Take advantage of global investment.
As the 500th anniversary of the European discovery of the Americas approaches, a reverse phenomenon is taking place: American pension funds are discovering the rest of the world. Like Columbus and his contemporaries, pension funds venture overseas seeking greater reward. Like the explorers of old, the journey overseas for pension funds can be fraught with risk and uncertainty. With time, crossing the ocean became as simple and efficient as taking a six-hour flight on a jumbo jet. And, in time, the same will hold true for international investing. But not yet.
The trend toward international investment
Over the last five years there has been a dramatic increase in the commitment of U.S. pension funds to the international sector. In a 1985 survey of the largest U.S. pension funds conducted by Pensions & Investments, the 200 largest funds had $11.7 billion invested in overseas assets. By 1990, the 200 largest funds had $51.1 billion in several categories of international assets, a 337-percent increase. On a relative basis, in 1985, the 200 largest funds had 1.4 percent of their assets invested internationally. By 1990, this amount had increased to 3.6 percent, and 51 percent of these pension portfolios included international investments.
There are several very good reasons why international investing is increasing:
* Growth of foreign markets. Twenty years ago, the U.S. stock markets represented nearly two-thirds of the world's market capitalization. Today, they are slightly less than one-third of the world market, although still larger than any other. But, while the U.S. market has shrunk, foreign markets have grown by leaps and bounds, largely as a result of the decline of the dollar and the massive privatizations of industry around the world in the last decade.
* Investment performance. Higher returns have been available in each of the last five years in overseas markets. This was true even in 1989, when the U.S. market handily outperformed the Morgan Stanley Capital international Europe Australia Far East (EAFE) Index.
* Risk reduction through diversification. It's possible to get higher returns at the same level of risk, or the same return at a lower level of risk, with a portfolio that includes both foreign and domestic securities than through a domestic portfolio. In fact, allocating up to 40 percent of a hypothetical portfolio to foreign stock would have produced higher returns at lower risk than a purely domestic portfolio over the ten-year period from 1980 to 1990.
Why, then, are U.S. pension funds only 3 percent invested in international assets, when many other countries have a significantly larger exposure to foreign investments?
First, of course, is the limited investment and diversification opportunities available in many countries. But, in large part, the answer involves the difficulties Americans experience when they trade and own foreign assets. Treacherous waters: foreign settlement and custody practices The settlement and custody practices in the U.S. securities markets are the most sophisticated and effective in the world. Trade settlements in the U.S. are highly reliable, the vast majority of securities are not held in physical form but through book-entry at depositories, and income collection is consistent and predictable.
Not so in foreign markets. While some countries have efficient settlement practices, others, even some highly developed countries, have very poor track records.
Here are some of the difficulties an American investor faces abroad:
* Myriad settlement procedures. Settlement periods in overseas markets can range from one day (Hong Kong) to once a month (Italy and France). Both extremes cause problems for the international investor. Hong Kong's one-day settlement period, and its location in the Far East, make it virtually impossible for trades originating in North America or Europe to be settled on time, exposing parties to the cost of either overdrafts or uninvested funds. And the month-long settlement periods in italy and France require investors trading in the early part of the month to bet on where exchange rates will be at the end of the month. if a trade fails, the investor has to wait another month before attempting to settle.
* High rate of trade failures. Causes for the high rate of failures range from lengthy and complicated registration procedures and strikes among workers responsible for settling trades to a general indifference towards settling trades on a timely basis. Failure to settle can create considerable difficulties for an American investor, who often will have parallel foreign exchange commitments, which do settle on schedule.
For example, in the summer of 1990, a strike of bank employees in Finland caused all trades there to fail. So an American investor, who had liquidated a sizable position in Finnish stocks, did not receive the trade proceeds in time to fulfill a foreign exchange contract that it had entered into to repatriate the markka (the currency of Finland). This in turn led to a sizable-and expensive -overdraft at a Finnish bank to cover the foreign exchange contract.
* Reliance on the movement of physical securities. In many countries, including Britain and japan, there are no central depositories for securities. It's very important, therefore, that trades are settled when they are delivered, so the securities and money move together at the same time and place. If trades are not settled at delivery, it becomes difficult to ensure that proceeds are received and ownership transferred in a timely fashion.
* Unreliable interest and dividend-payments. In many countries, interest and dividends are not paid consistently on the payable date. This can be costly, as a large pension fund discovered when it hedged the interest payment on a French government bond with a forward foreign exchange contract and did not receive the payment on the payable date. The fund had to cover the forward contract because exchange rates had changed significantly after it entered into the contract.
* Restrictions on foreign investment. Many countries restrict ownership of their companies by prohibiting foreign ownership of a specific company or in a specific industry, by restricting ownership to a certain percentage of outstanding shares in a given company, or by permitting foreigners to own only certain classes of securities.
Consider the case of a U.S. investment manager who bought shares of a company based in Thailand. Thailand allows foreign investors to own only a percentage of shares in any Thai company. The stock was within the percentage limit on the date of the trade, but by the settlement date three days later, enough of the company's shares had passed into foreign hands to reach the limit. So the investment manager could not take title to the stock until enough foreigners sold their shares back to Thais. In the meantime, the former owner continued to collect all income from the shares.
* Tax reclamations. Even though most countries recognize the nontaxable status of U.S. pension funds, they will withhold a portion of dividends for taxes. The pension fund can reclaim all or a portion of this tax from the taxing authority by filing forms certifying the fund is not taxable. This process can take months, or even years, to resolve.
Taxes can consume a significant portion of dividend income. Foreign tax rates range from nothing (in Hong Kong) to as high as 55 percent (in Mexico), with most countries falling in a range from 20 percent to 35 percent. In countries with which the United States has negotiated a tax treaty, the rate will typically drop to 15 percent of the dividend, which means that 10 percent to 20 percent of the dividend income can be recaptured by pursuing tax reclaims. (It should be noted that in many countries taxes are withheld at the treaty rate, making reclamation unnecessary).
For example, pension funds dealing with inland Revenue, the taxing authority in the United Kingdom, will be assaulted by wave after wave of documents and requests for information, transforming the reclamation process into a multi-year, Sisyphean task. And in italy, even though there is a procedure for tax reclaims, to my knowledge none has ever been paid.
* Capital actions, Finally, there is the problem of getting information about capital actions: the mergers and tenders, splits, stock dividends, rights offerings, and restructurings which in some way change the bundle of securities an investor holds. in the United States, this activity is monitored by the Securities and Exchange Commission, but the regulation of foreign markets often is not up to the exacting standards upon which the U.S. investor has come to rely.
Getting timely and accurate information on capital actions in foreign countries is complicated. There are currently several competing databases, but none has universal coverage, leaving recourse to foreign newspapers and financial journals necessary. The second problem is language. The terms of capital actions frequently have to be translated into English, which can be costly, time consuming, and a potential source of ambiguity. And, finally, all capital actions may not apply equally to all classes of a security, which could leave foreign investors disenfranchised.
How can them pitfalls be avoided?
The Group of Thirty, a group of leading bankers and brokers from the U.S., Europe, and Japan, has developed a set of guidelines in an attempt to streamline securities processing and to solve some of these problems. Its goal of worldwide uniformity is quite a way off, however. international money managers have simply allowed market forces to increase efficiencies in various markets, as when foreign funds threatened to pull out of the booming Italian stock market in the mid-1980s when they were faced with a high trade failure rate and other uncertainties. (The Italians quickly got the message and installed a central share depository and undertook other measures to significantly reduce trade settlement problems.) But market forces are unpredictable, and they can't be relied upon.
So what can a U.S. pension fund seeking to reap the rewards of international investing do? Here are some alternatives, with varying levels of cost and sophistication.
American Depository Receipts (ADRs) are domestically tradable bundles of shares of foreign stocks, the underlying foreign shares of which are held overseas by a domestic bank that acts as agent for the ADR issue. Hundreds of foreign companies have ADRs, which are either sponsored, where a single bank has been hired to serve as agent by the foreign company, or unsponsored, where a bank (or banks) issue ADR shares without any connection to the company.
The price of an ADR generally will track fairly closely with that of the underlying security, but not precisely. The agent bank charges a fee for creating new ADRs or for breaking them into their underlying shares, causing the ADR price to reflect a slight premium. The vast majority of ADRs are traded thinly, if at all continuously. And dividends in both cash and stock form do not necessarily flow through wholly to the ADR holders.
There also is the possibility for mishap along the way. Several years ago, the record and payable dates of a stock dividend for the ADR of a Japanese company overlapped with its Japanese counterpart, resulting in erroneous distribution of a large number of "bonus" shares, much to the chagrin of the agent bank, which still is trying to retrieve the shares.
Mutual funds and bank collective funds (like mutual funds, but offered only to qualified pension funds) which invest in foreign markets are another straightforward way to invest internationally. A pension fund may have a problem finding a fund that caters to its needs, and it will have virtually no input into how its money is being managed. The performance of these funds will be affected by untimely cash flows, as when a manager is forced to liquidate holdings in the face of a steep market decline to satisfy the demands of other holders who are liquidating their positions. Finally, the fees on mutual funds, targeted at a retail market, often will be considerably higher than the institutional rates a pension fund generally pays for money management.
A global custodian, using either branches of its own bank, a network of foreign banks, or a combination of both, arranges for the settlement of trades and safekeeping of assets in markets around the world. Until the 1970s, the field was limited to banks with branches around the world. During the 1970s, regulations were changed to permit the custody of assets at foreign banks. In a 1990 survey, 32 banks in North America identified themselves as providers of global custody services.
A global custodian serves as a bridge between a money manager and a foreign market. To coordinate and manage this activity, it must have an effective communications system and a centralized accounting system to account for all of the activity occurring in all necessary currencies.
As an alternative to a full-service global custodian, most custodians have some sort of mechanism for handling foreign securities, some more efficient than others. One common means of providing these services is through "private label" arrangements, which allow a domestic custodian to provide its clients access to global markets by subcontracting global custody services to a full-fledged global master custodian. Private-label domestic custodians generally do not operate multi-currency accounting systems or have access to international pricing sources, and they must rely extensively on the private-label global custodian for these services. Nevertheless, this arrangement can be good for a pension fund that wants to invest internationally but does not want to sever its relationship with its existing custodian. It can also work well for the smaller pension fund that feels it won't receive close attention from a global master custodian.
There are two general schemes for providing private-label services. Under the first, the domestic custodian attempts to make the relationship with the global custodian "transparent" to its clients by serving as the focal point for all information flowing to and from the global custodian. The problem here is that, given the importance of timely delivery of information in the global markets, the introduction of additional hands through which information must pass can lead to costly delays and lost opportunities.
In the second scheme, the domestic custodian abdicates responsibility for foreign assets to the private-label global custodian, who then handles all aspects of the relationship, including all contacts with clients and its investment managers, including reporting. This bifurcated arrangement, while expediting the handling of information, leaves the investor to deal with two separate vendors, each with its own procedures and reporting systems which complicates the task of the managers and makes it difficult to assess the fund sponsor's overall investment picture and to file reports with various regulatory bodies.
Evaluating the global custodians If you've decided to go global and you want to take advantage of the services of a global custodian, there are several things you should look for.
* Does the global custodian serve the markets in which your fund wants to invest?
* How does the custodian communicate with its sub-custodians? How does it manage its network? How often does it visit its subcustodians?
* Does it post trades on a theoretical settlement date or when they actually settle?
* Does it advance income on the payable date or only upon receipt?
* In which countries does it provide overnight vehicles for investing surplus cash?
* What fees does it charge for overdrafts?
* Will it provide foreign exchange facilities?
* Will it provide securities lending services?
There are no "correct" answers to these questions, but the answers will help determine how closely correlated are the price and benefits for the services provided by a global master custodian.
Master trust reporting
The part of a global custodian's job that should be most visible to pension fund managers is master trust reporting. As with domestic portfolios, this encompasses reporting activity, providing an inventory of holdings and their value, and fulfilling corporate, actuarial, and governmental reporting requirements.
But master trust reporting in the international environment differs from reporting in the domestic environment in several ways:
* Timing. Due to the greater effort required to reconcile holdings with sub-custodians and other difficulties related to pricing of assets, reports generally are not as timely as domestic reports. This can be a minor inconvenience-or it can disrupt important reporting and valuation processes, such as in the international holdings of a defined contribution pension plan.
* Local and base-cost reporting. All activity must be accounted for, both in terms of the currency used in a transaction (the local currency) and the currency upon which a fund is based (U.S. dollars for an American pension fund). This requires that base equivalent values be assigned to, and accounted for, in relation to every element of every transaction involving local currencies, including those that make no use of a base currency (i.e., exchanging French francs for Japanese yen).
* Currency and investment gains and losses. All investment gains and losses, both realized and unrealized, should be broken down into two components: those resulting from currency gains and losses and those resulting from appreciation or depreciation in the value of a security.
* Consolidated reporting. Integrated consolidated reporting is essential to provide an overview of all pension fund assets. In the past, consolidated reports have been somewhat problematical, since many of the earlier generations of global (or "multi-currency," as they are more commonly known) accounting systems were developed and operated separately from a custodian's domestic accounting systems, and integration of the two was done manually. But the past several years have marked the arrival of a new generation of systems for both domestic and multi-currency accounting. Now there is little difficulty in extracting reports consolidating all of a pension fund's holdings from these systems.
Measuring the rewards: evaluating investment performance
It goes without saying that evaluating the performance of people managing funds that include international investments is more complicated than evaluating those managing funds invested domestically.
In addition to the "traditional" measure of performance-asset allocation and sector and security selection-currency selection needs to be measured. Real investment gains have to be differentiated from those that result from fortuitous currency allocations. Take the example of a pension fund with two investment managers, one of whom had a higher return than the other. Evaluation revealed that the manager with the lower return had in fact had very strong performance in the local markets, while the other manager's performance was attributed largely to a decline in the dollar.
Evaluating the performance of international investments can be a daunting task. A global custodian should be able to draw from its multi-currency accounting system all the necessary information to examine and then to evaluate a manager.
Toward a new world'
In time, as barriers to the flow of capital and trade fall, the world will become a single, seamless market, and many of the benefits-and risks-of international investing will disappear. But until that time, even the small pension fund can benefit from investing internationally while minimizing the risk.
The Group of Thirty--uniformity in the distance?
In 1988, the Group of Thirty held a symposium in London to discuss the state of clearance and settlement practices in global markets. Concluding that these practices required significant improvement, a steering committee was assembled to propose a set of practices and standards that could be embraced by markets around the world.
The steering committee in turn spawned a working committee of experts, who, in March 1989, released a set of nine recommendations to remedy such deficiencies as:
* The absence of compatible trade comparison systems.
* Different settlement periods in different markets.
* Lack of delivery versus payment settlement basis.
* Lack of standardized trade guarantees.
* Absence of book entry processing in many countries.
* Most of the nine recommendations directly attempt to address these issues:
* The development and use of trade comparison systems to improve the confirmation of trade particulars.
* The adoption of standardized settlement periods and a delivery versus payment standard,
* The creation of securities depositories with book entry.
Other recommendations from the steering committee dealt with the problems indirectly, encouraging the expansion of securities lending practices to help alleviate trade failures and the utilization of a common security numbering system to facilitate communications.
Efforts to implement these recommendations are underway in 33 countries, including the United States. Originally, the recommendations were targeted for implementation by 1992, a goal that, at this time at least, appears unrealistic.
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|Title Annotation:||includes related article; Finance|
|Author:||Hawkins, Stephen G.|
|Date:||Nov 1, 1991|
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