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EMU - The Challenges for a Fund Manager
Chris Golden
Senior Economic AdviserFleming Investment Management
September, 1998
Issued by Fleming Investment Management Limited. Regulated by IMRO.
Fleming Investment Management Ltd
25 Copthall Avenue
London EC2R 7DR
Jardine Fleming Investment Management Ltd
47th Floor, Jardine House
2 Connaught Place
Central Hong Kong
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GLOBAL FIXED INCOME
Background : What does a fund manager do ?
A fund manager tries to capture trends
because that is what the index doesA fund manager tries to capture
variance because that is how you outperform
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GLOBAL FIXED INCOME
Benchmark Effects
Currency component within Euro-zone disappears ie relative returns between Euro-zone markets
remain the same in any reporting currency
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Benchmark Effects
Currency component within Euro-zone disappears ie relative returns between Euro-zone markets
remain the same in any reporting currencyBut amalgamated indices will be opaque
At least to begin withLocal return trends will also go
Convergence has already happened
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Correlation effects
No currency component => higher correlationsConvergence of fiscal policies
Growth and Stability pact Market discipline All increase correlation
Greater correlations => less diversification effect Eleven (or ten) different baskets Become one
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Correlation Effects
For the global managerHigher internal correlation of the Euro-zone
Means a lower exposure to Euro-zone marketsFor the Euro-zone managerLower variance of returns means that
The efficient frontier has less curvature And index outperformance becomes more
difficult
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Liquidity effects
Some positive effects The single repo area will be bigger than its
parts Positions in smaller country markets
become easier to finance Demand for the currency could increase flows
There will be more players
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Liquidity effects
Some negative effects Governments are likely to borrow less
Which will probably reduce outstanding debt/GDP
As demographic demand is rising FX diversification disappears
So fewer cross Euro-zone arbitrage opportunities
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Liquidity effects
The myth of the larger (=) more liquid market
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Bond Market Breakdown by Size (1997)
$0 Bn
$500 Bn
$1,000 Bn
$1,500 Bn
$2,000 Bn
$2,500 Bn
US
JP
DE IT FR
UK
CA
NL
SP
BE
SE
DK
AT FI
IE PT
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GLOBAL FIXED INCOME
Bond Market Breakdown by Size
Size of government markets by market valuation (1997) :
U.S. USD 2,064 Bn
Japan USD 1,703 Bn
Germany USD 459 Bn
Italy USD 408 Bn
France USD 400 Bn
U.K. USD 343 Bn
Canada USD 200 Bn
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GLOBAL FIXED INCOME
Market Breakdown by Size post EMU
$0 Bn
$500 Bn
$1,000 Bn
$1,500 Bn
$2,000 Bn
$2,500 Bn
US
Eu
rola
nd
JP
UK
CA
SE
DK
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GLOBAL FIXED INCOME
Bond Market Liquidity
Does not depend on aggregate market size alone
Individual issue size is more important
French OATs are typically larger than USTs
And Benchmark Bunds are about the same size as UST equivalent
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GLOBAL FIXED INCOME
Average Issue Size Today
$0 Bn
$2,000 Bn
$4,000 Bn
$6,000 Bn
$8,000 Bn
$10,000 Bn
$12,000 Bn
$14,000 Bn
FR
US
JP
SE IT SP
BE
DK FI
UK
DE
NL
CA IE PT
AT
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Bond Market Liquidity : The good news
A better measure of the overall liquidity of the market : Percentage of a liquid global government bond index
Euroland’s percentage share of the Lehman Brothers Global Government Bond Index is
Almost exactly the same as that of the US Almost three times that of Japan
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Relative Government Market Sizes
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
40.0%
45.0%
50.0%
US Euroland Japan Other Europe Other world
Dec-91Dec-92Dec-93Dec-94Dec-95Dec-96Dec-97May-98
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Bond Market Liquidity
Some additional comments Smaller government issuers may have to pay a liquidity
premium Which could be a source of additional variance
As part of a larger Euro government index, they may lose out to larger issuers
Some overall conclusions Maintained fiscal restraint and Reduced arbitrage opportunities Will outweigh funding advantages
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What to do ?
Allow more off-index asset classes Increase the credit range of the Euro-sector indexResist attempts to reduce the weighting of the
Euro-sector within the benchmarkReduce currency exposure constraints elsewhereReduce the agreed minimum benchmark
outperformance target
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GLOBAL FIXED INCOME
Allow more off-index asset classes
Pre-ins Denmark, Greece, Sweden, UK
EU candidates Czech Republic, Hungary, Poland
Euro-zone corporates
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Domestic Markets
Bank22%
Public Sector24%
Local Authority8%
Supranational7%
Corporate5%
ABS2%
Pfandbriefe32%
Lehman Brothers estimates
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Without the Public Sector
ABS2%
Corporate7% Local Authority
9%
Bank11%
Pfandbriefe43%
Supranational29%
Lehman Brothers estimates
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Allow more off-index asset classes
Pre-ins Denmark, Greece, Sweden, UK
EU candidates Czech Republic, Hungary, Poland
Euro-zone corporatesEuro-euro corporates
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Euro-Euro vs Domestic
$0
$50,000
$100,000
$150,000
$200,000
$250,000
$300,000
$350,000
$400,000
$450,000
AB
S
Co
rpo
rate
Ba
nk
Pu
blic
Se
cto
r
Su
pra
na
tio
na
l
Lo
ca
lA
uth
ori
ty
Euro-euro
Domestic
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Increase the credit range of the Euro-sector index
Euro-zone domestic market
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But it is a Quality Market
Aaa53%
Aa26%
Baa1%
NR9%
A9%
Ba or lower2%
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Increase the credit range of the Euro-sector index
Euro-zone domestic marketEuro-euro market
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The Euro-Euro Quality
Aaa38%
Aa36%
A12%
NR6%
Baa3%
Ba and lower5%
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Increase the credit range of the Euro-sector index
Euro-zone domestic marketEuro-euro marketBut this is only a partial solution
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A Comparison : The US Corporate Market
Aa 15%
Ba 8%
B13%
Aaa3%
CCC3%
A36%
Baa22%
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Do not reduce the weighting of the Euro-sector
A large weighting of highly internally correlated assets
Produces a benchmark with less varianceWhich is therefore easier to beat!
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Summary : The key effects of EMU on fund management
Benchmark effects: The Euro-sector may be deemed too large
Correlation effects: Tomorrow’s Euro-sector will be highly
internally correlatedLiquidity effects:
Lower deficits and less FX risk may lead to sharply reduced liquidity in today's asset classes
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Summary : What a fund manager should do to prepare
Increase the number of allowed non-benchmark asset classes
Analyse the characteristics of emerging and corporate markets BEFORE they become part of the benchmark
Resist attempts to reduce the weighting of the Euro-sector within the benchmark
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Summary : What a fund manager should do to prepare
Increase the number of allowed non-benchmark asset classes
Analyse the characteristics of emerging and corporate markets BEFORE they become part of the benchmark
Resist attempts to reduce the weighting of the Euro-sector within the benchmark
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EMU - The Challenges for a Fund Manager
Chris Golden
Senior Economic AdviserFleming Investment Management
September, 1998
Issued by Fleming Investment Management Limited. Regulated by IMRO.
Fleming Investment Management Ltd
25 Copthall Avenue
London EC2R 7DR
Jardine Fleming Investment Management Ltd
47th Floor, Jardine House
2 Connaught Place
Central Hong Kong