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1. Introduction

The past decade has seen a dramatic growth in equity investing in passively managed index
funds. It happened partly due to strong performance of S&P500 in the mid 1990’s and partly due
to ready access, particularly by U.S. investors, to a well diversified indexed portfolio at a low
cost. The decade has also been marked by growing integration of equity markets worldwide
resulting from financial liberalization measures and market oriented economic reforms, being
actively pursued by developing economies, as well as improvements in technology. As Khorana
et al. point out, “Given the rise in indexing and the interest in international investing, it is not
surprising that a new financial security responding to both of these trends has been introduced”
(1998, pp. 78). This new security is known as iShares (formerly known as World Equity
Benchmark Shares (WEBS)). iShares, organized as exchange-traded funds (ETFs), are designed
to track Morgan Stanley Capital International (MSCI) indexes in respective countries. They
provide a product that tracks a portfolio designed explicitly to allow internationally comparable
benchmark performances yet can be easily traded on organized exchanges. It thus combines the
diversification benefits of an index fund with the flexibility of a common stock. The popularity of
iShares has grown, with in excess of over $100b invested in this investment instrument by end
2004. Over 80% of investment in iShares is concentrated in the iShares of G7 countries
(
www.indexfunds.com).

Prior to the introduction of iShares, international investing by U.S. based investors occurred
either via well-diversified MNC’s, or via international index funds, which provided exposure to a
basket of countries, or via closed-end single country funds. Given that closed-end country funds
can only be traded in the secondary market, there is usually a discrepancy between their share
prices and the underlying net asset value (NAV). On the contrary, iShares are created or
redeemed only in kind and the resulting arbitrage opportunities ensure that the share prices do not



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