A recurrent theme in the fast-growing literature on financial contagion is contagion through portfolio reallocations unrelated to “fundamental” factors, that is, factors that determine the value of an asset. In this literature, the behavior of investors who choose to adjust their exposure to a particular asset in response to new information unrelated to asset fundamentals may or may not be fully rational.1 The environments where such response may be rational include the ones where investors act strategically, taking into account the actions of other market participants, or where investors act as price takers, but are subject to portfolio constraints that create links between their positions in the fundamentally unrelated markets. The latter will be the focus of this paper.2
The objective of this paper is twofold:
(1) To analyze optimal portfolio rebalancing by a fund manager in response to a “volatility shock” in one of the asset markets, under sufficiently realistic assumptions about the fund manager’s performance criteria and portfolio constraints; and
(2) To analyze how the composition of the investor base determines the sensitivity of equilibrium asset prices to a shock originating in one of the fundamentally unrelated asset markets.
Why are these issues important? First, when regulators design investment guidelines for mutual funds, pension funds, and insurance companies, their first priority is investor protection; the potential impact of these guidelines on the portfolio allocation decisions of institutional investors and, in turn, on asset price dynamics are rarely taken into account. Second, in less liquid markets (including most emerging markets) and, particularly, in those where foreign institutional investors account for a large share of asset holdings and turnover, portfolio rebalancing by large investors in response to local and external shocks may have significant implications for asset price movements. Thus, a better understanding of the role played by different types of institutional investors in propagating shocks across asset markets is critical to understanding the extent to which assets prices, particularly in emerging markets, may be driven by factors unrelated to asset fundamentals.
Over the past decade, the participation of foreign institutional investors in emerging debt and equity markets increased dramatically, driven by the capital account liberalization and improved credit fundamentals in many emerging market (EM) countries, as well as by the relaxation of investment restrictions for institutional investors in mature market (MM) countries. Figures 1 and 2 show the shares of EM equity and debt instruments held by foreign investors in selected EM countries.
Virtually all types of foreign institutional investors (mutual funds, pension funds, hedge funds, and proprietary trading desks of major investment banks) are present in emerging securities markets. Although it is difficult to find a comprehensive data source on foreign holdings of EM securities, it is possible to gauge the proportions of the main types of foreign institutional investors in EMs by looking at the client base of major investment banks. For instance, based on JPMorgan’s client survey of foreign investors in emerging debt markets (EDMs),3 the proportion of crossover investors and trading accounts has declined in the past five years from about 50 percent to 30 percent, whereas the share of dedicated EM investors has increased (as local investors in EM domestic debt securities were added to the survey at the end of 2003) (see Figure 3).4
Dedicated investors’ allocations to the EM asset class are generally viewed as more stable (“sticky”) than those of crossover investors and trading accounts. This is because the latter are typically not benchmarked against an EM index, and their investment decisions tend to be more sensitive to the developments in competing asset classes. For example, the U.S. high-grade/high-yield funds may change their EM allocations in response to developments in the U.S. corporate bond market. However, a larger share of dedicated investors in the foreign investor base for a particular EM does not necessarily imply that foreign holdings of securities in that particular EM would be more stable. This paper, for example, shows that excessive price volatility unrelated to fundamentals in a particular asset market can be generated by the portfolio reallocations of dedicated fund managers that are subject to multiple portfolio constraints.
Various strands of the contagion literature study the implications of institutional differences between investors for the “transmission” of shocks across asset markets. Papers by Schinasi and Smith (2000) and Calvo and Mendoza (2000) analyze contagion in the context of a single-investor decision problem. On the other hand, Kodres and Pritsker (2002); Kyle and Xiong (2001); and Danielsson, Shin, and Zigrand (2004) study the impact of portfolio reallocations by different types of investors on price dynamics in a general equilibrium framework. Instead of presenting a comprehensive overview of the literature on financial contagion, the rest of this section will focus on the discussion of the papers that are most closely related to the exercise presented here.
Schinasi and Smith (2000) study the optimal portfolio rebalancing in response to two types of shocks—an increase in volatility in one of the asset markets (“volatility event”) and a capital loss (“capital event”). They consider different portfolio management rules within a partial equilibrium mean-variance framework, allowing portfolio managers to take both long and short positions (no short-sale constraints). They find that only in the case of a positive covariance between asset returns does a volatility event in one asset market lead to an adjustment of positions in other assets.5 Furthermore, a leveraged investor always reduces risky asset positions when the return on the leveraged portfolio falls below the cost of funding. In this paper, we consider a broader class of portfolio management rules, including rules where the portfolio managers’ compensation is explicitly linked to the performance of a benchmark index and where fund managers may be subject to short-sale constraints. In contrast with Schinasi and Smith (2000), in this paper asset values are assumed to be uncorrelated, so that any possible contagion effects cannot be attributed to “fundamental” links between asset markets.
Calvo and Mendoza (2000) study the implications of institutional restrictions (in particular, the short-sale constraint) on investors’ incentives to gather costly information and take positions based on their private information, as opposed to imitating arbitrary market portfolios. They find that, in the presence of short-sale constraints, the gains from acquiring information at a fixed cost may diminish as markets grow (that is, as the number of assets increases). In this paper, the analysis is focused on what happens when the short-sale constraint is combined with other institutional restrictions, such as the benchmark-linked performance criterion, and whether this can create an additional transmission mechanism for contagion through portfolio rebalancing.
Danielsson, Shin, and Zigrand (2004) investigate the implications of the widespread adoption of value-at-risk (VaR) risk management techniques on asset price dynamics in a general equilibrium framework. A comparison of the simulated dynamics of asset prices with the use of VaR techniques against the asset price dynamics without VaR reveals that (1) prices are lower with VaR constraints, (2) troughs in the price paths with VaR constraints following a negative shock are deeper and longer, and (3) the variance of returns is larger with VaR constraints than without them.6 These results raise more general concerns that the widespread use of certain combinations of portfolio constraints (including those that restrict the fund manager’s portfolio choices in the interests of investor protection) may have a systematic negative impact on asset price dynamics.
The not-fully-rational behavior is often referred to as “herding” or “following the market.” See, for example, Bikhchandani and Sharma (2000) and Kaminsky and Reinhart (2000) for a review of different approaches toward modeling herding in financial markets.
EDM is the market for the dollar-or euro-denominated Eurobonds issued by the EM sovereigns and corporates.
The term “dedicated EM investor” typically refers to an asset manager who has a mandate to invest exclusively in EM securities. Such an investor is usually benchmarked against an EM index (that is, investor performance is measured relative to the performance of an EM benchmark portfolio). The term “crossover investor” typically refers to an asset manager who does not have an EM-specific mandate, but can invest in the EM securities that are part of the asset class that is specified in his or her investment mandate (equity or fixed income). Such an investor may or may not be benchmarked against an index that includes EM assets. (For instance, for the U.S. high-grade or U.S. high-yield bond fund manager, the EM dollar-denominated bond exposure represents an “out-of-index” bet; such investors would typically cross over into EMs to pick up yield.)
Schinasi and Smith argue that this is the most relevant case because asset returns are generally positively correlated across countries.
The VaR-based rules may not be “worse” than other portfolio rules in terms of their impact on the asset price dynamics. In the partial equilibrium framework, VaR rules do not seem to produce portfolio rebalancing dynamics that are very different from a variety of other portfolio management rules (see Schinasi and Smith, 2000).
An extensive literature on delegated portfolio management explores various ways in which the incentives of fund managers can be aligned with the preferences of end investors (under different assumptions about risk aversion and information asymmetries). The detailed discussion of these issues is beyond the scope of this paper. In what follows, the analysis will focus on the rules and restrictions that are standard in the finance literature, and no distinction will be made between “investors” and “fund managers.”
However, with the recent regulatory changes in the asset management industry, the boundaries between mutual funds and hedge funds are beginning to blur. For example, in the United States, the decision by Congress to repeal the short-sale restriction for mutual funds in 1997 and the Securities and Exchange Commission’s decision to expand the allowable securities list for mutual funds led to the appearance of the first long-short mutual funds in 1998. Some of these “next generation” mutual funds are also reportedly using limited leverage and limited incentive fees, and are commonly referred to as “hedged mutual funds” (HMFs). According to industry experts, assets under the management of HMFs grew from $2.4 billion in 1998 to about $6 billion in 2002, which was still a very small fraction of U.S. mutual fund industry assets (around $4 trillion, as of end-2002).
The commonly used EM benchmark indices are the JPMorgan Emerging Market Bond Indices for EM bonds and the Morgan Stanley Capital International (MSCI) Emerging Market Indices for EM equities.
According to the International Organization of Securities Commissions report (IOSCO, 2004), “Passive management encompasses benchmark funds, which follow some indices with a very tight tracking error.”
This may not be the case for other types of shocks. for instance, Schinasi and Smith (2000) show that leveraged risk-averse investors tend to scale back their risky asset exposures in response to a “capital event” (capital loss).
All proofs are in the Appendix.
The proof of Proposition 2 is similar to that of Proposition 1.