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EMU - The Challenges for a Fund Manager Chris Golden Senior Economic Adviser

EMU - The Challenges for a Fund Manager Chris Golden Senior Economic Adviser Fleming Investment Management September, 1998. Fleming Investment Management Ltd 25 Copthall Avenue London EC2R 7DR. Jardine Fleming Investment Management Ltd 47th Floor, Jardine House 2 Connaught Place

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EMU - The Challenges for a Fund Manager Chris Golden Senior Economic Adviser

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  1. EMU - The Challenges for a Fund Manager Chris Golden Senior Economic Adviser Fleming Investment Management September, 1998 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 Issued by Fleming Investment Management Limited. Regulated by IMRO.

  2. Background : What does a fund manager do ? • A fund manager tries to capture • trends • because that is what the index does • A fund manager tries to capture • variance • because that is how you outperform

  3. Benchmark Effects • Currency component within Euro-zone disappears • ie relative returns between Euro-zone markets remain the same in any reporting currency

  4. Benchmark Effects • Currency component within Euro-zone disappears • ie relative returns between Euro-zone markets remain the same in any reporting currency • But amalgamated indices will be opaque • At least to begin with • Local return trends will also go • Convergence has already happened

  5. Correlation effects • No currency component => higher correlations • Convergence of fiscal policies • Growth and Stability pact • Market discipline • All increase correlation • Greater correlations => less diversification effect • Eleven (or ten) different baskets • Become one

  6. Correlation Effects • For the global manager • Higher internal correlation of the Euro-zone • Means a lower exposure to Euro-zone markets • For the Euro-zone manager • Lower variance of returns means that • The efficient frontier has less curvature • And index outperformance becomes more difficult

  7. 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

  8. 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

  9. Liquidity effects • The myth of the larger (=) more liquid market

  10. Bond Market Breakdown by Size (1997)

  11. 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

  12. Market Breakdown by Size post EMU

  13. 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

  14. Average Issue Size Today

  15. 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

  16. Relative Government Market Sizes

  17. 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

  18. What to do ? • Allow more off-index asset classes • Increase the credit range of the Euro-sector index • Resist attempts to reduce the weighting of the Euro-sector within the benchmark • Reduce currency exposure constraints elsewhere • Reduce the agreed minimum benchmark outperformance target

  19. Allow more off-index asset classes • Pre-ins • Denmark, Greece, Sweden, UK • EU candidates • Czech Republic, Hungary, Poland • Euro-zone corporates

  20. Domestic Markets

  21. Without the Public Sector

  22. Allow more off-index asset classes • Pre-ins • Denmark, Greece, Sweden, UK • EU candidates • Czech Republic, Hungary, Poland • Euro-zone corporates • Euro-euro corporates

  23. Euro-Euro vs Domestic

  24. Increase the credit range of the Euro-sector index • Euro-zone domestic market

  25. But it is a Quality Market

  26. Increase the credit range of the Euro-sector index • Euro-zone domestic market • Euro-euro market

  27. The Euro-Euro Quality

  28. Increase the credit range of the Euro-sector index • Euro-zone domestic market • Euro-euro market • But this is only a partial solution

  29. A Comparison : The US Corporate Market

  30. Do not reduce the weighting of the Euro-sector • A large weighting of highly internally correlated assets • Produces a benchmark with less variance • Which is therefore easier to beat!

  31. 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 correlated • Liquidity effects: • Lower deficits and less FX risk may lead to sharply reduced liquidity in today's asset classes

  32. 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

  33. 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

  34. EMU - The Challenges for a Fund Manager Chris Golden Senior Economic Adviser Fleming Investment Management September, 1998 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 Issued by Fleming Investment Management Limited. Regulated by IMRO.

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