Since the 1990s, a large proportion of world savings have gone to institutional investors that manage those assets by investing globally. This trend has driven a sharp increase in capital market activity and financial globalisation (cf. Obstfeld and Taylor 2004; Kose, Prasad, Rogoff and Wei 2009). Given this accumulation of resources in professional and sophisticated asset managers, you might expect to see significant international diversification accompanying this process, with many countries and companies benefiting from the influx of foreign capital. You might also expect investors to profit from holding global, well-diversified portfolios. Yet little evidence to date exists on how institutional investors allocate their portfolios globally and what this might mean for recipient countries, underlying investors, and policymakers.
International mutual funds – those able to invest across the world – provide useful insights into how international portfolios are managed. Of these mutual funds, the ones that have attracted most of the savings during the last 15 years are 'global funds', which have been created in order to enable investment anywhere in the world. These funds enable investors to flee from countries in crisis, favour those with growth opportunities and have access to a large set of firms and countries.
Global funds do not seem to be very well diversified. They appear to leave behind significant unexploited gains from international diversification, at least relative to portfolios of 'specialised funds' that have been established to invest in specific countries or regions. This critique also holds if you evaluate a global fund relative to a specialised fund from the same mutual fund family or company (Didier, Rigobon and Schmukler, forthcoming).
Differences between specialised and global funds
For example, it pays better to hold a portfolio of Asia, Europe, Latin America, and US funds vis-à-vis a global fund that invests in all these regions. The differences are not negligible. For instance, a simple mean-variance analysis shows that global funds could obtain better risk-adjusted returns –between 2.6% and 5.5% per year – if they invest in portfolios that include holdings similar to those of specialised funds within the same mutual fund family.
Explaining the differences
These differences are not explained by the existence of an insurance premium. Because global funds can secure gains by moving away from troubled countries, investors might be willing to pay for this benefit and accept lower expected returns. Yet, global funds do not seem to better shield investors from tail risk. As such, the lack of diversification in global funds does not appear to be explained by their better performance during times of crisis.
What generates these differences? They appear to come from the fact that global funds hold a rather restrictive number of stocks. In fact, both specialised and global mutual funds hold a similar number of stocks, around one hundred. Moreover, the number of asset holdings in the mutual fund portfolios does not tend to be higher for global funds compared to specialised funds within the same mutual fund family, even though the pool of investable assets is significantly larger for global funds. Hence, within each region of exposure, global funds hold fewer assets from fewer countries when compared to specialised funds within the same mutual fund family.
Explaining restrictive investment practice
What might explain this restrictive investment practice?
- First, it seems we can rule out instrument availability or transaction costs.
The cross-fund comparison is especially revealing in this case: the fact that one particular fund holds a certain stock is an indication that no clear investment restrictions related to that company exist and that the transaction costs are small enough for that fund to hold that stock. Our point of comparison is the funds within the same family that differ only in their investment scope. For example, global funds, which hold particularly few stocks, could expand their holdings by investing in the stocks that specialised funds within the same firm hold.
- Second, by itself, lack of information at the family level does not seem to explain the apparent lack of international diversification by global funds.
The problem seems to stem from how information is used across funds within a family. If global and specialised funds within families share information and make similar decisions, one can expect to observe similar portfolios among them. However, the portfolios of global and specialised funds within families are different. Global funds do not seem to follow specialised funds in their portfolio allocations. Moreover, the portfolios become increasingly similar when global and specialised funds are run by the same managers. Indeed, the similarity increases with the number of common managers. This evidence does not appear to be consistent with managers using information already gathered and processed by other managers within the same mutual fund family; instead, the evidence seems consistent with competition between managers (cf. Brown et al. 1996, Chevalier and Ellison 1999, Carpenter 2000, Chen and Pennachi 2009, Kempf and Ruenzi 2008, and Pollet and Wilson 2008).
- Third, belonging to a mutual fund family is a strong driving factor behind the portfolio choices of individual funds.
A large dispersion exists in the number of stocks held around the world by mutual funds across different families. These family attributes explain almost 50% of the cross-sectional and time-series variation in the number of stock holdings and the loadings on the top ten holdings. Interestingly, these effects vastly exceed the explanatory power of commonly used measures that capture the abilities of funds and managers to gather and process information and select portfolios.
It’s about organisational structure
The evidence suggests that organisational aspects might help explain the investment choices of institutional investors. That is, the way that mutual fund companies are structured seems to have a significant impact on how their managers behave (Nanda et al. 2004, Gaspar et al. 2006). Global funds might not constitute – by themselves – the optimal portfolio for individual investors.
These findings have important policy implications related to capital flows, financial development, access to capital markets, and social security. To the extent that global funds continue expanding relative to specialised funds, the forgone diversification gains could be significant, and the cost to investors, firms, and countries could also be large.
In particular, the lack of diversification of global funds means that a large fraction of the portfolio capital flows goes into few, large companies and countries. Some policymakers would then need to manage large capital flows and their intrinsic volatility by, for example, embracing capital controls and/or macro-prudential policies. Others might need to try to attract foreign capital to their own countries or to companies that are left out of these portfolios (and that need to rely on bank financing and retained earnings).
These policies are always difficult to implement, but the trends we document make them even more challenging. The investment patterns seem to be rooted in the organisational structure of financial institutions, even in the sophisticated US asset management industry. In other words, the fact that the managers of such a large pool of assets invest in too few companies – no matter the investment scope – and that the lack of diversification seems to depend on each particular mutual fund family makes the trends difficult to change. In this context, how could policymakers entice mutual funds to invest in more countries and firms? How could popular macroeconomic policies, such as deregulation, modify the behavior of mature asset managers?
The patterns we document might also represent a substantial loss to investors. In many countries, households save for retirement by investing in mutual funds (sometimes through their pension plans). The large foregone diversification gains due to investors allocating their savings into global funds with few assets imply that these investors will have lower savings at retirement age. What could policymakers do to encourage investors to change their behavior? The policies adopted so far – such as increasing information transparency – have not proven to be overwhelmingly effective.
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