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What Lies Underneath? Portfolio Flows to Emerging Markets and Benchmark-Driven Investors

What drives cross-border portfolio flows to emerging markets? In our recent research, we focus on the role of benchmarks, which can trigger correlated portfolio flows, connecting countries that might otherwise be disconnected through country fundamentals. We attempt to quantify the size of benchmark-driven investors in EM local-currency bond markets, including its variation across time and countries.

Who Are Benchmark Driven Investors?

Foreign investors held about a trillion dollars of emerging market (EM) government debt by the end of 2015. According to our estimates, most of these investments—80% of the total—were intermediated through foreign nonbanks (i.e. global asset managers), while the rest belonged to foreign banks and foreign central banks.

Among foreign nonbank investors, we distinguish between two types of foreign investments in EM local-currency bond markets: benchmark-driven and unconstrained. We define benchmark-driven investors as those that invest in countries through a fund that either tracks or closely follows a flagship benchmark index. In the case of EM local-currency bond markets. that benchmark is usually the J.P. Morgan Government Bond Index-Emerging Markets (GBI-EM), which has a predefined list of countries and securities, but not the only one. In contrast, unconstrained investors are those that can invest in countries without being restricted by index considerations.

This differentiation of the investor base is somewhat different from the distinction between passive and active funds, or retail and institutional investors. In particular, our definition of benchmark-driven investors can include “passive,” “closet-index,” or “weakly active” funds. Similarly, it can include retail or institutional investors, depending on the investment mandate of portfolio managers.

An important advantage of looking at the investor base through this lens is that it allows us to decompose fluctuations in portfolio flows into a common factor (common across all counties) and a country-specific factor. It also allows us to think about different risk exposures. On the one hand, benchmark-driven investors could be seen as a stable source of funding, as they bring in capital solely because funds tracking the index have to make room in their portfolios for the country in the index. At the same time, benchmark-driven investment strategies could be a source of vulnerability to the extent that they introduce a high degree of similarity in the behaviour of asset managers investing in EMs. In particular, they can expose countries to correlated portfolio flows, regardless of country fundamentals, and raise their sensitivity to global risk sentiment.

We use the following three approaches to estimate the pool of benchmark-driven investors. First, we examine surveys that gauge the amount of assets under management tracking key benchmark indices. According to the J.P. Morgan survey, around $202bn of assets were managed against the GBI-EM suite of indices as of end-2015. Second, we conduct event studies with three countries (Colombia, Peru, and Romania) and detect foreign inflows stemming from their inclusion in benchmark indices, and infer the asset held by benchmark-driven investors. Overall, these event studies suggest that the pool of benchmark-driven investors is around $227bn, if we take the average of the three studies.  Third, we conduct an empirical study to decompose foreign holdings of EM local-currency bonds into benchmark-driven and unconstrained ones. Overall, this approach generates an estimate of benchmark-driven investors at around $200bn by the end of 2015.

To summarize, we find that benchmark-driven investors represented a significant portion of EM local bond investors at end-2015: $200–$230bn, or more than a third of total foreign holdings of $600bn.

How Do They Behave in The Post Taper Tantrum Era?

The composition of benchmark-driven and unconstrained investors varied over time and across countries during January 2010–June 2015 provides the country-specific time series (Figure 2). At its peak—just before the taper tantrum—benchmark-driven investors accounted for close to half of total foreign holdings in EMs. Moreover, for some countries, such as Colombia, Peru, and Romania, they still represent the bulk of the foreign investor base.

The prominence of these investors grew until it reached a peak before the May 2013 taper tantrum. It appears that the taper tantrum was an important milestone in the risk sentiment towards EMs, at least for benchmark-driven investors. A possible explanation is that the impact of exchange rate volatility became more important for these investors after May 2013, when they realized that the Federal Reserve may reduce the scale of its asset purchases sooner than previously. As a result, investors may have turned from broad asset allocation strategies to country selection. This is in line with studies that show that EM investors have since become more differentiating. Nevertheless, given their size, benchmark-driven investors are still likely to play an important role in driving portfolio flows to emerging markets, especially in countries where they have a large presence.

Going forward…

What we find above is highly relevant to the current market landscape. High correlation of EM portfolio flows could amplify the magnitude of a country-specific shock, potentially shaking global financial stability. A series of recent shock events, such as China’s stock market bubble, the Brexit referendum, and geopolitical events, could be propagated through investment behaviour of benchmark-driven investors. With the world’s largest central banks adopting stronger easing policies and new pockets of liquidity searching for yield in EMs, it is worthwhile watching this space even more closely.

Global Macro Currencies