The adage "great minds think alike" may apply to the virtually simultaneous decision by two exchanges to trade a gaggle of international equity index funds in ADR form. Last March the New York Stock Exchange and the American Stock Exchange began trading these products within days of each other. The NYSE offers Country Baskets in eight offshore markets (all found in the FT All Actuaries World Share Index) assembled by Deutsche Morgan Grenfell, while the Amex features 17 Morgan Stanley­designed WEBS (World Equity Benchmark Shares) based on its Morgan Stanley Capital International (MSCI) index. (See table.)

An attractive feature of both products is that they have traded very close to net asset value (NAV) and should continue to do so because investment houses can create and redeem shares at will by delivering or receiving the underlyings. In fact, most WEBS and Country Baskets will trade at a fraction higher than NAV most of the time because they are free of the taxes and fees that exist in some local markets. They also allow investors freedoms they might not enjoy with direct local investments like going short. At least one and possibly more institutions have used WEBS to take substantial short positions in the Malaysian and Mexican markets; in the Malaysian local markets, there are prohibitions on shorting.

Slow start

Despite their architectural elegance, these instruments have had so-so launches, judging from the tepid numbers in their first two months of life. By the end of May open interest on each of the rival index clusters totaled less than $300 million. The primary markets targeted are retail as well as the small and medium institutional investors that don't have global custodians. WEBS seems to be trying harder in the retail market, as evidenced by the fact that Morgan Stanley has bought a lot of print ads and has a toll-free 800 number for the curious.

But institutional volume has been lackluster. "It is a product that makes sense, but not enough people know about it yet," says one dealer. "People are still being told by their brokers to buy Telmex when they want exposure to Mexico."

Rivalry has hobbled both contenders. The thirst to be first to market shrunk the time that would otherwise have been devoted to pre-launch marketing and promotion, which would have pumped up liquidity from the outset. "So there is a kind of chicken-and-egg problem," says an authorized dealer in both products. "Obviously people don't want to invest when there is no liquidity and when there is no liquidity people don't want to invest. Both have suffered a little bit from this."

Additionally Country Baskets have been beset by lack of strong sponsorship. Amex and Morgan Stanley have much more experience than NYSE and Deutsche Morgan Grenfell in launching newfangled products. "If you were to call up the Amex and ask for something, you'd have it in a second, whereas at the NYSE it is difficult to find out who even to talk to," says Andy Pritchard of the Parallax Group.

Offshore alternative

WEBS' exchange-traded index funds represent a clear assault on offshore single-country funds (closed or open) like Fidelity's for Germany, Japan and Hong Kong-which have a 3 percent front-end load and a 2 percent annual fee-as opposed to no load and a management fee under 1 percent for WEBS. Yet another advantage over funds: WEBS can be shorted and they can be traded real-time after a market-moving event, for example, at a known price, whereas mutual fund transactions are both slower and are uncertain due to end-of-day pricings.

Sources at Morgan Stanley expect that in time WEBS will prove their mettle with institutions. Some of the possible advantages:

• For cash management purposes, investors with accumulated cash can put funds to work in small packages.
• An investor can take a country position in a hurry and, after completing a portfolio analysis, later switch into underlyings.
• New arbitrage possibilities will emerge, making it possible to go long and short in different markets.
• They also have attractive costs relative to the local futures markets in some countries where the costs of rolling forwards can be high.

Calport Asset Management of Westport, Connecticut, was one of the first institutions to see the attraction of WEBS. It has about $125 million under management, $25 million of which is earmarked to global equities. It follows a top-down strategy, making country-by-country decisions without much interest in the underlyings. "For us WEBS is a very cost-effective way to buy international securities," says president Michael Petrino. "I like the fact that I can short, or write a call against them."

Calport doesn't have the same enthusiasm for Country Baskets, in part because "The Morgan Stanley Global Index is a performance standard widely analyzed by major clients: it is a benchmark for U.S. pension funds. It enjoys better brand recognition." As for the future, Petrino forecasts that "This is a great idea that will spread to include all countries, possibly as many as 40. It will give small or medium-sized money managers as big a reach as large managers. With a choice of cash, bonds or stocks across the globe, individual stock selection becomes de minimus."

Maybe so in the long run. More immediately these products will probably gain acceptance quite slowly. "People are going to need time to digest them. They don't have a huge sales force behind them," says the Parallax Group's Pritchard. "They will gather steam eventually," concludes one dealer. "For investors interested in anything less than a year view they have a very attractive cost structure."

When JP Morgan released RiskMetrics more than a year ago, it offered users a free volatility and correlation database and the risk management methodology used to construct it. Now JP Morgan has agreed to collaborate with Reuters to develop a more powerful and elaborate version.

Morgan had been beseiged with requests to expand the original matrix to cover more markets and products. Each addition, however, involves new data collection problems and the threat of mathematical instability. As the model grew larger, moreover, some users were eager to cut up the matrix into the pieces they needed, which involves additional data headaches.

The solution, Morgan decided, was a strategic partnership with Reuters. Morgan will continue refining and adding to the methodology. Reuters will develop a new database engine, expand the database of the rates it covers and work with Morgan on building a new suite of analytical programs to allow users to make full use of the data.

"Reuters was a good match and had the right structure for the job," explains Jacques Longerstaey, who heads the bank's risk management advisory group. The discussions began in 1995 after Longerstaey met Martin Spencer, Reuter's new head of risk management. "I knew the risk management people at Sailfish, Reuter's risk management arm. Martin put in a business plan, and we worked closely specing out what this animal would look like." The partnership will allow Reuters users to get access to RiskMetrics data over the company's protected network via a Netscape browser.

TASS Management last month unveiled its first-quarter results on the 1,500 "alternative" investment managers it tracks worldwide. According to the survey, hedge funds in three specialist categories-European equities, distressed securities and U.S. equities-clocked average returns of 6.5, 5.3 and 4.8 percent respectively. Among the other alternative players, emerging market and convertible arbs and fixed income arbs did not do so well. Bringing up the rear were global macro players, who were on top of the heap in 1995 thanks to a 31 percent annual gain, but who in the first quarter of this year experienced a decline of 2.3 percent.

Faring particularly badly in this survey of alternative players are commodity trading advisors (CTAs), who are among the largest users of listed derivatives. In the first quarter of this year, the TASS index of CTAs posted a loss of 2.1 percent-this on top of a paltry 9 percent gain for all of 1995. From the TASS data, it seems that a handful of CTAs have a hot hand from time to time, but that the majority are beset with underperformance.

Two years after U.S. users of derivatives began fighting to stave off the attention of zealous regulators, U.K. firms are finding themselves embroiled in a similar battle. U.S. firms have long argued that overregulation will drive business overseas; their colleagues in London now argue that restrictive new rules could make them uncompetitive.

"If the rulemaking process is done in a sectional way the overall effect will be damaging to the industry," warned Anthony Belchambers, chief executive of the Futures and Options Association, at a recent London conference. "The cumulative effect of the series of regulatory changes means that sooner or later firms could say they could relocate elsewhere."

These fears come at a time when banking executives are worried that the advent of a single European currency could rob London of its status as a leading-perhaps the leading-global financial center. The proposed changes are designed to reduce the possibility of a repeat of the Barings debacle, but critics say they are too narrow and restrictive.

"There is a great emphasis on technical breaches of the rules," adds Lynn Johansen, a partner at the London law firm Clifford Chance. "This doesn't actually address the real concerns to make sure that the market is functioning in a well-regulated manner." She adds that in fact end-users are among the most ardent advocates of a less rather than more legalistic environment for derivatives.

Fed Research Beam on Derivatives

The odds that an entire issue of the New York Fed's Economic Policy Review would be devoted to derivatives are pretty slim. (Yes, Virginia, there are other things on the economic planet.) But last April's edition contains no fewer than three learned treatises on some aspect of derivatives.

In "Price Risk Intermediation in the OTC Derivatives Markets," academic researchers conduct a follow-up of the April 1995 sweep by central banks in 26 countries to get their arms around the scale and riskiness of derivatives globally. The analysis captures data on market values which, when broken down by counterparty types and disaggregated, provides a deep picture of dealer's intermediation of price risk. On the whole, dealers assume only small exposures to price risk in meeting end-user demands. The analysis of the data also shows that price shocks in OTC derivatives would "not be inordinately large." The study estimates that the price "shocks transmitted through the interest rates derivatives markets, even on a gross basis, would be smaller than those in the debt securities markets." Proof indeed of the market's resiliency, since dealers intermediate between different end-users far more than between end-users and dealer cash market positions. The report sums up: "The overall effect of derivatives markets may be to modify and redistribute exposures to price risk in the financial system, rather than to leverage those exposures."

"Risk Management by Structured Derivative Product Cos. (DPCs)" is a topic also discussed in a feature article in the current issue of this magazine. Both pieces conclude that four years after their birth, DPCs still account for a relatively small share of the potential market of low-credit counterparties. The study in Economic Policy Review says they've not lived up to their promise: "Banks without triple-A ratings are still among the dominant market players, and even the DPC's parents, with at best single-A ratings, engage in considerably more derivatives transactions." Why so? Since credit gridlock didn't materialize, the triple-A feature did not become decisive in customers' picks of intermediaries. Second, the study says that despite their efforts to save on capital, under current rating agency standards DPCs still face more demanding capital requirements than those faced by major intermediaries without triple-A subsidiaries. Conclusion: "The DPCs did not just get off to a slow start; they seem to have been structurally inhibited."

VAR is taken for a test drive in "Evaluation of VAR Models Using Historical Data." In this study VAR is applied to 1,000 randomly chosen FX portfolios between 1983 and 1994. The models are then analyzed according to nine criteria that show how closely their risk measures correspond to actual portfolio outcomes. All three of the most common VAR categories are included: equal-weighted moving averages, exponential-weighted moving averages and historical simulation. The study finds that "in almost all cases the approaches cover the risk that they were intended to" without producing risk estimates that vary in average size. No approach seems to be superior by every measure. However, there are differences, sometimes substantial, among the various VAR approaches for the same portfolio on the same day. As to general conclusions, the research finds that extreme outcomes occur more often and are larger than predicted by the normal distribution-that is, they have fat-tailed distribution. The research also concludes that the size of market movements is not constant over time, but is subject to conditional volatility.

Readers can get a free copy of the April Economic Policy Review by calling (212) 720-6135 or faxing a note to (212) 720-6628.

Presidential Elections: Stocks Up, Vols Down

The impact of U.S. presidential elections on price and volatility has been addressed recently by equity derivatives researchers at Goldman Sachs, who've studied the historical record since the 1964 contest between Lyndon B. Johnson and Barry Goldwater. Despite the limited sample and the static of a million other forces, they arrived at some interesting conclusions. They looked at three phases-pre-convention, convention-to-election and post-election-and compared these with non-election years.

They report: "Although not statistically significant, there does appear to be a tendency for election years to have stronger performance overall relative to non-election years, with most of the outperformance coming in the April through November period." The researchers found "some beneficial economic window dressing and anticipation of a favorable outcome from the election process." It seems that after going to the polls investors are somehow sapped of their animal spirits and there is a big price letdown in the post-election period. The average price return for eight presidential election years was 11.7 percent, versus 6.3 percent for non-election years. What's more, nearly a third of the non-election years were down markets, whereas seven out of eight election years were up markets.

As to volatility, two features stand out. First, presidential election years are on average less volatile than non-election years. Of the eight periods studied only the market ebullience following Reagan's 1980 victory over Carter and the 1988 Bush­Dukakis contest had above-average volatility. Second, the seasonal occurrence of volatility is different in election years. The typical seasonal pattern is for low levels in the summer followed by a peak in October. In election years there is a pretty steady decline from the spring to the end of the year.

Conclusion? If this year's high volatility is sustained through 1996, we are unlikely to have the presidential election to blame.

Best, Quickest and Cheapest Indicator of a Recession

Two New York Fed economists have discovered that the yield curve can play a "useful role in macroeconomic prediction, particularly with longer lead times." Bank researchers Frederic S. Mishkin and Arturo Estralla tested the forecasting accuracy of the spread between interest rates on the ten-year Treasury note and the three-month T-bill, comparing them to the predictive power of stocks prices, the Commerce Department/Conference Board index of leading indicators and the Stock­Watson index. The result, unveiled in the June issue of the New York Fed's publication Current Issues in Economics and Finance, is that the yield curve wins the contest hands down. "It dominates the other variables, and this dominance increases as the forecast horizon grows," the duo say. Quicker and cheaper to create than most other indicators, and a fraction of the cost and complexity of macro computer models, the little ol' yield curve also has a much higher probability of forecasting an oncoming recession.