Benchmark Blues. (allocation of capital in global emerging markets).

Agency problems in the construction of global emerging market benchmarks and the allocation of global capital.

It is well known that the ratio of "Buy" recommendations to "Sell" recommendations proposed by Wall Street security analysts is at least 95 to 5. This phenomenon arises in part because of a classic incentive mismatch problem: The incentive structure of sell-side analysts does not neatly coincide with the interests of their clients. Two and a half trillion dollars in losses since March 2000 give investors additional cause to ponder this phenomenon.

What is perhaps less well known is that behavioral factors may influence the construction of benchmarks used by global equity investors. Changes in benchmarks frequently drive global institutional equity capital flows. A poorly constructed benchmark can do a disservice to investors and to a stable, well-functioning global capital market.

What is a benchmark? A benchmark plays many roles: a default holding in the absence of information; a proxy for an asset class; and a performance target for active portfolio managers. Suppose you are a Japanese equity investor. You believe that markets are reasonably efficient, that you have no special information, and that active managers will have a difficult time outperforming the market portfolio over time. Thus, you wish to hold the U.S. market. But what is the U.S. market? The S&P 500? The Wilshire 5000? Or the Russell 3000? Each of these potential benchmarks has different structural characteristics and implications for the investor's ultimate portfolio.

The benchmark serves not only as a proxy for the asset class, but also as a performance target for active managers. An investor can generally obtain the systematic return of an asset class through indexing--passive management. The decision to invest in an asset class--say emerging markets--is distinct from the decision to hire an active manager.

The Capital Asset Pricing Model, still a robust theory after all these years, suggests that investors are rational and that the market portfolio is the most efficient, that is, provides the highest rate of expected return for a given level of anticipated risk. Many financial economists likewise agree that the world market portfolio is the most efficient over the long term. Equity returns tend to revert to a global mean. For example, over the past thirty-one years in dollars, the Morgan Stanley Capital International (MSCI) Japan and Europe Indices and the S&P 500 have returned within 110 basis points of one another (about 12. 2 percent per annum compounded.) Despite this evidence, factors like home country bias, regulation, transaction costs, and information gaps all inhibit a world market weighting by major institutional investors. For example, by regulation, Canadian pension funds can invest only 30 percent of the book value of their assets abroad.

But whether the world market portfolio is in fact the truly efficient portfolio is not free from doubt. To begin with, as Richard Roll argued, the true market portfolio is unobservable. In addition, as Will Goetzmann and Phillipe Jorion observed, many global equity markets have suffered long periods of disruption--the Polish market under the Soviet occupation, for example. They pointed out that many emerging markets of today are in fact "re-emerging markets." As well, investors must take into account transaction costs, which today average about 130 basis points one way for an emerging markets investor. These and other phenomena led Goetzmann and Jorion to argue that: "The high equity premium obtained for U.S. equities therefore appears to be the exception rather than the rule." (The equity premium is the amount by which the return of stocks exceeds the return of bonds or cash.)

The definition of benchmarks is important because it shapes institutional investors' view of the feasible investment opportunity set. Benchmark inclusion sends a positive signal to investors, and investors make decisions based on benchmark information. For example, in general, benchmark providers characterize countries either as "developed" or "emerging." Some investors do not invest in emerging markets because they view them as too "risky."

Pension fund consultants and financial economists have attempted to define the properties of a desirable benchmark. A good benchmark must be complete (that is, include all investable assets); unbiased (that is, not skewed towards one sector or another); transparent in its construction methodology (think of this as the difference between rules-based and discretionary monetary policy); and representative of the investment manager's normal habitat. (One would not hire a U.S. small capitalization manager and measure him against a large capitalization benchmark.) But perhaps the most desirable characteristic in a good benchmark is investability; that is, the ability to replicate in practice, the return stream of a "paper" portfolio.

The construction of benchmarks is complex, highly labor/information intensive, and by definition, imprecise. By one measure, Japan's stock market comprises about 23 percent of the total capitalization of the Developed World ex-U.S. By another, adjusting for cross-holdings in Japan ("float" adjustment in the parlance of portfolio managers) reduces Japan's weight to roughly 18 percent.

The benchmark business is a dynamic industry, given the globalization of world pension flows. Competition among benchmark vendors has led to more transparent, more investable, and more robust representations of the world market. The payoffs to the benchmark providers--in the form of commissions on derivative contracts, licensing fees, corporate finance/underwriting business, and other revenue sources--are large. It is here that the incentive problem, and its implications for global financial stability, arise.

There are currently two major investable emerging market benchmarks: Standard and Poor's/International Finance Corporation Investable (S&P/IFCI) and the Morgan Stanley Capital International Emerging Markets Free (MSCI EMF.)

The following tables list the countries included in the MSCI EMF and S&P / IFCI indices as of 03/31/2001.

In the 1980's, the Capital Markets Division of the IFC undertook pathbreaking work in terms of establishing an emerging markets database and benchmark. This effort included defining and resolving complex methodological issues; what defines an emerging stock market; what stocks/industries to include; which countries meet prudential requirements; and so on.

At the same time the IFC played an important role in emerging market (a term coined in 1981) capital market development, including building institutions, advising on regulations, and providing databases. This substantive effort established a global metric for emerging markets investing and, on balance, provided significant benefits for the liberalizing countries. The IFC Emerging Markets Data Base was backfilled to 1975. IFC started weekly indexes at the end of 1988, and investable indexes in March 1993. Large-scale cross-border portfolio investment in emerging markets (in this iteration) was born. IFC has added several markets over the years.

As recent development economic literature has stressed, capital market development and, in particular, the avoidance of financial suppression are central to the economic development process. Thus, Bekaert and others found in a recent National Bureau of Economic Research paper that, if one examines economic growth in emerging markets before and after financial market liberalization, the results suggest that financial market liberalizations are associated with higher real growth.

But just as the incentive structure in the World Bank has been to make loans, so in the IFC Capital Markets Division the incentive was to add stock markets to the benchmark. In the 1960's, many LDCs (as they were then called) wanted their own steel mills and airlines; after the fall of the Berlin Wall, many want their own stock markets. This development is salutary for investors and countries alike, provided countries are not failed states and adopt minimally acceptable international norms of regulation, disclosure, corporate governance, and accounting--in short, the infrastructure to make the market work. To be sure, the IFC consulted with institutional investors about economic, financial, and regulatory conditions in prospective additions to the benchmark. But the final say rested with the IFC, a development finance institution. (IFC sold its indices to Standard and Poor's in January 2000.)

Are institutional investors--and ultimately the countries themselves--well served when institutionally weak and illiquid markets are added to the benchmark? Note that the combined capitalization of the Zimbabwean, Pakistani, Sri Lankan, and Slovakian markets is less than $3 billion. To sell a small position in a Pakistani stock, for example, takes a week; it may take a month to obtain dollar proceeds.

Admittedly, the potential systemic problems of recent years have risen in the larger benchmark markets. The addition of a small market to a benchmark does not necessarily lead to herding behavior. The experience of Russia in 1998, however, shows that an overshoot in a smaller market can have adverse global consequences.

Morgan Stanley Capital International is one of the world's major benchmark providers. Morgan Stanley, a related but operationally separate entity from MSCI, has played a major role in corporate finance activities in emerging markets. With the pace of global privatization/IPOs running in excess of $30 billion a year, there is ample incentive to do so.

Over the past thirty years, MSCI has developed a comprehensive methodology to measure and define both developed and emerging markets. According to Bloomberg, about 1,500 money managers use the MSCI Indices as benchmarks for about $4 trillion in investments. MSCI recently announced, after mulling the decision for several years, its intention float adjust its indices. This readjustment may trigger at least $300 billion in share transactions. Thirty years ago, when the MSCI Indices began, they were an intriguing piece of research. Today, with the rise of indexing and international investing, they are frequently a determinant of the allocation of cross border equity flows.

While the MSCI EMF includes fewer illiquid markets than the IFCI does, it still has representation in several small illiquid markets. An intriguing case in point took place when Malaysia imposed capital controls in November 1998. MSCI removed Malaysia from its benchmark shortly thereafter; however, soon after Malaysia lifted capital controls in May 2000, MSCI reinstated Malaysia into its EMF benchmark. While this action may or may not have been appropriate (capital controls are, after all, a systematic risk of emerging markets investing), many portfolio managers felt that the reinclusion of Malaysia was far too hasty. (Morgan Stanley did drop Malaysia from its developed market index, in which that country had, curiously, also been included.)

At the heart of the issue of benchmark construction is the tension between the tenets of the Capital Asset Pricing Model (own the world, all the known risks are adequately priced in), and real world definition, implementation and market structure issues. The possibility of misspecification of emerging market benchmarks is demonstrated by the fact that several large pension plans exclude on investability grounds some of the countries included in major benchmarks. With $13 trillion of pension assets worldwide (out of an investable global stock market capitalization of roughly $25 trillion), and given the growth of cross border investing, the issue of benchmark definition is not trivial.

Korea and Taiwan, for example, may graduate from emerging to developed status in the next five years. At that point, a whole new class of investors--indexed and active alike--will invest in these countries. Such a move will be carefully considered. But, even if commercial and behavioral influences will be negligible in the decision to graduate countries, the benchmark providers need to codify more systematically the combination of business, regulatory and political practices that define a developed market, and apply these to prospective graduating countries.

Behavioral Finance attacks CAPM's view of how the world works in terms of asset pricing. It posits that individuals are overconfident in their ability to forecast. Thus, the overly rapid inclusion of countries in benchmarks may increase the potential for market overshoots, by implying to investors that the necessary preconditions for investability are in place when in fact they aren't.

An interesting test case will be the treatment of Frontier Emerging Markets, markets that are in the embryonic phase. These markets are not included in current investable indices but, over time, can be expected to graduate to such status. S&P/IFCI calculates monthly returns for twenty Frontier Markets, including Bangladesh, Ecuador, Kenya, and Tunisia.

What needs to be done? The vendors of emerging markets benchmarks:

1) Need to take into account the systemic implications of their country/stock inclusion rules.

2) Drop from their current benchmarks small, illiquid markets/stocks that are effectively uninvestable and adopt a substantially higher and more objective liquidity test for benchmark inclusion. Market practice should guide their deliberations.

3) Adopt a more quantitative, comprehensive, transparent, rules-based system for defining country criteria for admission to developed and emerging benchmarks. Admittedly, quantitative metrics for factors like transparency and corporate governance are elusive, but not impossible to develop. A rules-based system would reduce the potential for agency problems and serve as an incentive for countries to accelerate their reform efforts.

4) Recognize that there are many non-economic factors that define developed markets, a functioning democratic multiparty state, civil society and the rule of law, to name a few. In point of fact, political scientists have made progress in developing quantitative tools to measure such phenomena.

In addition,

5) The International Financial Institutions, in promoting capital market development, should pay particular attention to helping countries develop adequate regulatory, corporate governance, accounting, and disclosure regimes. The World Bank and IMF need to intensify their efforts in this area. And, as Paul Volcker has argued, the gradual movement towards a global accounting standard is helpful.

6) The pace of capital market liberalization in some emerging markets should be carefully modulated. Each market must take into account the stage of its institutional, legal, regulatory, and capital market development.

The nub of the issue is whether benchmark providers have a responsibility to exercise a prudential function, or whether their function is simply to describe the world market. Ultimately investors shape prices; but for better or ill, benchmark descriptions can shape expectations.

Agency problems in investment management are not limited to benchmark providers. But a more carefully considered methodology by benchmark providers, and a more deliberate approach by countries and companies seeking to enter the major emerging market benchmarks, could modestly improve the prospects of avoiding some of the speculative excesses, and attendant hardships, of the past.

MORGAN STANLEY CAPITAL INTERNATIONAL
Market Capitalization Report - Emerging Markets Free

                                   No. of   Market Cap
                                  Cos. in     US $       % of EMF
31-MAR-2001                        Index     Billion      3/31/01

Asia

China                                30        57.5          6.1
India                                71        65.4          6.9
Indonesia                            35         7.3          0.8
Korea                                69        94.1         10.0
Malaysia                             74        62.5          6.6
Pakistan                             22         2.6          0.3
Philippines                          21         8.6          0.8
Sri Lanka                            10         0.3          0.0
Taiwan                               63       175.0        148.0
Thailand                             34        15.2          1.6

Latin America

Argentina                            17        15.4          1.6
Brazil                               47        94.0          9.9
Chile                                28        30.9          3.3
Colombia                             10         2.7          0.3
Mexico                               23        99.4         10.5
Peru                                  9         3.5          0.4
Venezuela                             7         4.4          0.5

Europe, Middle East, and Africa

Czech Republic                        6         5.9          0.6
Greece                               45        47.9          5.1
Hungary                              13         7.5          0.8
Israel                               44        40.5          4.3
Jordan                               10         1.3          1.0
Poland                               22        12.1          1.3
Russia                               11        21.9          2.3
South Africa                         45        89.1          9.4
Turkey                               39        15.9          1.7

Regions

Emerging Markets Free (EMF)         812       999.4
EMF Asia                            432       492.0
EMF Far East                        329       423.8
EMF Latin America                   145       265.3
S&P/INTERNATIONAL FINANCE CORPORATION
Market Capitalization Report - Investable Indices

                    No. of   Market Cap
                   Cos. in      US $      % of EMF
31-MAR-2001         Index     Billion      3/31/01

Latin America

Argentina              20        12.9         1.7
Brazil                 74        81.2        10.7
Chile                  33        28.0         3.7
Colombia                8         2.1         0.3
Mexico                 49        92.4        12.2
Peru                   16         4.5         0.6
Venezuela               5         2.3         0.3

Asia

China                  62        46.8         6.2
India                  84        18.3         2.4
Indonesia              37         7.5         1.0
Korea                 152        84.8        11.2
Malaysia              123        38.1         5.0
Pakistan               15         1.9         0.2
Philippines            26         7.2         0.9
Sri Lanka               5         .15         0.0
Taiwan,China           96        98.3        13.0
Thailand               43         7.8         1.0

Europe

Czech Republic          7         2.6         0.3
Greece                 66        45.2         6.0
Hungary                13         6.9         0.9
Poland                 31        13.6         1.8
Russia                  9        17.5         2.3
Slovakia                5         .27         0.0
Turkey                 58        21.1         2.8

Mideast/Africa

Egypt                  23         4.3         0.6
Israel                 45        27.8         3.1
Jordan                  5         1.5         0.2
Morocco                10         6.3         8.0
South Africa           67        80.8        10.6
Zimbabwe                5         .59         0.1

Regions

Composite           1,192       758.5       100.0
Latin America         205       223.3       294.0
Asia                  643       310.8        41.0
EMEA                  344       224.4        29.6
Europe                189       107.3        14.1
Eastern Europe         65        41.0         5.4
Mideast & Africa      155       117.1        15.4

Source: Factset

George R. Hoguet is Head of Active Emerging Market Equities at State Street Global Advisors.