How Does a PM Manage an International Index Fund

At a glance, it seems easy to just replicate an international index for a PM to manage the fund. Who doesn’t know how to pick and weight an security following a blueprint provided already.

However, things can be much more difficult than imagined. The complexities come in in three parts: Price and Currency Risk, Settlement in Different Time Zone, and Restriction of Ownership or Trading in certain countries.

First, Price and Currency Risk. For Non-US securities, the price varies among different source and mechanism of applying exchange rate to calculate prices in uniform. Foreign currencies trade around the clock whereas the equity market does not open 24 hours. To make things trickier, many emerging market economies impose currency repatriation rules to govern foreign exchange transactions. A good example is that Malaysia government clampdown capital controls in 1998 during the financial crisis, causing Malaysia stocks deemed as non-qualified and excluded from major EM indexes, and fund managers scrambling to the rescue solutions. Hence in running an international index tied fund, an active management is required to handle price fluctuation event like this, while the index provider just need to apply a consistent rule, for instance, WM/Reuters Mid-spot rate of currency i on selection date ST at 4pm London time is strictly used in the equation.

Second, Settlement in Different Time Zone. There are two kinds with repsect to this point, the settlement on purchasing or selling of securities and settlement on corporate actions with impact on the index/fund constituents. In the former situation, most developed countries adopt a T+3 settlement cycle, with Germany and Hong Kong able to provide T+2 cycle, while in Emerging or Frontier Markets, the time varies. South Africa settles T+5, meaning cash will not be available for 5 days. For latter case, the benchmark provider usually employ a particular rule to handle corporate actions, for instance, when a constituent is acquired or absorbed by another constituent, there is a settlement/gap between the delisting day and re-listing day, the indexer will fill in the settlement window with closing price on exact delisted day for a smooth calcuation of index value. However, in reality, the story is different. To add more complexity, rights/warranty exercision, restriction on option trading etc are quite often in the real investment world.

Third, Restriction of Ownership or Trading in certain countries. It’s well known that some countries, particularily in Asia, notoriously in China, impose foreign ownership limits(FOL) on companies domiciled in their markets. That means, if the PM needs to purchase or sell that stock, she is very constrained in terms how much, or even whether she is able to practice so. In China, there is Qualified Foreign Institutional Investor (QFII) program. Only licensed foreign investors are granted to buy RMB-denominated A shares in China’s Shanghai and Shenzhen stock exchanges, with a limit of quota. On the flip side, some US companies impose Qualified institutional buyer (QIB) rules, restricting participants based on their QIB status. Apparently, one can see the discrepancies between underlying index and real fund will present. In reality, the index/benchmark provider will consider this factor when constructing the index. This explains why certain fund manager in Asia market needs customized Asia focused index to be created.

There are more to elaborate on tax differentials reclaims, cash drag, principle trading liquidity, restriction on short-selling, and even culture diversities, so on and so forth. a wide range of factors throws challenges to PM to manage.



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