debt with a captive class of investors, even though high debt ratios would normally reduce an investor’s appetite for the country’s debt.

Even if a fund is not specifically benchmarked to an index, investment of funds received through institutional mandates may be constrained both by risk-tolerance limits (defined in such terms as limits on investments in certain types of assets, diversification rules, minimum allowed rating of investable securities, maximum tracking error from an index) and through the performance criteria for evaluating management. In almost all cases, a good part of a fund managers compensation is based on the fund’s performance relative to a benchmark index. Consequently, the manager cannot afford to take substantial off-index country bets (i.e., create too much tracking error), as she risks her own compensation or retraction of the mandate if events go awry, even if they are not related to her active portfolio management. While it does not rule out specific non-index countries, performance evaluation relative to benchmark performance does limit the amount of funds available to non-index countries.

The problems associated with benchmarking are well known, and have gained renewed scrutiny since the Argentine default.<sup>9</sup> In the early to mid-1990s international investors invested heavily in Argentina, rewarding the country for the implementation of economic reforms. By 2000, the government had built up a large debt stock, so that Argentina represented one of the largest country components in all emerging market debt indices. As the macroeconomic and political climate soured, and questions surfaced regarding the sustainability of the debt profile, investors steadily reduced their holdings of Argentine debt. However, Argentina’s large weight in the indices forced many managers to maintain some holdings. According to an article in the Washington Post, several money managers admitted “The index virtually forced big investors to lend vast sums to Argentina even if they feared that the country was likely to default in the long run,...”<sup>10</sup> . Although default would hurt absolute performance, the fund would still lose less than the index as long as the fund was underweight Argentine bonds.

The distribution of countries in terms of weights in various emerging market benchmark indices is shown in table 1, below. The EMBI indices are emerging market global hard currency bond indices calculated by JP Morgan Chase. The ELMI is an emerging market global local currency index also calculated by JP Morgan Chase, and the MSCI (Emerging Markets Free) and Standard & Poor’s (global composite) indices are both emerging market equity indices produced by Morgan Stanley and Standard & Poor’s. Those countries that show up in the last two columns, for weights in indices of over 5%, typically “must” be included in institutional investors’ portfolios, for reasons specified above. For those countries in the 0-5% category, investment managers

> 9 The BIS Committee on the Global financial System (CGFS) has recently examined the implications of the increased use of indexing for financial markets in connection with the work of an ad hoc Working Group on Incentive Structures in Institutional Asset Management. See BIS (2003a).

> 10 Paul Blustein. The Washington Post. Aug 3, 2003. Argentina Didn't Fall on Its Own; Wall Street Pushed Debt Till the Last.

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