Question

After much research on the developing economy and capital markets of the country ofOtunia, your firm, GAC, has decided to include an investment in the Otunia stock marketin its Emerging Markets Commingled Fund. However, GAC has not yet decidedwhether to invest actively or by indexing. Your opinion on the active versus indexing decisionhas been solicited.

The following is a summary of the research findings:

Otunia’s economy is fairly well diversified across agricultural and natural resources, manufacturing(both consumer and durable goods), and a growing finance sector. Transaction costs in securitiesmarkets are relatively large in Otunia because of high commissions and government “stamp taxes”on securities trades. Accounting standards and disclosure regulations are quite detailed, resultingin wide public availability of reliable information about companies’ financial performance.

Capital flows into and out of Otunia, and foreign ownership of Otunia securities is strictly regulatedby an agency of the national government. The settlement procedures under these ownership rulesoften cause long delays in settling trades made by non-residents. Senior finance officials in the governmentare working to deregulate capital flows and foreign ownership, but GAC’s political consultantbelieves that isolationist sentiment may prevent much real progress in the short run.

a. Briefly discuss aspects of the Otunia environment that favor investing actively, andaspects that favor indexing.

b. Recommend whether GAC should invest in Otunia actively or by indexing. Justifyyour recommendation based on the factors identified

Short answer

a. Aspects such as economic diversity, transaction cost, good financial disclosure, developing economy and securities market, capital restrictions are factors that favor investing activity.

b. Active management is recommended.

Step-by-step solution

Aspect of Otunia environment that favour investing actively

Economic diversity: This diversity may give the opportunity to employ "top-down" sector timing strategies.

High transaction costs: This may discourage trading activity by international investors and lead to inefficiencies that may be exploited successfully by active investors.

Good financial disclosure and detailed accounting standards: This may give an opportunity to do research analysis to identify inefficiently priced securities.

Capital restrictions: This may discourage foreign investor participation from serving the Otunian market better, thereby creating exploitable market inefficiencies for the active investor.

Developing economy and securities market: These are often characterized by inefficiently priced securities that an active investor may exploit.

Settlement problems: Such problems may discourage international investors, leading to inefficiently priced securities that active investors may exploit.

Explanation on recommendation

Active management would be recommended to focus on short-term inefficiencies and long-term prospects for the developing Otunian markets and economy.

Indexing would be recommended to focus on the factors of economic diversity, high transaction costs, settlement delays, capital flow restrictions, and lower management fees.