Viewpoint The World Bank Group September 1996 Note No.89 Portfolio Investment Funds Assessing the Impact on Emerging Markets Teresa Barger, The portfolio funds industry in emerging markets is roughly ten years old. By 1995, the industry had Laurend e Craner grown to more than US$100 billion managed through 1,300 funds, and represented about half the for- and Irlving Kuczynski eign capital flows to emerging markets. Although portfolio funds account for only about 5 percent of the capitalization of emerging stock markets, they have been responsible for kick starting the develop- ment of many of these markets. And contrary to common perceptions, the main beneficiaries of this growth have been the local firms and investors who hold about 90 percent of emerging market stocks. Where developing country stock markets existed stocks, low turnover, a weak regulatory and in- ten years ago, they were characterized by small stitutional environment for investors (poor ac- capitalization relative to GDP, relatively few listed counting standards, little research, weak investor protection, few brokers), and restrictions on for- eign entry and on capital and dividend repatria- TABLEI IFC INVESTMENTS-OPENING MARKETS TO FOREIGN tion. Much has changed. The number of stock PORTFOLIO INVEST-MEhT markets, the number of listed firms, market capi- POaTFOLIO INVatTMENT talization, and turnover have all grown dramati- CapitalizatioV . cally over the past decade, particularly since 1990. (US$n illions) Emerging market capitalization increased more IFC Country Dec. than tenfold between 1985 and 1994, from US$170 approval or region Fund Initial 1995 billion to nearly US$2 trillion. Such countries as Bangladesh, Ecuador, Namibia, Swaziland, and 1984 Korea, Rep. of Korea Fund 60 747 Zambia and many transition economies have set 1986 Global Emerging Markets Growth Fund 50 5,571 up stock markets during the past five years. By 1986 Thailand Thailand Fund 3 the end of 1994, there were 17,000 firms listed on emerging stock markets-almost as many as 1987 Malaysia Malaysia Fund Inc. 84 181 on markets in industrial countries. 1989 Latin Amenrica New World nvestment Fund 62 233 1989 Philippines Manila Fund Inc. 50 51 Birth of an industry 1989 Turkey Turkish Investment Fund Inc. 24 32 1990 Chile Five Arrows Chile Fund 75 347 The development of foreign portfolio investment 1996 Portugal Portuguese Investment Fund 30 24 funds has been a prime mover in this explosion 1992 Mauritius Mautitius Fund 1 7 28 in stock market growth. The International Fi- 1992 Mauritius Mauritius Fund 17 2 nance Corporation (IFC) has played a key role 1993 Africa Africa Emerging Markets Fund 30 64 in creating the portfolio funds industry in emerg- 1994 Middle East Emerging Middle East Fund 40 36 ing markets (see table 1 for countries or regions where IFC cosponsored the first foreign invest- Somee:lFC. ment vehicles; also see box 1). Its involvement goes back to the late 1970s, when, after identi- International Finance Corporation - Vice Presidency for Finance and Private Sector Development Portfolio Investment Funds-Assessing the Impact on Emerging Markets The Korea and Mexico Funds, started in the early govrnmnt efoa iititivs~ nd nvetorintres hameattht 980s, marked the beginning of the portfolio IFO' fud prmoton ffors hve eoke diferetlyin dffeentequity industry in emerging markets. Interest was countries. Often, lEC will develop aluniYs concept'structure1befmdquickly kindled in other countries, and initial efecit its nrnnagers,dfine-itspoliiesan4inves-'m-nifiocui -ndfunds quickly drew in others. For example, two mohiizeaworld-class rmdenivriting group. And eftenit will move in years after the Malaysia Fund's launch in 1987, advnceof riateiniiatve, bcaue arkts arey xis orrethe country had attracted eight other funds, which raised US$600 million. At the end of 1991, hestan o beaus tereis o oca plye tointodce ew rouct,lust seven years after the launch of the Korea IFCsfistnvetinntaste ore Fud n 154 ByJun ISSSFCFund, there were nearly 300 funds-managing bad committed lJS0i8 mllliontathirty-one funds, whoetal su8 at US$20 billion-targeting emerging markets. ineto wa US21 iu 3 blion Aitpmoe fud in oe cun-t tresFlG hsbetrgtoaradragoinetrshuhtsBefore long, most policymakers in emerging underwriting and placement effors. IE also uses itsunderwritingmarkets had relaxed their attitudes and were 0.andplacemt capacity to generate keen to move beyond the closed-end vehicles demonstrtion effcts useand attract a variety of portfolio funds. As inter- value exceeds the mo-eyraisedfatthefuhd. national investment banks and asset managers A sampl of .EG's portfolio-covering a reasonable investmentbecame willing to enter the emerging market volume jea-nd numbof fundsuan several years of experience- funds business, IFC scaled back its activities, suggst~ hat he aeragz43prcen nomnal ate f reurnshifting to the promotion of funds targeting stock e n G i n p markets untouched by foreign portfolio invest- of this assetclns..s..... ment-especially in Africa and the Middle East. i-- iiiiiconsistently -g'ood-performanc3eii-of*:'l's-ja-"e, ''IFC's board approved investments in the Africa E-0, ~~~~~~~~Fund and the Mauritius Fund in 1993. And in fying regulatory barriers as the key constraint to October 1994, it approved an investment in the stock market growth, IFC began working with a Emerging Middle East Fund, the first publicly few interested governments to amend these offered New York-listed investment fund cov- regulations and identify potential investors and ering markets in the region. The US$40 million fund managers. IFC's Emerging Markets Data fund, the first in the region to be listed on a Base, set up around this time, was an important major international market, is initially focusing lubricant in the process. For the first time, in- on Egypt, Israel, Jordan, Morocco, Oman, and vestors could get a comparative picture of the Tunisia. investment environment and stock market re- turns in different countries. While all this was a revolution waiting to hap- pen, the speed with which it happened caught But the birth of the early funds was not easy. For most observers by surprise. Several currents hap- example, IFC started work in 1977 on the con- pened to coincide. Privatization increased the cept of the Emerging Markets Growth Fund, the supply of assets for investors to buy. A few gov- first global fund targeting developing countries. ernments started to promote private pension This fund had a nine-year gestation, not coming funds and domestic mutual funds to raise na- to closure until mid-1986. Initially, some govern- tional savings rates. In transition economies, the ments were persuaded to open up to closed-end combination of many new private firms, dis- country funds, because these funds seemed to tressed banking sectors, and voucher privatiza- overcome the two main concerns of host gov- tion led to big opportunities for portfolio funds. ernments: foreign control of domestic firms and improved telecommunications and financial in- destabilizing, "hot" money flows. Closed-end novation made it easier to invest. And now, as funds raise a fixed sum and then close the share- the industry has become more competitive, the holder group. Structured as finite pools owned market's response to the introduction of suc- by multiple investors and aiming for diverse port- cessful new fund vehicles has accelerated-as folios, these closed-end portfolio country funds illustrated by the growth of the passively man- seemed to pose little threat. aged "index" fund industry in emerging mar- FIGURE 1 FUND MANAGERS DRIVE INSTITUTIONAL DEVELOPMENT kets. By late 1995, less than two years after the mnavestors and fund inception of the first index fund, the indexed managers demand: emerging market funds had surged to more than Entorcement Regulatory US$4 billion, a twentyfold increase over 1994. agency is (Roughly 75 percent of emerging market index strengthened funds are now using IFC's Emerging Markets Custody and Custodians Funds Data Base indexes.) transfer agents spring up Beter o Accounting The catalytic effect ~~~~~~~~~~ ~ ~~~~~~~~disclosure standards The catalytic effect | | i | g i improve Better Research In many markets, relatively small amounts of information improves foreign capital have been enough to act as a Lower i Brokers catalyst (box 2). For example, although the first transaction become more country funds in Malaysia, the Republic of Ko- costs competitive rea, and Thailand each raised less than 1 per- Better price Market cent of the host market's capitalization at the disnovery transactions time, they had a big effect on the financial and institutional development of these markets. A recent review of size, liquidity, pricing, and in- Market attracts small Trust in market increases, and receutiont l eview investors and savers market functions more efficiently stitutional development measures in eleven de- veloping economies where country funds opened the market found significant increases in most of these measures.' BOX 2 THLE MAURITIUS FUND How have relatively small infusions of foreign The closed-end Mauritius Fund, launed in 19S3, offered the first capital through funds so successfully stimulated the development of emerging markets? Foreign opportunityforinternationalportfolioinvestorstobuyMauritian entry typically has set off two parallel virtuous securities. This fund played a pivotal role in a wider government cycles. First, an institutional development cycle strategy to promote securities markets and open capital markets to (figure 1). International investors-and, by foreign investors. proxy, the managers of their funds--demand FC took a 17 percent stake in the fund, helped refine the structure, high standards in regulation and information. Spurred by the prospect of new investment, an laced part oftheund with otherinvestors.ilnvestorsinthefund market regulators often undertake reforms as were given a year's exclusive access. Institutional investors part of the opening-up process. In addition, fund subscribed US$17.3 milion. The funds impact together with the managers require local services, such as brokers, government's liberalization strategy, has led to dramatic growth in custody and transfer agents, and information on the size, liquidity, and breadth of the market (see table). local companies. In response to this demand, local providers spring up, competition increases, MAURITIUS-STOCK MARKET INDICATORS and standards improve. Although these changes Iatr DICATORS are driven initially by foreign investment, the Indicator December1992 December1994 benefits of more market intermediaries and a Number of companies 22 35 more transparent, efficient market accrue to all Market capitalization (US$ millions) 416 1,514 players. As trust in the market improves, more local investors and firms enter the market- attracting more funds and encouraging the de- Turnover ratio (percent) 2.9 7 velopment of local fund managers. Market index 183 474 Price-eamings ratio 11.6 1BA Second, a cycle of financial broadening and deepening. Although the inflows of foreign funds Source: IFC. may be small relative to the market, they often Portfolio Investment Funds-Assessing the Impact on Emerging Markets have a significant effect on trading activity. Stock or new equity issues) than do enterprises in in- prices rise in response to the extra demand. dustrial economies.2 Stock markets remain places Higher price-earnings ratios reduce firms' cost where local firms raise equity overwhelmingly of raising equity, with dramatic effects. The from local investors. Adding in other foreign higher ratios encourage listed firms to raise more capital (for example, direct equity holdings) capital from the market, and new firms to enter brings the estimated foreign portfolio capital in- the market through initial public offerings. The vested in emerging markets at the end of 1994 larger, more liquid market attracts more foreign to about US$200 billion-still only about 10 and domestic investors. New percent of their total capi- investors emerge-domestic T -- ----- talization. Thus, with about insurance companies, pen- F E 90 percent of emerging mar- sion funds, mutual funds, ket capitalization, local in- LOAINVEST _OR OWNl-- and individuals. More inter- vestors have been the main mediaries-brokers, under- 0 P C OF E beneficiaries of the recent writers, custodians-enter Eme w'-k 'ca 't"liati'.' growth (figure 2). the market to meet the de- M I ... Fl mand from the larger num- -,, ,ill The benefits of more, ber of investors and firms. 2 deeper, and broader stock As market liquidity and effi- markets in developing coun- ciency increase, more firms 1 tries reach many more firms issue stock, including "sec- than those that tap the mar- The Note series is an ond-tier" companies that 1 kets directly. Liquid stock open forum intended is openfourage dissemina previously would not have markets drawing on large tion of and debate on considered a public listing. 2- 0 numbers of savers and in- ideas, innvaions,and The key element in this vir- vestors improve exit oppor- best practices far expanding the private tuous cycle is liquidlity: im- FrTn Lcltnte o nrpeer sector. The views proved market liquidity for Sonw- - . and investors. Initial public published are those of existing securities (the sec- offerings provide firms the suthors and shouldmakt not be attributed to the ondary market) encourages owners and private equity World Bank or any of its more new stock issues by listed firms and initial investors the opportunity to realize high returns. affiliated organizations. public offerings by firms new to the market (the That encourages more entrepreneurs to start Nor do any of the con- clusions represent primary market). firms and more investors to provide funds for official policy of the investment through venture capital funds and World Bank or of its Conclusion larger private equity vehicles. The greater avail- Executive Directors or the countries they ability of private equity improves access to such represent. While foreign portfolio funds were not the only finance for growing, investing firms. factor in jump-starting the growth in emerging To order additional copies please call the stock markets over the past decade, they clearly This Note and the data in it are drawn from the InternationaL Finance FPD Note line to leave a have catalytic effects far beyond the money they Corporation, Investment Funds in Emerging Mnarkets (Washington, message (202-458-tlll) mobilize. They help to put countries "on the D.C., 1996). or contact Suzanne I Ross Levine and Sara Zervos, '¶lntern-ational CapitaltFlow Lbheraliza- Smith, editor, Room map" for emerging market investors, and in- Xon and stock Market Development" (World Bank, Policy Research G8105, The World Bank, crease the amount and quality of research on Department, Washington, D.C., 1994). The economies reviewed 1818 H Street, NW, these markets. And by improving the price-earn- wvere Brazil, Chile, India, Malaysia, Mexico, the Philippines, Portu- Washington, D.C. 20433, r l a p e of gal, the Republic of Korea, Thailand, Turkey, and Taiwan (China). Or Internet address ings ratios, liquidity, and pricng efficiency of Ajit Singh, 'Corporate Financial Patterns in Industrializing Econo- ssmith7tfworldbank.org. domestic markets, they improve firms' access mies: A Comparative International Study" (IFC Technical Paper 2, Previous issues are also to all equity capital in emerging markets-criti- Intemational Finance Corporation, Washington, D.C., 1995). available on-line lhttp:// www.worldbank.org/ cal for busmess growth in developing econo- html/fpd/notes/ mies. IFC research shows that, contrary to Teresa Barger, Capital Markets, Laurence notelist.html). common perceptions, large firms in developing Carter, Corporate Planning Department (email: ®Printed on recycled countries finance more investment from exter- Icarter@ifc.org), and Irving Kuczynski, Finan- paper. nal sources (through borrowing, private equity, cial Sector Issues, IFC