financial liberalization. Many papers argue that liberalization increases capital flows, which in turn can be linked to economic variables such as growth and investment. For example, Bekaert, Harvey and Lundblad (2001) demonstrate that equity market liberalizations lead to a one percent increase in annual real growth rates. Henry (2000a,b) show that stock market liberalizations contribute to higher investment, and reduces the cost of capital in the country. More examples of the relationship between liberalization and financial development can be found in Bekaert (1995), Bekaert and Harvey (1995,2000), as well as in Levine and Zervos (1998). As shown below, our paper touches on these topics as the degree of financial liberalization will affect the investors’ ability to enter / exit a country, and can put a country off the investable list.

A third category of research explains fund management decisions in light of incentive schemes, trading strategies, herding behavior, etc. Kaminsky, Lyons and Schumkler (2000) look at the behavior of investors and managers, focusing on the motivations behind trading strategies. Cho, Kho and Stulz (1999) and Kim and Wei (2002) look at positive feedback trading and herding behavior by foreign investors. Finally, a paper by Borenszstein and Gelos (2000) presents findings on the degree of herding behavior in emerging markets, especially in times of crisis. In this paper we shed some light on how the behavior of the market participants at large, and benchmark driven fund managers in particular, influence investors’ investability decisions.

Outside of academic literature, asset management practices have evolved toward more rule-based investment methodologies. For example, the California Public Employees’ Retirement System (CalPERS), which manages around USD 145 billion globally, recently changed their permissible country list according to a new rigid methodology whereby a country must achieve a minimum score in order to be considered investable. Furthermore, public interest groups and academics have started to focus on analyzing and setting criteria for so-called “socially responsible” investments globally that also predefines an investable universe. For example, the UK Social Investment Forum, the Social Investment Forum in the US and the Dutch Association of Investment Analysts in cooperation with University of Nyenrode, have all carried out surveys of asset management practices in this area (Hummels and Timmer (2003), Green (2003), and Social Investment Forum (2001)). At the same time, investment managers have developed in-house quantitative risk models in order to be more precise and consistent in the evaluation of investment opportunities. These models are also used to provide more information to end-clients about the fundamental strategies employed by the managers. Our paper investigates the extent to which a variety of investors employ investment rules or risk models in deciding whether a country is investable.

In sum, our paper seeks to complement existing academic literature by documenting the practical internal decision-making processes used by international portfolio investors as well as uncovering the factors they indicate matter most in defining the investable universe. As such, this paper combines features of the three areas of academic literature mentioned above as it addresses issues in investment manager decision making, and the external and country specific factors which drive the investability decision.

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