metadata: authors: 0: author: Diwan, Ishac
1: author: Errunza, Vihang
2: author: Senbet, Lemma W.
docna: 0: docna: Empirical perspectives on national index funds
docty: Policy Research Working Paper
subtopic: Macro-Fiscal Policy,Taxation & Subsidies,Economic Adjustment and Lending,Public Sector Economics,Capital Markets and Capital Flows,Capital Flows,International Trade and Trade Rules,Public Finance Decentralization and
            Poverty Reduction,Crime and Society,Economic Insecurity
teratopic: International Economics and Trade
abstracts: cdata!: Closed-end national index funds (NIFs of
            country funds) invest primarily in the stocks of the
            originating countries, such as Brazil, India, and the
            Republic of Korea.  They are typically traded in the
            organized exchanges of industrial countries, such as the
            United States and the United Kingdom. Although NIFs have not
            raised large amounts of external funds, recently they have
            expanded rapidly.  In a companion paper ("The Pricing
            of Country Funds and Their Role in Capital Mobilization for
            Emerging Economies," WPS 1058), the authors develop a
            theoretical model to compare the pricing of country funds in
            the reference markets (say the United States) with the
            pricing of the underlying component assets (or net asset
            valuation) in the originating securities market under
            various assumptions about market structure.  In this paper,
            they empirically investigate the hypotheses that emerge from
            the model. They first analyze country fund pricing and
            associated premia, or discounts, and then explore the issue
            of diversification services provided by NIFs from emerging
            markets.  The emphasis on emerging markets is important as
            many markets are otherwise closed to foreign investors.
            They compare results across emerging and industrial markets
            and, where appropriate, over different subperiods. Their
            evidence suggests that U.S. investors could benefit
            significantly in diversification that involves NIFs,
            particularly funds originating from countries to whose local
            markets they have limited access.  The authors investigate
            the pricing of NIFs, testing their principal theoretical
            predictions about the relative significance of the home
            market, host market, and global closed-end fund factors.
            They analyze initial (public-offering literature) and
            after-market returns, and explain the behavior of fund
            premia/discounts.  The evidence shows that variables that
            proxy the degree of access and substitution effects show up
            as significant determinants of country fund
            premia/discounts.  The empirical study supports their theory
            about the welfare implication for emerging economies that
            originate country funds.  The model suggests that country
            funds can improve pricing efficiency in local capital
            markets and promote local capital mobilization by firms at
            more favorable terms (lower costs of capital).
repnme: repnme: Empirical perspectives on national index funds
display_title: Empirical perspectives on national
            index funds
listing_relative_url: /research/1993/10/698805/empirical-perspectives-national-index-funds
topicv3: Market Risks m1326284 1247,Trade m1326924 698,Capital Markets m1326967 332,Criminal Justice m1326993 1014,Taxation m1327615 1121
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: International Economics and Trade
origu: UNKNOWN
no_of_pages: 55
model_extractions: 2J, <!-- Start of picture text --> :;...<br><!-- End of picture text --> <!-- Start of picture text --> $. ~ ~ ~ ~ ~ w ,,.<br>Ddl ntwhbo F«7o2<br><!-- End of picture text -->

## WPS 1206

**This** paper -a product of the Debt and Litemadonal Finance Division, Intemational Econemics Departmnent-is a companion paper **to** the heoretical analysis of country _funds by_ the sane authors, **'The** Pricing of Country Funds and Their Role in Capital Mobilization for Emerging Economies," Policy Research Working Paper **1058.** Copies of this paper are available _frec_ fom **the** Wodd Bank, 1818 H Street NW, Washngt DC 20433. Please contact Azeb Yldeiu, **room H7-03,** extension 36067 (October 1993, 49 pages).

# **Closed-end nadonal index uds (NIFs or**

**"country** fmnds") invest primarily in the stocks of the originating countries, such as Brazil, India, and the Republic of Korea. They are typically traded in the organized exchanges of industrial countries, such as the Urited States and the United Kingdom. Although NIFs have not raised large amounts of extemal funds, recently they have expanded rapidly.

In a companion paper ('The Pricing of Country Funds and Their Role in Capital Mobilization for Emerging Economies," WPS 1058), Diwan, Errunza, and Senbet develop a theoretical model to compare the pricing of country funds in the reference malkets (say, the United States) with the pricing of the underlying component assets (or net asset valuation) in the originating securities market under various assumptions about market structure.

In this paper, they empirically investigate the hypotheses that emerge from the model. They first analyze country fund pricing and associated premia, or discounts, and then explore the issue of diversification services provided by NIFs from emerging markets. The emphasis on emerging markets is important as many markets are otherwise closed to foreign investors. They

**compare rslts across emergin and industrial** markets and, where appropriate, over different subperiods.

Their evidence suggests **that** U.S. investors could benefit significantLv in **diversification that** involves NIFs, particularly funds originating from countries to whose local markets they have limited access.

Diwan, Errunza, and Senbet investigate the pricing of NEFs, testing their principal theoretical predictions about the relative significance of the home market, host market, and global closed-end fund factors. They analyze initial (publicoffering literature) and after-market returns, and explain the behavior of fund premia/discounts. The evidence shows that variables that pioxy the degree of access and substitution effects show up as significant determinants of country fund premia/discounts.

The empirical study supports their theory about the welfare implication for emerging economies that originate country funds. The model suggests that country funds can improve pricing efficiency in local capital markets and promote local capital mobilization by firms at more favorable tenns (lower costs of capital).

The Policy ResearchWorking PaperSeries disseminates the findings of work under way in theBank Anobjective ofthe series is to get these findings out quickly, even if presentations are less than _fully_ polished. The fndings, interpretations, and conclusions in these papers do not necessarily re?resent official Bank policy.

Produced by the Policy Research Dissemination Center
# Empirical Perspectives on National **Index** Funds

## **by**

**Ishac Diwan, Vihang Errunza, and Lemma W. Senbet***

*The authors are, respectively, from the World Bank, McGill University, and University of Maryland.

_Note:_ This is a companion paper to "The Pricing of Country Funds and Their Role in Capital Mobilization for Emerging Economies, Policy Research Working Paper 1058, World Bank, 1992. The authors thank Ked Hogan, Art Moreau, Vikram Nehru, and Morty Yalovsky for comments.<sup>Financial</sup> support was received by the au.hors from the World Bank, Faculty of Management at McGill University, and the William E. Mayer endowment at Maryland. We thank Joseph Salva tore, Santiago Galindez, and Philip O'Connor for able research assistance.
# TABLE OF CONTENTS

||||Page|
|---|---|---|---|
|**SUM**|**MARY**|.......|I|
|NAT|IONA|L**INDEX**FUNDS: EMPIRICAL PERSPECTIVES.|**.**<br>3|
|1.|THE|DATA AND SAMPLE ................................|4|
|11.|GAI|NS FROM DIVERSIFCATION INTO EMERGING MARKETS ...|<br>5|
||I. 1|**Pairwise Correlations**.<br>.<br>.<br>..............|7|
||II.2|Components of Risk...........|9|
||11.3|Mean-Variance Efficient Frontiers ........................|I l|
|||11.3.1<br>Idealized Diversification Gains ....................|I 1|
|||11.3.2<br>U.S. Based Diversification .......................|12|
|ilI.|PRIC|ING OF NIFs .....................................|13|
||III.I|Imperfect Substitution**.14**||
||111.2|Methodology .14||
||111.3|Results .........................................|16|
|IV.|IPOs|OF NIFs<br>..|18|
||IV.I|Initial Returns .19||
||IV.2|After Market Returns .19||
||IV.3|The Seasoning Effect .20||
|V.|PRE|MIUMS/DISCOUNTS ON NIFs<br>..|20|
||V.1.|Determinants**ol**Premium/Discount .21||
||V.2.|Variable Definilions .21||
||V.3.|The Test Procedure .................................|23|
||V.4.|Test Results .....................|25|
|VI.|CON|CLUDING REMARKS ....................|26|
|REF|ERENC|ES .............|28|
|ANN|EX T|ABLES .............|29|
|li-JR|ES ......|.........................<br>I ................|47|
# **SUMMAR I**

Closed-end national index funds **(NIFs** or "country funds") primarily invest in the stocks of the issuing or originating countries, such as India, Korea, Brazil, and are typically traded in **the organized exchanges of the developed** countriLs, such as the **US** and the UK. AlthoLigh the **external funds tapped through NIFs have been small to date, they have expanded** at a rapid rate **over the recent past. This raises the** issues **of their role** in **providing** pricing **efficiency** in the originating stock markets of emerging economies and enhancing capital rnobilization by local firms of such economies. (Since country fiNnas themselves remain a very small fraction of the stock of external capital available to emerging economies, external capital mobilization is less important.) This paper is a companion paper to a theoretical analysis of countrv funds (Diwan, I., V. Errunza, and L. Senbet. "The Pricing of Country Funds and Their Role in Capital Mobilization for Emerging Economies," PRE Paper, 1058, The World Bank, December 1992.) The first paper focussed on the pricing of country funds in the reference markets (say the US) relative to the pricing of the component underlying assets (or net asset valuation) in the originating securities markets. Thai paper identified several variations of mnarket segmentation structure and arbitrage restrictions.

This paper provides an empirical investigation of country funds with particular attention to their diversification benefits and their pricing behavior. Based on the theoretical analysis of the companion paper, this paper analyzes the empirics of country fund pricing and the associated premia or discounts. The paper explores the issue of diversification services provided by the NIFs from emerging markets. The emphasis on emerging markets is of particular importance,
since many of them are otherwise closed to foreign investors. We compare the results across emerging and developed markets and report them for sub-pexriods, where appropriate. The evidence suggests a significant diversification benefit to US investors arising from NIFs, particularly those funds originating from countries with limited access tJ their local markets.

The paper also investigates the pricing of NIFs. Specifically, it tests the principal theoretical predictions regarJing the relative significance of the home market, host market and the global closed-end fund factors. It analyzes the initial and after market returns, as in the initial ,.ublic offering (IPO) literature. It also attempts to explain the behavior of premia/discounts of these funds. The evidence for this question supports the predictions of the companion theoretical paper with regard to the pricing of country funds, relative to their net asset values. Variables that proxy the degree of access and substitution effects show up as significarnt determninants of country fund premia/discounts.

The empirical support for the theoretical analysis is particularly useful, since the companion paper has advanced a number of welfare implications for emerging economies that originate country funds. The model suggests tha. vountry funds can enhance pricing efficiency in the local capital markets and promote local capital mobilization by firms at more favorable terms (lower costs of capital). Thus, we are encouraged that the policy implications drawn from the theore'ical analysis for the promotion and support of country funds have an empirical basis.

2
# NATIONAL INDEX FUNDS: **EMPIRICAL PERSPECTIVES**

Although the benefits of international diversification have been apparent for quite some time, they are impeded by barriers (explicit and implicit) to cross-border portfolio flows. In recent years, National Index Funds (NIFs) that specialize in assets of a given country (or region) and trade on a developed market, such as the NYSE, have been offered as an alternative investment vehicle to foreign markets.' Some of these funds special',,e in developed markets (DMs) that are largely aevoid of explicit barriers but may involve high transaction, information and other costs. Other funds invest in Emerging Markets (EMs), many of whom have imposed prohibitive barriers to foreign investments. Thus, many EM funds may provide the only opportunity to investors who wish to diversify in these closed markets.<sup>2</sup> From the perspective of the home country, the NIFs may serve several purposes: (a) serving as a means of attracting external funds, (b) developing and liberalizing local capital markets, and (c) providing pricing efficiency through globalization, thereby enhancing local mobilization of investment capital. As argued in the companion paper, although the external funds tapped through NIFs have been small to date, their contribution to the local economy can be substantial through pricing efficiency and local capital mobilization. Despite the significance 'This is primarily a late 1980's phenorren'rn, although a few funds were available prior to 1985. 2lndirect investmen **t** s hrough the multinationuis and a handfuli of American depository receipts are also available. See Errunza and Senbet (1981) for the valuation effects of indirect diversification through multinationals.

3
of the NIFs and their phenomenal growth since 1986 (see Figure 1), though, important empirical issues remain largely unexplored.<sup>3</sup> This paper provides an einpiical investigation of country funds with particular atteniion to their diversification benefits and their pricing behavior. The theoretical analysis of the companion paper will provide a basis for the empirics on country fund pricing and the associated premia or discounts. We begin with a description of the data and sample. **In** Sectior **II,** we exrlore the issue of diversification services provided by the NIFs from emerging markets. The emphasis on EMs is of particular importance, since many of therl are otherwise closed to foreign inve,tors. The theoretical gains from diversification are con pared with the achievable NIF-based diversification. We compare the results across EMs and [)Ms and report them for subperiods, where appropriate. Section III reports on the pricing of NIFs. Specifically, it tests the principal theoretical predictions regarding the relative significance of the home market, host market and the global closed-end tund factors. Section IV analyzes the initial and after market return., as in the initial public offering (IPO) literature. Section V attempts to explain the behavior of pr!mia/discounts based on theoretical predictioris of the companion paper. Section VI provides concluding remarks.

# I - THE DATA AND SAMPLE

The study covers all closed-end single country funds publicly traded in New York by the end of 1990. Table I lists the thirty-two funds in the sample, their offering dates and the 'Bailey and Lim (1989, 1990) analyze the diversification henefits and some issues related to their initial ofterings.

4
number cf weeks of trading.<sup>4</sup> Eighteen funds are fronm EMs **ard** 14 from DMs. Table 2 provides the initial size, number of shares, price and value at the end of 1990. It should be noted that the initial size represents total capital raised by the fund tnrough one or more offerings up to the end of 1990. About 39% of the global market valuL :n 1990 corresponds to EM funds. Figure 1 documents the dramatic increase since 1981 througih 1990.

The data base contains wcekly data for each fund since its inceotion. It comprises: Friday closing prices as reported in the NYSE records; net asset value (NAV) as obtained from fund managers; dividends and distributions of capital gains; local stock market inde; pro"ided by local exchanges; representative indices calculated by the International Finance Corporation for fifteen funds -eleven countries- (series start only in January i989); exchange rates (from IMF) between local currencies and U.S. dollar; and the Standard & Poors Composite Stock Price Index of 500 Stocks. Tables 3 to 6 report returns on the various funds. Table 7 reports returns on the coiresponding local stock market indices.

# **II** - GAINS FROM DIVERSIFICATION INTO EMERGING MARKETS

The gains from international portfolio diversification documented in traditional analyse. do not take account of barriers to capital flows and the associated costs of accessing capital markets across national boundaries.j It is apparent that portfolio capital does not flow freely 4Twelve closed-end multi-country funds that traded in New York are not included in the study. We also do not consider non-diversified country funds, warrant funds or debt-conversion funds.

> 'See Levy and Sarnat (1970) and Errunza (1977), among others.

5
among many EMs and a number of developed markets.<sup>6</sup> Thus, the evidence based on the assumption of free flow of capital and corresponding market indices may not reflect the true benefits of diversification.

The purpose of this section is tn provide new evidence on the benefits of interrational diversification. The emphasis will be on EMs, many of whom are closed to foreign investors. We **use** the freely accessed National Index Funds that are also freely traded on the U.S. stock ex%zhanges together with various freely accessible developed market portfolios to document gains fro-m international diversification. We also use the EM and DM market indices (many of which are not freely accessible) to provide comparisons with past work and distinguish among theoretically desirable versus practically attainable diversification opportunities.<sup>7</sup> Following the tradition, we begin by reporting the pairwise correlations, and then the systematic risks of the various NIFs with respect to the benchmark local and U.S. market indices. We proceed to develop various mean-variance efficient frontiers to document theoretical gains from diversification based on various market indices and the diversification potential based solely on the U.S. market that includes the National Index Funds. Finally, we provide the evidence of attainable diversification gains from the U.S. perspective based on all available assets, including all NIFs from developed and emerging markets as well as all freely accessible 6Stulz (1981) and Errunza and Losq (1989), among others, develop asset pricing models that suggest higher expected returns on securities from markets that cannot be accessed freely.

'Note that the debate as to whether the National Index Funds serve as a substitute for direct portfolio investments in the corresponding markets is moot in the case of markets otherwise closed to foreign investors. In the statistical sense, though, the behavior of NIFs will he compared to the underlying assets and market inc<sup>1</sup> 'ces in this and the next section.

6
national market portfolios. Comparisons are made across DM and EM assets, and where appropriate, the results are reported for subperiods to establish time stability.

# - **1.1** Pairwise Correlati!nQ

We begin with a correlation analysis for the period 1989-1990. The price returns arv based on market clearing prices of the NIFs in the abcve host (U.S.) market. The NAV returns are based on home market clearing p;;_es of the underlying securities that constitute the NIF. Note that we do not include dividends in computing price and NAV returns so as to make them comparable with returns on various market indices (which are not adjusted for dividends) used in the analysis of this paper. The results are presented in Table 8 and summarized below. The coefficients of correlation are: between returns on prices (ROP) and NAVs is **CPN;** between ROP and returns of local market index in U.S.$ (RLM) is CP,L;<sup>8</sup> between ROP and returns on S&P500 is Cpsp; between NAV returns and RLM is CNL; and between NAV and S&P500 is **CNSP.**

> **8 Table** 8 also contains correlation coefficients computed between price and NAV returns with respect to IFC local stock market indexes. Waeneveg there is no IFC index, a N.C. (non computable) messages appears.

7
**_Table 1: Summary of Correlations of Pricjs and NA Vs_**

||**Mean**|**Std. Dev.**|**Maxim**|**Minim**|
|---|---|---|---|---|
|CP'N|**0.4136**|**0.1780**|**0.7175**|**-0.039**|
|**CP,-**|I<br>**0.4525**|**Li. 1560**|**0.7941**|**0.2167**|
|**ICpsp**|**0.3297**|**0.i465**|**0.5680**|**-0.131**|
|CNL|**0.7851**|**0.1764**|**0.9784**|**0.1944**|
|CN,SP|**0.2143**|**0.1934**|**0.5468**|**-0.161**|

**Source: Table 8.**

These numbers are (across funds) averages of the correlation coefficients computed between two variables for each fund. Fc example, the correlation coefficients between prices and NAVs are computed first for each fund, resulting in a new series of thirty-two observations. Then a univariate exercise is done on that series, to obtain a mean of 0.4136, standard deviation of 0. 178, and so or, The same procedure is used for the other four pairs of coefficients.

The first coefficient (0.4136) reflects that returns on prices and on NAV have recorded some degree of co-movement over the period, in average terms. This provides thb. initial evidence of imperfect substitution between NIFs and their underlying assets (see Case III of the companion paper).

Secondly, country funds price returns are slightly more correlated with the home country index returns (average of 0.4525) than to S&P500 index returns (0.3297). Given that the typica!

8
correlation among U.S. securities is about 0.5 to 0.6,9 this is preliminary evidence that country funds, on average, provide diversification benefits to a U.S. investor. On average, the EMs are also less correlated with the S&P530 in comparison to DMs, thus providing some support to the higher diversification potential of EMs over DMs. As expected, returns on NAV are much more closely associated with returns on local stock market indexes (0.7851) than to returns on S&P500 (0.2143).

# **11.2 - Components of Risk**

A risk components analysis is conducted by regressing NIF price returns on their corresponding local stock market returns (Model 1) and then on the S&P500 returns (Model 2), respectively. The detailed results are reported in Table 9 and are summarized below:

**_Table 11._** _Decomposition of Risk_

||Model I(%)|Model 2(%)|
|---|---|---|
|Average systematic risk|22.8|13.1|
|Average unsystematic risk|77.2|86.9|
|Total risk (variance)|100.0|100.0|
|Maximum unsystematic risk|95.3<br>(India)|100.0<br>(Turkish)|
|Maximum systematic risk|63.1<br>(Emer. Germ)|32.5<br>(Irish 1.)|

Source: **Table** 9.

> 9Chapter 8 of Frank K. Reilly, 'Investment Analysis and Portfolio Management", Third Edition.

9
For each model and each fund, the residual variance is computed by squaring the residuals from the estimated model. Systematic risk is given by the square of the product of the beta (the slope of the regression) with the market return standard deviation.

The results of all regressions are reported in Table 9. Averages are across all regressions, for each model.

_aFwud)_ = _p2aMarket)_ +<sup>_2_</sup> _(Residua)_ where, <!-- Start of picture text --> p= Cov[R(Fund),R(market)]<br>Var[(R(market)]<br>and<br>R (market) = Home market in model 1<br>S&P500 in model 2<br>R (Fund) = Price return<br><!-- End of picture text --> On average, the proportion of variance, that is attributable to the unique features of country funds, and not by the movements of their local stock markets, is about 77% in the case of Model 1. The average share increases up to 87% when the market measure used characterized by the movements of the S&P500 index. Another interesting feature is that the 10
maximum systematic risk proportion for Model 2 is about one half of the maximum of same risk for Model 1.

Again, these results suggest that international diversification via NIFs is desirable for the U.S. investor. It also points out that, on average, the NIFs are not a good proxy for their corresponding local market index (i.e., NIF-based diversification gains would be lower than theoretical diversification gains based on (inaccessible) local market indices).

# **11.3** - Mean-Variance Efricient Frontiers

Although there are 18 EM and 14 DM funds that trade on the NYSE representing 13 EMs and 10 DMs, in this subsection, we include all NIFs that continuously traded over the period July 1989 to June 1991. Thus, the data consists of weekly returns on 8 EM and 6 DM national index funds traded on the NYSE and the corresponding data on 7 EM and 6 DM market portfolios. The efficient frontiers are defined as usual as the set of portfolios that have less risk than any other with comparable expected return, and more return than any other with comparable risk. These frontiers were developed using standard packages using historical time series of returns.'

# 11.3.1 - Idealized Diversification Gains

We first investigate whether the diversification benefits documented in the past studies carry through to the more recent period and for our sample countries. Specifically, we inquire whether the benefits (in terms of mean-variance (M-V) efficiency) to the passive U.S. investor sequentially increase as (s)he diversifies into developed and emerging markets. As in the previous studies, we use various market indices and assume no barriers to international

> **10** Since the local market indices do not include dividends, we do not include distributions of the sample NIFs in computing returns. We use the S&P500 without dividends as a proxy for the U.S. market return.

11
investments, and hence the diversifications are presumed to be achitved in an idealized, costless manner.

Figure 2 plots the M-V efficient frontiers for 6 developed and 7 emerging market indices over the July 1989-June 1991 period. It is apparent that the passive U.S. investor (in S&P 500) would have improved performance by diversifying into other markets. 'ionsistent with past studies, the benefits of such investments into EMs are substantially larger than those of developed markets. The S&P 500 portfolio is sequentially dominated by efficient frontiers based on developed markets, emerging markets and the global markets." Thus, the traditional diversification argument carries through to the most recen1t period.

**H.3.2 -** U.S. Based **Diversification**

The previous results (and past studies) do not account for the possible impediments facing U.S. investors in accessing the sample countries. It is now a common knowledge that there are a host of market imperfections (barriers) that inhibit free portfolio flows across national boundaries, particularly emerging and less developed economies. The barriers may take the form of border taxes, exchange controls or capital flow restrictions. Further, the pricing relationships undergo substantial revision on removal of such barriers. Thus, the gains from diversification documented in past studies and the previous section may be illusory. Finally, due to regulatory restrictions (% of foreign traded assets that can be held in a pension fund) and personal preferences, U.S. investors may wish to restrict their investment opportunity set to securities traded on the home market. Thus, this section restricts the U.S. investor opportunity set to securities traded on the NYSE.

"Note that at the lower risk levels, the global frontier dominates the EM frontier. At higher levels of risk, the two (global and EM) frontiers overlap since no developed markets enter the M-V efficient portfolios.

12
Figure 3 plots M-V efficient frontiers based on 6 NIFs from developed countries and 8 NIFs from the emerging markets over the July 1989-June 1991 period.'<sup>2</sup> Although the benefits of international diversification are not as dramatic as those in the previous section, they are substantial. Again the S&P 500 portfolio is dominated by developed market NIFs which in turn is dominated by the frontier based on emerging market funds. Thus, the benefits of international diversification are real and the portfolio performance can be substantially enhanced by including emerging markets in the opportunity set.

To summarize, the traditional argument of intemational diversification carries through to the most recent period. The benefits reported in this section are real based on freely traded and accessible assets and suggest the advisability of global diversification that includes assets from emerging markets.

# IH - PRICING OF NIFs

The evidence presented in the previous section suggests that, although NIFs provide substantial diversification benefits to U.S. investors, the gains are smaller than if they had access to the originating market portfolios or if the funds had been designed to mimic the local index (i.e., a true national index fund). This raises an important question as to **tfle** pricing of these funds. Specifically, do these funds behave like domestic U.S. securities or follow the originating country returns? Bailey and Lim (p. 8, 1989) conclude that, "countrv funds are priced more like domestic U.S. stocks than the foreign equities they are invested in." They consider intraday

> 12 All results are reported for returns based on prices since N1Fs can only be traded (as a unit) on price basis, Note that the risk-return perfonnance based on NAV dominate that hased on prices for all NiFs. Detailed results are available from the authors.

13
correlations and volatilities during trading and non-trading hours. Their tests follow the existing empirical literature on cross-border stock market relationships. Although they attempt to explain these results, we must study this issue further based on theoretical insights of the companion paper. Note that their conclusion is consistent with the prediction of Case 11 of the companion paper which rests on perfect substitution and imperfect arbitrage.

# **[A. - Imperfect** Substitution

As noted earlier, the return behavior of NIFs in our sample does not qualify them as perfect substitutes for the underlying assets traded in the home market. As further evidence, consider the ratio of standard deviations of price returns and NAV returns for the sample NIFs [ratio (1)/(2)] as reported in Table 10. In all cases the price returns display substantially higher volatility compared to the NAV returns. The mean of the ratio of volatilities is 2.12 with a standard deviation of 0.79. The only exceptions are Turkish and Brazil funds whose portfolios had substantial holdings of the U.S. T-bills during the period studied. This leads us to consider the empirical implications of Case III of the companion paper, that admits imperfect substitution, in what follows.

# **11I.2 -** Methodology

The multiple-partial correlation coefficients are used to study the relationship between returns on funds and the given market factor(s) while controlling for the influence of the other factor(s). For example, we first test the importance of the U.S. factor while controlling for the originating country factor. That is, we test the hypothesis, 14
(1)

# **_Ho:_** pR1(R1,5)IRd=O

using sample multiple-partial correlation. To test the hypothesis, we calculate the F statistics,

# **_F [SSR(Rdi_** _in_ **_Model)-SSR(R,,RdI_** _in_ **_ModeO]/k_** _SSR(R,J,R& in_ **_Model)/n-p_**

where Ri is the price return on ith fund, R", is the return on S&P500, Rd, is return on the ith market index, k refers to number of restrictions (one in this case), n is the number of observations, **p** is the number of parameters (total number of independent variables plus the constant - 3 in this case), and SSR (-) refers to the relevant sum of squared residuals.

We reject Ho at c level if F 2 **FK,** ,,p .- We test the following other hypotheses,

## (2)

**_Ho: pRci(Rd,) IRs=O_**

# **(3)**

**_Ho: p Rci(R,is)_** _gRF=O_

# **(4)**

**_Ho:_** _p_ **_RCi(R)_** _IRF=O_

**_(5)_**

**_Ho:_** _pRc1(Rs) IRFRdj=O_

(6)

**_Ho: pRcg(Rdj) IRRFRss=O_**

where RF iS the return on global fund index based on total sample. This index is value-weighted and calculated for Price and NAV series corresponding to the two (developed and emerging) subgroups of funds and the total sample. Details are available from the authors. Note that the tests using global fund factor that conforms neither to the originating countries nor to the host _15_
countries is based on the prediction of the Case III of the companion paper. We argued in the companion paper that there may be other factors that are unrelated to either originating countries or reference countries that affect country fund prices. With such "imperfect substitution", we postulated that there may be a factor related to noise trading activity that would be common to all finds. We attempt to capture this factor through the construction of the global fund index based on our sample of NIFs.

# **m.3** - **Results**

To test the hypotheses outlined above, the following regressions were run for each ith fund since their time of inception: Tables 1 la and 1 lb report the relative importance of the domestic, U.S. and the (total sample) global factors for the NIFs from developed and emerging countries respectively. Specifically, we report the calculated F values and their significance levels for the six hypotheses under investigation. Similar results are reported in Tables I Ic and I Id with the total sample global factor being replaced by the subgroup (developed or emerging) global factor for the corresponding group of NIFs.

Let us first review the importance of the U.S. factor in explaining the price returns of developed market NIFs (Table I la). The U.S. market factors' importance is significant for 8 16
of the 14 funds after taking into account the influence of the corresponding domestic market factor. The U.S. market factor is less important (for 5 of the 14 funds) if we were to take into account the global factors influence. The importance of the U.S. factor almost disappears (except in one case) when we take into account the contributions of the domestic as well as the global factors. Let us now consider the importance of the domestic factor. It is significant for 12 of 14 funds after taking into account the influence of the U.S. factor and for 6 of 14 funds when the impact of global factor is taken into consideration. If both the U.S. and the global factors are included, the importance of the domestic factor in explaining price returns of developed market NIFs is reduced to _5_ of 14 funds. The findings remain unaltered when the total sample global factor is replaced by a factor based on only the developed market NIFs (Table I lc). Thus, for our sample of developed market NIFs, the global factor seems to be the most important in explaining price returns followed by the domestic market factor. The U.S. factor does not seem to be important except in the case of Spain fund price returns which seem to be affected solely by the movements in the S&P 500 index return.

The results are very similar for emerging market funds (Tables 1 lb and I Id). Although, the U.S. factor is important in the presence of the home market factor, its importance declines precipitously when the global factor is taken into account. Although the home factor also becomes less important given the global factor, it remains significant in a majority of cases.

To summarize, the results of this section provide strong support to the theoretical predictions of the companion paper. The case III of the companion paper, which admits imperfect substitution and suggests the presence of an additional factor common to NIFs, is borne out by the importance of the global index factor in explaining price returns of NIFs from 17
EMs and DMs as reported in this section. This finding has important implications for the design of NIFs and policies to reduce imperfect substitutability of the funds and its component assets traded in the home market.

# **IV** - **IPOs OF NIFs**

The theoretical and empirical literature dealing with the underpricing of 1POs of individual U.S. firms is extensive.'<sup>3</sup> These authors contend that underpricing results from information asymmetry and gaming strategies among various IPO participants. On the other hand, Mauer and Senbet (1992) develop an equilibrium model of IPO's that suggest that the socalled underpricing is a fair price differential based on incomplete access and imperfect substitution of the IPO in the secondary market. Recently, Peavy (1990) tests the IPOs of closed-end funds, and reports a mean initial return not significantly different from zero and attributes it to knowledge regarding the value of the underlying assets i.e. low information asymmetry. His conclusions also hold for the subset of international closed-end funds if three special-access funds that prohibit direct portfolio investments by U.S. investors are excluded. He also reports significantly negative after market returns. In a similar vein, Bailey and Lim (1990) also report statistically insignificant initial returns on average with high positive returns on funds specializing in Pacific Rim and Eastern Europe. With respect to aster market returns, they report poor performance except in the case of Pacific Rim countries.

> '<sup>3</sup> See for example, Ibbotson (1975), Ritter (1984) and Rock (1986).

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# **IV.1** - lnitial Returns

For our sample of NIFs, we calculated the initial returns defined as the offering day's closing price minus the offering price divided by the offering price.'<sup>4</sup> The results are reported in Table 12. With respect to the emerging market funds, the initial returns are all positive with the exception of Emerging Mexico Fund and insignificantly negative returns for India and Mexico Equity/Income Funds. The mean return is a highly significant 6.44%, suggesting significant underpricing of EM funds. The information asymmetry and the difficulty of access, coupled with the diversification potential of EMs, may give rise to this initial return. For developed markets, with some exceptions, returns cluster around zero consistent M ith past findings. The average mean return is 5.02% which reduces to an insignificant 0.74% if we exclude the abnormal performance of the New Germany Fund.

# **IV.2 -** After Market Returns

The after market returns are calculated as percent returns from the first trading day to the ninetieth calendar day i.e. end of the 13th week. The results are reported in Table 12. The after market returns for EMs on average are slightly negative. If we were to exclude the abnormally high return on the Taiwan Fund, the returns become substantially lower. Inclusion of the impact of the opportunity cost (i.e., T-bill interest rate) would further lower the performance. As a subgroup, the Pacific Rim countries outperform the other EMs. Thus, the result is consistent with Bailey and Lim (1990). With respect to the developed market funds, "'Due to uncertainty regarding offering date and data problems, the initial return is based on the closing price of 2nd or 3rd trading day for a few funds. This should not cause any concern since as Peajy (p. 697, 1990) states, .semi-strong form market efficiency implies that closed-end fund returns will not be significantly different from zero on days subsequent to the initial trading day".

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the returns are more negative (-12.79%), on average, and are similar to those reported by Peavy (1990).

# **IV.3 - The Seasoning Effect**

As suggested in Mauer and Senbet (1992) and as extended to the NIFs in the companion paper, we would expect a lowering of the underpricing due to the access effect, as new funds that are spanned (by existing funds) in the host market are issued. This is bome out in the case of Mexico - Mexico Equity/Income - Emerging Mexico; Taiwan - R.O.C. Taiwan; Indonesia - Jakarta and New Germany - Future Germany - Emerging Germany. Note that we do not include Germany Fund, which was issued in 1986, wh'ereas the other three German Funds were issued during January-March 1990, a period characterized by German reunification and political changes in Eastern Europe. Only the Spain - Growth Spain Funds do not conform to the seasoning hypothesis. Of course, a rigorous examination of this issue should involve a careful consideration of the issue dates, market environment, the fund investment objectives, relative issue sizes, etc.

## V - PREMIUMS/DISCOUNTS ON NIFs

Premiums/discounts are determined by comparing NAV with closing market prices. When the market value of a share is above its NAV, the fund is selling at a premium, and when the market price is below NAV it is selling at a discount. Both NAV (the current value of the component, underlying assets) and the closing market prices are readily observable, since the underlying assets are marketable securities in the local markets, and the closing prices are obtained from the stock markets of the host countries. Thus, 20
# PREMJUWDISCoUNT= _(PRICE-NA_ **EX1OO** **_NA V_**

Average weekly premiums/discounts for each of the thirty-two funds and their corresponding standard deviations and coefficient of variation are reported in Tables 13 and 14 respectively.

# **V.1** - **Determinants of** Premium/Discount

On the basis of the existing literature and the theoretical insights of the companion paper, ue can postulate the premium (discount) as dependent on (a) degree of access to the local market, (b) degree of spanning of local assets within the host market, (c) degree of substitution between the fund and its underlying assets, (d) the fund size, and (e) global country fund ' discount.

## V.2 - **Variable Derinitions**

Premium/discount (PD): The premium/discount for all funds show high fluctuations over time. Detailed data are available from the authors. Given the scope of this project, we do not conduct empirical tests that would explicitly consider the investor sentiment/noise trader hypotheses.'<sup>6</sup> Rather, we conduct cross-sectional and time-series analysis as detailed below.

Degree of access (ACC): It is very difficult to systematically classify our sample by degree of access. No study exists (to our knowledge) that would provide us with indicators or "<sup>5</sup> As discussed in the companion paper, the premium (discount) will also depend on differential pnce of risk, differential tax rates, differential real interest rates, changes in market sentiment and noise trading, arbitrage restrictions and expropriation risk. Given the limitations of data and scope of the project, these variables will not be explicitly considered.

"<sup>6</sup> As Long, Shleifer, Summers and Waldmann 1990) state, "The fluctuations in noise trader opinion of the expected return on the funds also explain why the discounts fluctuate". Although there appears to be some corroborating evidence in favor of the hypotheses put forward by Lee, Shleifer and Thaler (1991), a systematic analysis would require some additional data and modelling.

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benchmarks to construct al index. As the second best alternative, we have divided our sample countries into three categories based on IFC Emerging Stock Markets Factbooks 1989 and 1990. (a) Completely open:- All ten developed markets, Singapore, Malaysia, Portugal (b) Relatively easier access:- Thailand, Indonesia, Mexico, Philippines, Turkey (c) Virtually closed:- Korea, Taiwan, Brazil, India, Chile. We would expect the premium to be relatively higher for funds that invest in markets with difficult access.

Degree of spanning within host mark.t (SPN): As discussed in the companion paper, the availability of substitute assets (for a given fun,:) in the host market would determine the potential diversification benefits of the fund uneier nsideration. The natural proxy would be the residual volatility of a fund obtained from time series regressions on the U.S. index. Since this proxy would suffer from measurement error problem, we cor ider another proxy for diversification benefits, namely the host and home market retums correlation coefficient. A priori, we would expect higher premium for funds with the lower correlation.

Degree of substitution between the fund and the underlying assets (SUB): The results of the companion paper suggest that the degree of substitution between the fund and the underlying asset has ar, important bearing on the premium/discount. We use the ratio of volatility of price and NAV returns as a reasonable proxy to capture the degree of imperfect substitution. We would expect a higher ratio to have a lower premium effect.

Fund size (FSZ): The initial size of the offering could proxy investor demand, since the size is usually determined by the investment bankers to reflect market interest and conditions. We would expect a larger initial offering to command a larger premium.

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Global country fund premium/discount (AGB): Given the theoretical prediction of a common NIF factor and the results of Section III that suggest the significance of the global factor, we incorporate the global premium/discount as an independent variable. We would expect a positive relationship between the individual fund premium/discount and the global premium/discount.

**V.3 - The** Test **Procedure**

Following the preceding discussion, we postulate the following relationship: _[(PD),,] =Constant+ Pl(A_ **_CC)_** _+ P 2(SPN)j,, +P 3(SUB),1 +_ **_P4(FSZ)_** _+_ P **_(A GB), +error term_** The variables in the above relationship are as defined previously. Subscripts i and t denote the ith fund and t' period, respectively. It should be noted that the [(AGB)] discounts vary over time whereas the degree of Access (ACC) and the fund size (FSZ) vary across the funds. That is, depending on the variable, there is time variation, variability across funds, or both. In order to capture these properties, we conduct time series and cross-sectional tests.

Time-Series Tests: For each fund, the test uses all available data. Since the global country fund premium/discount can be calculated from January 1989 (based on 13 available NIFs) the test period begins in January 1989 or later. We use correlation coefficient between the host and home market returns as the proxy for (SPN) and the ratio of price to NAV return volatility as the proxy for (SUB). In both cases, we use a proxy formation period of 26 weekly observations (host-home market returns for correlation and price - NAV returns for volatility) preceding the test period to estimate the two proxies (SPN) and SOB). That is, observations for t= -25,... 0 periods are used to arrive at the proxy estimate for the **t=** I period. Similarly, 23
observations for t = -24, ... 0, I periods are used to arrive at the proxy estimate for the t = 2 period and so on. Thus, the proxy formation period for eac", subsequent test period is obtained by replacing the first observation of the previous proxy formation period by the observation corresponding to the last test period. Finally, the following OLS regression is run for eacn ith fund.

# _[(PD),] =Constant + P l(SPN), + ,B2(StUB), + P_ **_3(A_** _GB), + error term_

Cross-Sectional Tests: Seventeen of the funds in our sample have complete data beginning in Deeember 1989. The sample increases to twenty-nine funds in July 1990. Since **_6_** months (twenty-six observations) are used to calculate proxies (SPN and S0B) for each fund as described under the time-series tests above, we have a total of 57 periods (27 for a seventeen fund sample and 30 for a twenty-nine fund sample) for cross-sectional tests. The following OLS regressions are run for each of the 57 periods (weeks):

# _[(PD) -A GB] = Constant + p1(SPN)I_ + _p2(SUB)1_ + p _3(FSZ)1 +error term_

where all variables are defined as before.

Since the global country fund premium/discount is invariant across funds for a given period, we use the NIF premium/discount net of the AGB as the dependent variable as in Errunza (1991). These regressions result in weekly OLS values of the coefficients (p's) for each of the 57 periods. Note that although it would be interesting to include the access variable in these regressions, the use of two dummy variables to capture three categories would add two intercept and six slope terms (on R.H.S.). Given the very small sample sizes, we have found it appropriate to exclude this variable.

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# **V.4 -** Test **Results**

The time series test results are reported in Table 15. Since tne residuals indicated significant auto correlation, we used the Cochrane-Orcutt procedure. The resulting residuals are well behaved. In all cases, the adjusted R<sup>2</sup> are reasonably high - they range from a low of 29.6% for France Fund to a high of 95.98% for Korea Fund. The spanning variable is significant for only four sample NIFs. The substitution variable does somewhat better being significant in 9 of the 29 cases. Further, 3 out of 4 and 5 out of 9 significant coefficients for spanning and substitution proxies respectively suggest positive relationship with the premium/discount. Thus, the results are not very encouraging with respect to these two variables. Potential difficulty may lie with the choice of proxies. For example, both the proxies are very volatile in case of most funds. During our test period, the correlation coefficient (SPN) for Thailand moves over time from positive (high of 0.34) to negative (low of -0.32) to positive (high of 0.58). With respect to the global premium/discount va,iable, the results are as predicted by the theory, the only exceptions being the Brazil and Turkish Funds. Coefficients for all other funds are positive and very significant.

The cross-sectional regression results on a weekly basis are very weak. In most cases, the adjusted R<sup>2</sup> are zero and coefficient estimates are not significant. This is neither very surprising nor contrary to our theoretical rnodel which states the equilibrium relationship between prwi!iurn/discounts and the various independent variables. The postulated relationship should hold on average and not necessarily, week by week. Thus, we report the average values and summary measures of the time-series properties of coefficients Pl,, _P2,_ and _03,_ below in Table IIl.

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**_Table 11. Determinants of Premiums/Discounts on_** _NIFS._ **_OLS_** _Estimates_

||**_pit_**|**_P2._**|i|
|---|---|---|---|
|**Mean**|-0.0434|-0.0162|0.0001|
|**Standard Deviation**|0.1726|0.0307|0.0003|
|**t statistic**|-1.898|-3.983|2.5**17**|
|**Significance Level**|**0.062**|**0.001**|0.014|

The above result provides strong support to the predictions of the theoretical model. The spanning and substitution effects are negative and significant. whereas the size effect is positive and significant.

To summarize, the results of the time series regressions strongly support the theoretical prediction of a common NIF factor. The week results for the spanning and substitution effects need to be further studied based on better proxies and more powerful time series models. The results of cross-sectional regressions are very encouraging, even though a larger sample should strengthen the results. Filially, efforts to quantify some of the variables (e.g. access, taxation effects, political risk, asymmetric information and valuation) not included in the above tests should prove ;nteresting and useful.

# **VI - CONCLUDING REMARKS**

This paper has provided an empirical investigation of national index funds on the basis of the available data. The available data are quite limiting, both in time series and crosssectional terms, but the results are, nonetheless, encouraging. The evidence suggests a 26
significant diversification benefit to US investors arising from NIFs, particularly those funds originating from countries with limited access to their local markets.

Further, the evidence supports the predictions of the companion theoretical paper with regard to the pricing of country funds, relative to their net asset values. Variables that proxy the degree of access and substitution effects show up as significant determinants of country fund premia/discounts. The support for the theoretical analysis is particularly useful, since the companion paper has advanced a number of welfare implications for emerging economies that originate country funds. The model suggests that country funds can enhance pricing efficiency in the local capital markets and promote local capital mobilization by firms at terms more favorable (lower costs of capital). Thus, we are encouraged that the policy implications drawn from the theoretical analysis for the promotion and support for country funds have an empirical basis.

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