,k,t is the net assets in a particular dedicated equity fund i in country k at time t.

Investments by crossover equity funds are less clear. In order to estimate the amount of crossover funds allocated to emerging market equities, we estimate the following:

(2)AC,k,t=i=1nαi,tCi,k,t ,

where AC,k,,t is the total net assets allocated by a crossover equity fund in country k to emerging market equities at time t, Ci,k,t is the net assets in a crossover equity fund i in country k at period t and ai,t is the weighting assigned to emerging market equities in the corresponding Morgan Stanley Capital International All-Country (MSCI AC) index at time t.16 Thus, the total net assets allocated to emerging market equities in period t, AT,t, in country k could be estimated as:

(3)AT,k,t=AD,k,t+AC,k,t .

Despite the large amount allocated to overseas assets, dedicated emerging market equity accounts held by U.S. funds only represented an estimated $19.7 billion in 2003—around 0.5 percent of all equity mutual funds in United States or 3.8 percent of all funds assigned to portfolios which invest internationally. For the crossover class of investors, a weighting of 4.9 percent was assigned to emerging markets as a whole in the ACWI, which suggests that some $10 billion of the $203.5 billion in crossover global funds were allocated to emerging markets, based on equation (2). Further, using weightings from the ACWI ex-U.S. for crossover international and regional equity funds, an estimated 11.4 percent from these funds was assigned to emerging markets at the end of 2003 (Table 3, first panel). This translates to another allocation of $33.6 billion to emerging markets. In other words, investments by U.S. crossover (global, international and regional) funds in emerging equity markets would have totaled $43.5 billion in 2003, per equation (3), making them the more important investor base in emerging markets.

TABLE 3

US World Mutual Funds: Estimated Allocation to Emerging Markets

(In billions of U.S. dollars)

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Sources: Bank for International Settlements, Investment Company Institute, MSCI, World Federation of Exchanges, various stock exchanges, IMF staff estimates

Weightings calculated based on MSCI ACWI weights ex-U.S.