# _2.1.1. International diversification ofportfolio_

Institutional investors can diversify their portfolios globally<sup>by investing in foreign</sup> securities. By diversifying with emerging market securities, many<sup>investors believe (or</sup> believed before the Asian crisis) that they reduce portfolio risk<sup>and increase return.'0</sup> There is a gradual but clear trend toward internationally diversified<sup>portfolios of pension</sup> funds. Portfolios of life insurance companies are less diversified<sup>than those of pension</sup> funds. Mutual funds in larger OECD countries have significantly<sup>more diversified</sup> portfolios than those of insurance companies and pension funds.'I Institutional investors as a group are much less internationally<sup>diversified than</sup> would be true for a world market portfolio. Reasons for this home<sup>bias have been</sup> identified in the literature12 and include, for emerging<sup>countries, exchange rate risk,</sup> transfer risk, settlement risk, and liquidity risk. The use of<sup>hedging instruments such as</sup> forwards, futures and options can reduce exchange rate risk,'<sup>3</sup> but these<sup>instruments are</sup> not always available for emerging market currencies. Furthermore,<sup>the price of these</sup> instruments will offset part of the gain from foreign investment,<sup>they may only be</sup> available for short periods, and trust deeds for pension funds<sup>may limit their use.</sup> Transfer risk may affect the ability to repatriate returns; examples<sup>are exchange controls</sup> and nationalization of foreign assets. Settlement risk in less-developed<sup>securities markets</sup> may be large, with a high proportion of delayed or failing transactions.<sup>Liquidity risk</sup> may be significant in narrow overseas markets.

Other impediments to international diversification include the<sup>nature of institutional</sup> investor liabilities. Many pension schemes and life insurance contracts have very precisely defined nominal liabilities. In these cases, the preferred<sup>investment strategy</sup> may be to match domestic liabilities with domestic assets. Regulatory<sup>constraints on</sup> foreign investments, the "benchmark" orientation of fund managers,<sup>and treatment by</sup> institutional investors of emerging market securities as a separate<sup>asset class"4constitute</sup> yet other reasons. Broadly based mutual funds (in contrast to<sup>dedicated developing</sup> country mutual funds) are limited in the proportion of fund assets<sup>that can be invested in</sup> developing country securities by the portfolio allocation guidelines<sup>outlined in their</sup> prospectuses.

# _2.1.2. Characteristics of institutional investors_

Institutional investors have different investment objectives and<sup>fiduciary mandates,</sup> operate under different regulatory and tax regimes, and have different<sup>tolerances to risk.</sup> The international investment behavior of pension funds, insurance<sup>companies and</sup> investment funds differs largely because of the different structure<sup>of their liabilities.</sup>

**10** For example, see Deutsche Morgan Grenfell, 1996 for this line<sup>of argument with respect to international</sup> fixed income portfolios.

> 11 Blommenstein, 1997.

> 12 See Blomnmenstein, 1998.

> 13 See BIS, 1986.

> **14** See IMF, 1995a for statistical evidence on the hypothesis of investors'<sup>treating developing country</sup> equities as a separate asset class.

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