Investment guidelines should account for market response to shocks, says IMF working paper

By Reshmi Basu

New York, Oct. 7 - Investment guidelines should factor in the effects of portfolio allocation due to volatility shocks, according to an International Monetary Fund working paper titled "Investment Restrictions and Contagion in Emerging Markets" by Anna Ilyina. In doing so, the contagion effect will be lessened.

Ilyina noted that investor protection is the foremost priority in designing investment guidelines for institutional investors, such as mutual funds, pension funds and insurance companies.

But these guidelines rarely take into account the potential impact of portfolio allocations in response to new information unrelated to asset management such as market shocks, according to the paper, which represents the author's views, not those of the IMF.

For instance, dedicated investors' allocations into emerging markets are seen as more stable than allocations from opportunistic investors such as crossover investors and hedge funds. Opportunistic investors' decisions tend to be more sensitive to competing asset classes because their moves do not take into consideration benchmark measurements, remarked the author. Hence, crossover fund flows tend to be seen as more volatile than those of dedicated EM mutual fund flows.

However, there is a school of thought that inclusion of emerging market assets into broader benchmark indexes may limit the overall volatility of portfolio flows into individual markets.

Through empirical analysis, the author shows that is not the case. The author finds that "excessive price volatility in a particular asset market (which unrelated to changes in the underlying asset fundamentals) can be generated by the portfolio reallocations of the fund managers that are subject to multiple investment restrictions."

Restrictions include investment mandates, performance criteria and portfolio management rules.

The excessive price volatility may be due to the use of widespread use of short-sale constraints and benchmark-based performance criteria, noted Ilyina.

Through empirical analysis, Ilyina shows that opportunistic investors can "play a stabilizing role in asset markets when other market participants, which (collectively) have a significant market power, face tight investment restrictions."

This can happen when opportunistic investors are able "to take a contrarian position in the face of a sell-off induced by the actions of the tightly regulated "real money" funds reacting to a shock originating in a fundamental unrelated market," Ilyina writes.

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