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over-the-counter; in some countries, investors are restricted to securities listed on local exchanges. Some Canadian, British and Swiss investors, though, reported that they actually prefer the smaller companies recommended by “regional” (non-New York) brokers.

The Mechanisms of Foreign Portfolio

Investment

policy can cause shifts in portfolio composi-
tion. Fiscal policy tends not to have as direct
an impact. However, changes in fiscal policy
affect a country's economy, and therefore can
influence equity performance.
The tax treatment of investment and income
flows by the investor's country. Tax laws in-
fluence portfolio composition because in most
countries capital gains are taxed differently
than income. For example, a high tax on in-
come and a low tax on capital gains might
allow an investor to achieve a better return in
equities for a given amount of risk, even
though he would have preferred bonds in the

absence of taxes. Factors which influence the industry composition of a portfolio include:

The relative growth prospects for specific in-
dustries. Recently, for example, foreign inves-
tors have expressed optimism about the out-
look for oil and gas producers in the U.S., as
well as other companies involved in natural
resources.

Foreign portfolio investors use the same investment channels, for the most part, as do U.S. portfolio managers. For equities, these channels are, in relative order of size, the New York and American Stock Exchanges, regional exchanges, the OTC market and foreign exchanges which list U.S. securities.

Foreign private investors deal in the following U.S. investment instruments for their portfolios: -Equities listed on a U.S. exchange only

-Equities dually listed on U.S. and foreign exchanges -Equities traded over-the-counter (OTC) -Options -Externally issued corporate debt (Eurodollar obligations) - Internally issued corporate debt (marketable) - Internally issued corporate debt (privately placed)

Mechanisms for Equity Investments

More than 85 percent of total foreign holdings of common stocks consisted of issues listed on the New York Stock Exchange, as shown in Table 13. Most of the remainder consisted of stocks traded over the counter, or not formally traded in any organized U.S. market.

Table 13.-U.S. Common Stock Issues Held Abroad by U.S. Ex

changes Where Traded
(Amounts in millions of dollars)

The history and forecast of earnings for individual companies, especially 6 months to a year in the future. Given two companies with the same average earnings growth rate in the past the company with the more stable growth pattern is generally considered to be less risky. This is taken into account when comparing the current price-earnings ratios. (Much more importance is attached to the relationship between prices and earnings of U.S. stocks than foreign stocks; the uniquely strict conditions imposed by the SEC for reporting earnings are doubtless responsible for this. The earnings of foreign companies are often accounted for in ways that are not permitted in the United States.) The extent to which a company is known by foreign investors. The best-known U.S. multinationals are popular with many foreign portfolio managers. Smaller U.S. companies will rarely attract significant foreign attention without a strong public relations effort abroad. The liquidity of secondary markets for individual stocks. Foreign investors are generally aware of the proportion of outstanding shares held in a given institutional account or even, in the case of the larger investors, across all institutional accounts. With few exceptions, foreign portfolio managers tend to avoid narrow markets. In some cases, however, the investor has no choice. In the Netherlands, for example, a permit from the central bank is required in order to invest in U.S. shares traded only

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Table 14.-U.S. Stocks Listed on Foreign Exchanges, end-1974 Location of exchange

Number of issues
London..

121
Frankfort.

36 Amsterdam.

174 Zurich.

123 Paris..

37 Brussels .

39 Luxembourg

7 Toronto

678 Tokyo.

14b Source: New York Stock Exchange - International Finance

End-1973 b May 1976

research capability. The complexity of these arrangements has caused most foreign institutional portfolio managers to use the services of a relatively small number of U.S. brokers.

Since almost all foreign investors are dependent on U.S. brokers for research and other information on U.S. companies, the foreign investors are not as "commission conscious' as their U.S. counterparts. While they expect a reduction from the fixed rates of pre-May 1, 1975, most indicated that they do not seek the lowest possible cost co execute transactions.

Some foreign investors also expressed concern that the competitive commission structure would result in a significant reduction in the amount of investment research that U.S. brokers provide; their comments reflect their dependence upon U.S. brokers for such information. Mechanisms for Option Investments

Foreign portfolio investors are increasing their investment in options on the Chicago Board of Options Exchange (CBOE) and other U.S. exchanges. The mechan. isms for option investments are similar to those for equity investments. For the most part, foreign institutional investors are sellers of call options against a portion of their portfolio rather than buyers of calls for appreciation.

Foreign investors use the following as intermediaries for equity transactions: U.S. brokers, U.S. subsidiaries foreign firms, and, when dealing on an overseas exchange, the “stock exchange” departments (or trading desks) of the foreign bank. The point was made by some U.S. subsidiaries of foreign banks that, although they had originally been created to serve as a captive vehicle to reduce commission expenses for their parents, 3 they had become independent brokerage firms competing with U.S. brokers for the same clients.

With the trends towards increasing independence by the formerly “captive” subsidiaries, more brokerage business is again being directed by foreign portfolio managers to U.S. brokers. The type of brokerage firm used is typically one which has good research facilities, will service overseas accounts well, and has execution expertise. In addition, many foreign investors seek firms which will act as a "block positioner."'4

Some foreign portfolio managers will enter all orders to buy and sell listed securities to the New York Stock Exchange, while others use local exchanges. The number of U.S. securities listed on foreign exchanges varies, but will usually include the major U.S. corporations, as well as some of the multinationals doing business in the host foreign country.

Foreign investors were asked how they selected U.S. brokers. The results of a questionnaire on the subject are shown in Chart 2. This chart shows that research capability and "quality of investment ideas" are most important. Another important factor that was mentioned often was “the broker's ability to invite us (a foreign bank) into key underwritings.

To a greater extent than their U.S. counterparts, most foreign portfolio managers pay for securities research with so-called "soft" dollars. This means that the manager agrees to place a certain volume of business with the broker in exchange for access to the firm's

Mechanisms for Debt Investments

In recent years Eurodollar bonds have been the most frequently used vehicle for foreign investment in U.S. bonds. The mechanism normally used is for the foreign bank to join the underwriting group, if possible, and then to sell to his accounts directly. Less frequently, the foreign portfolio manager will purchase these securities from U.S. or foreign underwriters of these issues.

Few foreign investors purchase domestically issued U.S. corporate debt obligations. However, some Canadian and U.K. insurance companies maintain a portfolio expert in the United States to facilitate participation in original underwritings.

How Foreign Investors Obtain Information to

Aid in Decisions About U.S. Investments

In general, there are six major sources of information for foreign portfolio investors. These sources include:

-U.S. broker/dealers
-U.S. subsidiaries of foreign financial institutions
-Federal Government statistics and reports on the
overall economy
-The financial press
-Company reports (annual and quarterly)
-Visits with U.S. companies and institutional inves-
tors

3Except for Canadian firms, foreign owned brokers have been prohibited from becoming members of the New York Stock Exchange. However, they are permitted to join regional exchanges. Under fixed commission rates, they would execute orders, whenever possible, on a regional exchange, thus reducing their execution costs.

A block positioner is a firm which will commit its own capital to acquire a portion of a securities position which is being sold.

Relationships among foreign financial institutions, U.S. brokerage firms, U.S. subsidiaries of foreign finan. cial institutions, and other U.S. financial institutions are

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Note: Responses to question: "Do you agree that factor X is an important consideration affecting the choice of a U.S. broker/intermediary?"

well established. Although foreign institutions execute a majority of their transactions in American securities on U.S. stock exchanges, over 200 U.S. securities are traded on foreign stock exchanges. Foreign newspapers report prices on the New York Stock Exchange daily. In the case of Canadian investors, they have had such close ties with the U.S. markets for so long that many do not even view their investments in the U.S. as "foreign.” In short, foreign investors have access to practically the same information about U.S. investment opportunities as U.S. institutions.

There are some important exceptions, however. These exceptions stem from the physical distance separating investors and the U.S. markets, time differences in terms of market openings and closings, and ability to digest and interpret the mass of information (e.g., because of cultural and language differences, among others). A variety of important personal and organizational relationships have evolved largely as a consequence of these differences. These differences have an impact on foreign investment strategy. The main effect has been to avoid the more volatile small companies and over-the-counter stocks where it is more important to follow corporate earnings closely.

Foreign investors believe they are at a disadvantage relative to U.S. investors because of time differences. Except for Canada, foreign offices are closed while the U.S. markets are still open. Moreover, mailing times cause late arrival of research reports and of U.S. financial publications. Most foreign investors agree that they do not receive satisfactory information about market timing. Recommendations are often received too late. “Sell” recommendations are perceived as being poor at best, or non-existent.

These difficulties have been assessed and met by foreign investors in various ways. Many foreign financial institutions have formed U.S. subsidiaries. Some U.S. subsidiaries are owned by two or more foreign institutions from different countries. While these subsidiaries perform trading services (many are members of U.S. regional exchanges; some would seek membership on the New York Stock Exchange if allowed), one of their primary functions is to collect, interpret and relay market and other investment-related information to the foreign parent(s).

Depending upon the size of an institution and its proximity to the United States, research analysts, economists, portfolio managers and key administrators also visit U.S. corporations and financial institutions. Every institution that sponsors such trips includes selected New York brokers on the itinerary. Many also meet with one or more of the major New York banks to assess the general economic outlook in the United States. An increasing number of representatives from foreign institutions now meet regularly with regional brokers; some also meet with Federal authorities in Washington and with private research organizations.

But, paradoxically, many foreign investors say they receive too much information from U.S. brokers on the U.S. economy and investment opportunities in the United States. As mentioned previously, those firms with

U.S. subsidiaries might have this information screened in the United States. Attitudes toward this abundance of information differ: some say it is only of minor importance; others, especially those responsible for smaller portfolios, rely heavily on this source.

Foreign investors and researchers read a number of periodicals and journals pertaining to the United States. Key articles are translated into the local language, especially in Japan.

Most foreign portfolio managers have adjusted their behavior, strategies and tactics to the reality that they are not physically in New York while the markets are open. Recent advances in telecommunications and computer technology, in terms of both hardware and software, have facilitated these adjustments. Quotation machines, news wire services and dealer wire systems are becoming so efficient that no consequential foreign investor need be far from current news.

Foreign economists and research analysts rely upon more technical sources of information about the United States. The monthly reports from the Federal Reserve Banks were mentioned frequently, as well as the Economic Report of the President and official statistics from U.S. Government departments. A few institutions maintain contact with some of the academic leaders in the United States known for their expertise in investment research and policy.

Of course, foreign investment analysts also receive the quarterly and annual reports of all companies on their "master list" of approved holdings. While most interviewees said this information was better than they could get on companies in other countries, there were a few comments to the contrary. The practice of banks carrying securities and loans at par (or cost), as opposed to market value was criticized as misleading. Methods of accounting for currency gains and losses of international subsidiaries of U.S. companies were also criticized.

Contrasts Between Portfolio and Direct

Investments

Virtually all portfolio managers and intermediaries interviewed emphasized the total difference between portfolio and direct investment.

Characteristics of attractive portfolio investments include:

-Liquidity
-Freedom from restrictions on sale
-No company management responsibility
-No legal fees or complications
- Safety
-Diversification
-Simple valuation procedures
-Seasoned securities
-Holdings that are easy to explain

Foreign portfolio managers universally disclaimed any intent ever to convert portfolio holdings to direct investment, nor did any international investor claim to have seen a portfolio investment converted later to a direct investment.

Some of the foreign portfolio managers interviewed did comment, however, that their organizations had participated as intermediaries in tender offers for the stock of U.S. companies. They pointed out that different departments of their organizations were involved, and that they were simply performing investment banking and advisory functions as do U.S. brokers/dealers. Only one exception was discovered. A foreign company had made a normal portfolio investment in a U.S. firm; subsequently, it elected to make a tender offer for a majority of the shares in order to protect the original investment which had deteriorated significantly.

ceeded by the $300 million due to foreigners. U.S. brokers, banks, and other lenders are, of course, subject to Federal controls on margin requirements with respect to their foreign as well as their U.S. customers.

There are two possible exceptions to the rule that foreign portfolio investment in the United States is not financed with borrowed funds, but neither of them represents an actual leveraging of assets. First, British investors have from time to time engaged in what are called "loan fund” operations. These funds are explicitly set up to avoid the effects of U.K. exchange regulations, and involve the use of "back-to-back" loans designed to obtain the foreign currency necessary to purchase foreign assets, in effect bypassing the “investment dollar” pool with its attendant premium.

The second possible exception is that, from time to time, foreigners issuing bonds in the U.S. market may have placed the proceeds of their U.S. borrowings in U.S. assets (mostly of a short-term nature) during the period between take-down of the proceeds and actual expenditure of funds. This would be particularly true of the largest borrowers-international organizations and Canadian entitities. Indeed it was for some years U.S. policy to strongly encourage such actions.

How Foreign Portfolio Investment in the

United States is Financed

With rare exceptions, foreign portfolio investment is not “financed,” i.e., does not involve borrowing funds either in the United States or abroad. At the end of 1974, for instance, U.S. brokers reported only $200 million "due from foreigners,” an amount that was actually ex

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