Bridge over ocean
1 May 2013 CFA Institute Journal Review

Asset Fire Sales and Purchases and the International Transmission of Funding Shocks (Digest Summary)

  1. Victoria Rati

The authors discover a new channel through which international shocks are transmitted across global equity markets. They find that when investors contribute to or withdraw from global equity funds that are domiciled in developed markets, there are significant implications for equity allocations in those funds in emerging markets (EM). The forced asset sales and purchases in EM affect the pricing, correlations, and betas of EM equity investments.

What’s Inside?

Equity investments in emerging markets (EM) are of increasing interest to investors, so understanding what drives EM returns (EM prices, betas, and correlations) is becoming increasingly important. The authors study the contagion effect on EM equity markets of investor cash flows into and out of global funds domiciled in developed markets (DM). The authors find statistical evidence that investor flows into the DM-domiciled funds affect investment returns in EM (i.e., there is a contagion effect). Strong investor flows into and out of DM-domiciled funds generate overreactions in individual EM country returns. The authors find that flow-implied fund allocation changes (FIFA) have significant price return effects on EM equities. FIFA measures the amount of capital that is expected to flow into an individual EM as a result of the DM-domiciled fund inflows or outflows.

How Is This Research Useful to Practitioners?

EM countries with the highest FIFA (top quintile) outperform those in the bottom quintile of FIFA by 176 bps over a three-week period. EM countries in the top quintile experience price increases, and those in the bottom quintile exhibit price decreases. The authors also find the price effects are mostly short term (over a 3-week period) and significantly reverse during the next 12 weeks. The effects are most pronounced when DM returns are at an extreme, either extremely high or extremely low, or when EM are experiencing a crisis.

Regarding the realized (ex post) betas of EM with the MSCI G–7 index, the authors find the betas of individual EM increase by 8–15% if the EM is in either the highest or the lowest FIFA quintile, but the effect depends, or is conditional, on the G–7 market return. If the G–7 market return is positive, the top FIFA quintile of EM has a higher conditional beta and the bottom quintile does not. If the G–7 market return is negative, the bottom FIFA quintile of EM has a higher conditional beta and the top quintile does not.

The authors then investigate whether FIFA can explain the co-movement or correlation in returns among individual EM. They find that when individual EM are simultaneously in the top (or bottom) FIFA quintile, the realized monthly correlations of the returns between these individual EM are 22–30% higher.

How Did the Authors Conduct This Research?

The authors research EM equity returns using a new approach and a new, more comprehensive dataset to analyze the co-movement of international equity returns. They study more than 1,000 DM-domiciled funds that have allocations to EM (global equity funds) for the period of 1996–2009. Funds are selected from their database that have, on average, a 6% allocation to EM (25 EM countries), and the maximum allocation is 17%. The authors calculate the FIFA for each DM-domiciled fund. FIFA measures the amount of capital that should flow into an individual EM as a result of the DM-domiciled fund inflows or outflows.

The authors empirically quantify the effect of FIFA on EM equity market returns—namely, EM prices, betas, and correlations. They conduct robustness tests, and the key results remain intact. The impact of lagging and leading FIFA, the impact of underlying EM liquidity, and control for EM momentum trading are considered. Finally, the authors develop a simple theoretical model to better understand their empirical results. The theoretical model is a further robustness test and is successful in capturing and confirming the patterns observed in the empirical results.

Abstractor’s Viewpoint

The study is on the highly topical subject of EM investing. Given the expected better growth prospects for EM relative to DM and, thus, increasing interest in EM investments, these key findings are a reminder of the potential indirect or contagion shocks that may occur in a globally connected investment world. Indirect effects from investor cash flows into and out of DM-domiciled funds have a significant contagion effect on EM equity markets. It would be interesting to see the results for a similar study of EM debt markets, although data would be more difficult to collect. Given the interest in EM debt markets and the liquidity issues in some of these markets, one would expect there to be highly pronounced FIFA impacts.

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