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

- 2 - GLOBAL FIXED INCOME 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 - 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

- 4 - 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 But amalgamated indices will be opaque  At least to begin with Local return trends will also go  Convergence has already happened

- 5 - GLOBAL FIXED INCOME 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 - GLOBAL FIXED INCOME 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 - GLOBAL FIXED INCOME 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 - GLOBAL FIXED INCOME 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 - GLOBAL FIXED INCOME Liquidity effects The myth of the larger (=) more liquid market

GLOBAL FIXED INCOME Bond Market Breakdown by Size (1997)

GLOBAL FIXED INCOME Bond Market Breakdown by Size  Size of government markets by market valuation (1997) :  U.S.USD 2,064 Bn  JapanUSD 1,703 Bn  GermanyUSD 459 Bn  ItalyUSD 408 Bn  FranceUSD 400 Bn  U.K.USD 343 Bn  CanadaUSD 200 Bn

GLOBAL FIXED INCOME Market Breakdown by Size post EMU

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

GLOBAL FIXED INCOME Average Issue Size Today

GLOBAL FIXED INCOME 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

GLOBAL FIXED INCOME Relative Government Market Sizes

GLOBAL FIXED INCOME 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

GLOBAL FIXED INCOME 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

GLOBAL FIXED INCOME Allow more off-index asset classes Pre-ins  Denmark, Greece, Sweden, UK EU candidates  Czech Republic, Hungary, Poland Euro-zone corporates

GLOBAL FIXED INCOME Domestic Markets

GLOBAL FIXED INCOME Without the Public Sector

GLOBAL FIXED INCOME Allow more off-index asset classes Pre-ins  Denmark, Greece, Sweden, UK EU candidates  Czech Republic, Hungary, Poland Euro-zone corporates Euro-euro corporates

GLOBAL FIXED INCOME Euro-Euro vs Domestic

GLOBAL FIXED INCOME Increase the credit range of the Euro-sector index Euro-zone domestic market

GLOBAL FIXED INCOME But it is a Quality Market

GLOBAL FIXED INCOME Increase the credit range of the Euro-sector index Euro-zone domestic market Euro-euro market

GLOBAL FIXED INCOME The Euro-Euro Quality

GLOBAL FIXED INCOME Increase the credit range of the Euro-sector index Euro-zone domestic market Euro-euro market But this is only a partial solution

GLOBAL FIXED INCOME A Comparison : The US Corporate Market

GLOBAL FIXED INCOME 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!

GLOBAL FIXED INCOME 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

GLOBAL FIXED INCOME 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

GLOBAL FIXED INCOME 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

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