spective, this kink also illustrates that small improvements in its risk assessment may result in big reductions in the expected required returns, and as a result, a substantial reduction in financing costs. Even more importantly, it shows that especially for countries that score low in the investability analysis (high risk), even small improvements may have large effects on the access to capital even in situations where the ranking is mainly a result of the macro (monetary/exchange rate and fiscal policy) stance.

The minimum required expected return curve divides the universe of investments into “attractive” and “unattractive” investments depending on whether the actual investment is expected to yield more or less than the minimum required expected return. While the model represents a crucial core of the investability decision, in all of the cases we interviewed, the data or model output alone did not decisively put a country on or off the investable list or in the “attractive” or “unattractive” category. After the model process, each could use subjective criteria (i.e., interpretation, the search for a story that overrides the data, etc.) to either rule out a country or overlook a bad score.

# **5 “MUST” INVEST COUNTRIES**

Benchmark indices for both equity and debt have significant explicit and implicit effects on whether an institutional investor will consider investments in a country.<sup>6</sup> Many funds that recruit client money are marketed as benchmarked to an index, which obliges the fund manager to hold the majority of the assets in the countries of the index, with small deviations allowed for cash management and some active decision-making.<sup>7</sup> According to the MSCI website, over 90% of U.S. institutional assets held in international equities are benchmarked to the MSCI indices.<sup>8</sup> For these stricter funds, a large part of the investor’s investability decision is not a matter of choice but rather a function of whether a country has enough debt to warrant inclusion in an index. Perversely, this characteristic of benchmarked funds thus rewards countries with a large quantity of 6 A number of daily updated emerging market indexes are available: EMBI, EMBI+, and EMBI Global from J.P. Morgan Chase, Brady Bond Index from Salomon Brothers, Morgan Stanley Capital International (MSCI) and emerging Market indexes from Merrill Lynch and Lehman Brothers.

7 Normally, few indexing strategies can perfectly match the performance of the index or benchmark. The tracking error quantifies the degree to which the strategy differed from the index or benchmark. Tracking error can be defined in different ways, the most common being either as the variance (standard deviation) of the difference between benchmark returns and returns on the replicating portfolio (see for example Pope and Yadav (1994)), or as the difference between portfolio returns and benchmark returns (see for example Roll (1992)). The latter is the most common definition used by market practitioners.

8 A new strategy in asset management is becoming increasingly popular in both Europe and the U.S. among institutional investors. Instead of making choosing between either active or passive management a strategy is employed where the major part of the assets is invested in a “core” benchmark driven portfolio with low management fees and low allowed tracking error, while a small share of the assets is invested in “satellites” where managers can invest freely. This "core/satellite" approach lowers cost as the higher fees associated with active management of the portfolio are only paid for the part of the portfolio, which is truly actively managed.

11