EMU - The Challenges for a Fund Manager

Chris Golden

Senior Economic AdviserFleming Investment Management

September, 1998

Issued by Fleming Investment Management Limited. Regulated by IMRO.

Fleming Investment Management Ltd

25 Copthall Avenue

London EC2R 7DR

Jardine Fleming Investment Management Ltd

47th Floor, Jardine House

2 Connaught Place

Central Hong Kong

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Background : What does a fund manager do ?

A fund manager tries to capture trends

because that is what the index doesA fund manager tries to capture

variance because that is how you outperform

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Benchmark Effects

Currency component within Euro-zone disappears ie relative returns between Euro-zone markets

remain the same in any reporting currency

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Benchmark Effects

Currency component within Euro-zone disappears ie relative returns between Euro-zone markets

remain the same in any reporting currencyBut amalgamated indices will be opaque

At least to begin withLocal return trends will also go

Convergence has already happened

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Correlation effects

No currency component => higher correlationsConvergence of fiscal policies

Growth and Stability pact Market discipline All increase correlation

Greater correlations => less diversification effect Eleven (or ten) different baskets Become one

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Correlation Effects

For the global managerHigher internal correlation of the Euro-zone

Means a lower exposure to Euro-zone marketsFor the Euro-zone managerLower variance of returns means that

The efficient frontier has less curvature And index outperformance becomes more

difficult

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Liquidity effects

Some positive effects The single repo area will be bigger than its

parts Positions in smaller country markets

become easier to finance Demand for the currency could increase flows

There will be more players

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Liquidity effects

Some negative effects Governments are likely to borrow less

Which will probably reduce outstanding debt/GDP

As demographic demand is rising FX diversification disappears

So fewer cross Euro-zone arbitrage opportunities

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Liquidity effects

The myth of the larger (=) more liquid market

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Bond Market Breakdown by Size (1997)

$0 Bn

$500 Bn

$1,000 Bn

$1,500 Bn

$2,000 Bn

$2,500 Bn

US

JP

DE IT FR

UK

CA

NL

SP

BE

SE

DK

AT FI

IE PT

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Bond Market Breakdown by Size

Size of government markets by market valuation (1997) :

U.S. USD 2,064 Bn

Japan USD 1,703 Bn

Germany USD 459 Bn

Italy USD 408 Bn

France USD 400 Bn

U.K. USD 343 Bn

Canada USD 200 Bn

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Market Breakdown by Size post EMU

$0 Bn

$500 Bn

$1,000 Bn

$1,500 Bn

$2,000 Bn

$2,500 Bn

US

Eu

rola

nd

JP

UK

CA

SE

DK

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Bond Market Liquidity

Does not depend on aggregate market size alone

Individual issue size is more important

French OATs are typically larger than USTs

And Benchmark Bunds are about the same size as UST equivalent

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Average Issue Size Today

$0 Bn

$2,000 Bn

$4,000 Bn

$6,000 Bn

$8,000 Bn

$10,000 Bn

$12,000 Bn

$14,000 Bn

FR

US

JP

SE IT SP

BE

DK FI

UK

DE

NL

CA IE PT

AT

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Bond Market Liquidity : The good news

A better measure of the overall liquidity of the market : Percentage of a liquid global government bond index

Euroland’s percentage share of the Lehman Brothers Global Government Bond Index is

Almost exactly the same as that of the US Almost three times that of Japan

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Relative Government Market Sizes

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

30.0%

35.0%

40.0%

45.0%

50.0%

US Euroland Japan Other Europe Other world

Dec-91Dec-92Dec-93Dec-94Dec-95Dec-96Dec-97May-98

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Bond Market Liquidity

Some additional comments Smaller government issuers may have to pay a liquidity

premium Which could be a source of additional variance

As part of a larger Euro government index, they may lose out to larger issuers

Some overall conclusions Maintained fiscal restraint and Reduced arbitrage opportunities Will outweigh funding advantages

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What to do ?

Allow more off-index asset classes Increase the credit range of the Euro-sector indexResist attempts to reduce the weighting of the

Euro-sector within the benchmarkReduce currency exposure constraints elsewhereReduce the agreed minimum benchmark

outperformance target

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Allow more off-index asset classes

Pre-ins Denmark, Greece, Sweden, UK

EU candidates Czech Republic, Hungary, Poland

Euro-zone corporates

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Domestic Markets

Bank22%

Public Sector24%

Local Authority8%

Supranational7%

Corporate5%

ABS2%

Pfandbriefe32%

Lehman Brothers estimates

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Without the Public Sector

ABS2%

Corporate7% Local Authority

9%

Bank11%

Pfandbriefe43%

Supranational29%

Lehman Brothers estimates

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Allow more off-index asset classes

Pre-ins Denmark, Greece, Sweden, UK

EU candidates Czech Republic, Hungary, Poland

Euro-zone corporatesEuro-euro corporates

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Euro-Euro vs Domestic

$0

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

$350,000

$400,000

$450,000

AB

S

Co

rpo

rate

Ba

nk

Pu

blic

Se

cto

r

Su

pra

na

tio

na

l

Lo

ca

lA

uth

ori

ty

Euro-euro

Domestic

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Increase the credit range of the Euro-sector index

Euro-zone domestic market

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But it is a Quality Market

Aaa53%

Aa26%

Baa1%

NR9%

A9%

Ba or lower2%

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Increase the credit range of the Euro-sector index

Euro-zone domestic marketEuro-euro market

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The Euro-Euro Quality

Aaa38%

Aa36%

A12%

NR6%

Baa3%

Ba and lower5%

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Increase the credit range of the Euro-sector index

Euro-zone domestic marketEuro-euro marketBut this is only a partial solution

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A Comparison : The US Corporate Market

Aa 15%

Ba 8%

B13%

Aaa3%

CCC3%

A36%

Baa22%

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Do not reduce the weighting of the Euro-sector

A large weighting of highly internally correlated assets

Produces a benchmark with less varianceWhich is therefore easier to beat!

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Summary : The key effects of EMU on fund management

Benchmark effects: The Euro-sector may be deemed too large

Correlation effects: Tomorrow’s Euro-sector will be highly

internally correlatedLiquidity effects:

Lower deficits and less FX risk may lead to sharply reduced liquidity in today's asset classes

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Summary : What a fund manager should do to prepare

Increase the number of allowed non-benchmark asset classes

Analyse the characteristics of emerging and corporate markets BEFORE they become part of the benchmark

Resist attempts to reduce the weighting of the Euro-sector within the benchmark

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Summary : What a fund manager should do to prepare

Increase the number of allowed non-benchmark asset classes

Analyse the characteristics of emerging and corporate markets BEFORE they become part of the benchmark

Resist attempts to reduce the weighting of the Euro-sector within the benchmark

EMU - The Challenges for a Fund Manager

Chris Golden

Senior Economic AdviserFleming Investment Management

September, 1998

Issued by Fleming Investment Management Limited. Regulated by IMRO.

Fleming Investment Management Ltd

25 Copthall Avenue

London EC2R 7DR

Jardine Fleming Investment Management Ltd

47th Floor, Jardine House

2 Connaught Place

Central Hong Kong