Domestic and foreign country bias in international equity portfolios

Distinguishing two components of the preference for geographical proximity – the domestic country bias assessing investors’ holdings within the domestic market, and the foreign country bias assessing investors’ bilateral holdings within a particular host, I document a number of stylized facts related to international equity portfolios. First, investors in emerging countries hold systematically larger shares in their local markets compared to investors in developed countries. Second, while investors generally allocate trivial shares to most of the available destinations and completely disregard the remaining ones, I report several positive country bias ratios suggesting that the source country's investors overweigh the destination market. Third, the portfolio equity held in only a small number of destination markets generates much of countries’ existing foreign assets. I refer to this observation as the geographical shrinkage suggesting that the domestic bias coexists with an equally imperfect diversification of investors’ foreign asset holdings.     

SEC monitoring of foreign firms’ disclosures in the presence of foreign regulators

SEC comment letters indicate that the SEC has reviewed the firm’s filings and identified a disclosure issue. Using the existence of an SEC comment letter as a proxy for SEC monitoring, we document a negative association between the level of SEC monitoring of foreign firms and the strength of those foreign firms’ home-country institutions, consistent with the idea that the SEC implicitly shares its regulatory duties with international securities regulators. We find that foreign cross-listed firms are subject to lower monitoring intensity than foreign firms listed only on US exchanges, but do not find a statistically significant difference in monitoring between foreign firms listed only on US exchanges and US firms. These findings suggest that it is the presence of another regulator that drives the intensity of SEC monitoring. We also find that US investor holdings are positively associated with the level of SEC oversight, suggesting that the SEC focuses its resources on firms that pose a greater risk to US investors. Collectively, our analyses show that two countervailing forces drive the SEC’s choice to monitor foreign firms. On the one hand, the SEC reduces monitoring intensity when it can rely on the public and private enforcement institutions in the foreign firm’s home country. On the other hand, the SEC provides increased monitoring of certain foreign firms when investors on US exchanges have greater investment exposure in those firms.     

Multinationals and stock return comovement

We find that when a U.S. domestic firm becomes a multinational (MNC), its returns comove more with those of existing multinational firms and less with those of purely domestic firms in the following year. This result is robust to a propensity score matching method and an exogenous shock. Turnover comovement and changes in mutual funds' holdings of these MNC initiators further indicate that investors prefer multinationals as a style investment. Moreover, MNC initiators with larger foreign sales experience larger shifts in return comovement. Finally, the effect of MNC initiation on return comovement is relatively weaker for 2000–2016 than for 1979–1997.     

ADR holdings of US-based emerging market funds

What motivates investors to hold American Depositary Receipts (ADRs) rather than the underlying stock of US listed foreign firms? We analyze the investment allocation decision of actively-managed emerging market mutual fund managers. Although legal provisions are typically assumed to affect ADR and its underlying domestic shares equally, investors holding ADRs may have a higher level of legal protection as these securities are issued and traded in the US. We find that ADRs are the preferred mode of holdings if the local market of the issuer has weak investor protection, low liquidity and high transaction costs.     

Uncovered Equity Parity and rebalancing in international portfolios

Portfolio rebalancing is a key driver of the Uncovered Equity Parity (UEP) condition. According to UEP, when foreign equity holdings outperform domestic holdings, domestic investors are exposed to higher exchange rate exposure and hence repatriate some of the foreign equity to decrease their exchange rate risk. By doing so, foreign currency is sold, leading to foreign currency depreciation. We examine the relationship between U.S. investors' portfolio reallocations and returns and find some evidence consistent with UEP: Portfolio shifts are related to past returns in the underlying equity markets. But we argue that a motive other than reducing currency risk exposure is likely behind this rebalancing. In particular, U.S. investors rebalance away from equity markets that recently performed well and move into equity markets just prior to relatively strong performance, suggesting tactical reallocations to increase returns rather than reduce risk.     

IFRS and the regulatory environment: The case of U.S. investor allocation choice

This paper investigates whether a country’s use of international financial reporting standards (IFRS) is associated with increased US investment in foreign equities. The recent global trend towards the use of IFRS may signal attempts by policy makers to reduce information asymmetries for international investors. However, a concern is that these standards must be accompanied by a stronger regulatory environment in order for them to gain legitimacy. Investor allocation choice is based on US holdings of foreign equities and the regulatory environment is interpreted using two distinct factors: the legal standards system and the enforcement regime. We document that US investment is associated with IFRS only when it is combined with a strong regulatory environment, specifically a strong enforcement regime. We also find that mandating IFRS is attractive to US investors only when combined with a strong regulatory environment.     

Homemade international diversification under economic policy uncertainty

We examine how US mutual funds that invest domestically make portfolio adjustments by incorporating US-listed foreign stocks (cross-listed stocks) when faced with US market economic policy uncertainty. We document a positive association between US economic policy uncertainty and US mutual funds’ weight of cross-listed stocks, and find that the effect is concentrated in funds that mainly invest in the US domestic market. The findings are not sensitive to the instrumental variable approach, model specification, sampling, variable definition, and controlling for macro characteristics. Funds with higher weight of cross-listed foreign stocks when US economic policy uncertainty increases outperform other funds, indicating the rationality of such an investment strategy. A long-short portfolio generates 3.4% annualized abnormal return in the immediate following quarter. Our study shields light not only on the international diversification benefit of US-listed foreign stocks but also on the importance of capital market openness for domestic investors.     

Domestic and Foreign Earnings, Stock Return Variability, and the Impact of Investor Sophistication

We examine the importance of foreign earnings relative to domestic earnings for a sample of U.S. multinationals using variance decomposition. Our methodology represents an alternative and complementary approach over the prior literature, which is based on traditional regressions and earnings response coefficients. We document that domestic earnings are more important in explaining the variance of unexpected returns than are foreign earnings and that the relative importance of domestic earnings is a decreasing function of investor sophistication. Last, we classify institutional investors as either short‐ or long‐term oriented following Bushee [1998]. We find that the variance contribution of foreign earnings increases with the level of investment by long‐term investors. In contrast, there is no significant relation between the degree of ownership by short‐term (or transient) investors and the variance contribution of domestic and foreign earnings. Overall, our results are consistent with Thomas's [1999] finding that investors on average underestimate the persistence of foreign earnings.     

Institutional investors' holdings surrounding equity rights offerings

We examine shareholding surrounding Swedish rights offerings using detailed information on the ownership in firms. We analyze shareholding levels and their changes for domestic and foreign institutional investors. As institutional holdings change, domestic institutions increase their holdings more than foreign institutions. Our examination of low and high buying activities by institutional investors surrounding rights offerings shows no stock picking ability, thus not supporting the “smart-money hypothesis” (Gibson et al., 2004). We also find that investor domicile influences firm value following the offering. Overall, foreign investors exhibit a strong and opposite directional reaction to adverse selection costs than domestic investors.     

Foreign institutional investors,information asymmetries,and asset valuation in emerging markets

This study investigates the effects of information asymmetries and asset valuation model differences (investor heterogeneity) between foreign and domestic investors on their distinct portfolio holdings in an emerging market setting. I argue that information asymmetry and investor heterogeneity views significantly interact in explaining the different asset allocation decisions of foreign and domestic investors. Employing a large dataset from Turkey, the findings suggest that both information asymmetry and investor heterogeneity view play a key role in explaining the investment decisions of different investor groups. Specifically, different from domestic investors, foreign investors are more likely to invest in firms with a higher global market performance which supports the investor heterogeneity view. However, this relationship only holds for firms with high information asymmetries. The difference in valuation models between foreign and domestic investors converge when asymmetric information problems between these investor groups weaken. This study contributes to the international finance literature by providing a new explanation of why foreign and domestic investors invest in different assets.     

Social trust and foreign ownership: Evidence from qualified foreign institutional investors in China

We investigate the effects of social trust on foreign institutional investors’ equity holdings in listed Chinese firms from 2005 to 2011. We find that social trust embedded in the regional environment is an important factor for the investment decisions of foreign institutional investors. We also find that the proportion and likelihood of foreign ownership increases with the level of social trust. The results support the notion that social trust and trust-related information help mitigate informational barriers in international equity investments. Our results are robust to alternative measures of social trust and a range of model specifications, including instrumental variable estimation. We document that the effects of social trust on foreign ownership diminishes in the presence of organizational learning, better formal institutional development, conservative financial reporting, and asset transparency. We also show that foreign institutional investors from countries with a common law origin are more likely to incorporate trust-related information in their investment decisions.     

Stocks for the long run? Evidence from emerging markets

We estimate the myopic (single-period) and intertemporal hedging (long-run) demand for stocks in 20 growth-leading emerging market economies during the 1999–2012 period. We consider two types of investors: a domestic investor who invests in emerging-market assets only (with returns in local currency) and an international investor who invests in both US and emerging-market assets (with returns in US dollars). We establish economically relevant short-run and long-run demand for stocks in several emerging market economies, for both domestic and international investors. From a welfare perspective, however, the myopic demand for emerging-market stocks is much more important than the hedging demand. Further international diversification and foreign currency hedging by the international investor do not alter this conclusion. Hence, for both domestic and international investors emerging-market stocks are mainly assets for the short run.     

International portfolio diversification is better than you think

Using aggregate data on bilateral cross-border equity holdings, we investigate whether investors correctly hedge their over-exposure to domestic risk (the well-known equity home bias) by investing in foreign stock markets that have low correlation with their home stock market. To deal with the endogeneity of stock return correlations, we instrument current correlations with past correlations. Controlling for many determinants of international portfolios, we find that, all else equal, investors do tilt their foreign holdings towards countries, which offer better diversification opportunities. The diversification motive that we uncover is stronger for source countries exhibiting a higher level of home bias.     

The value of excess cash and corporate governance: Evidence from US cross-listings

We examine whether and how a US cross-listing mitigates the risk that insiders will turn their firm’s cash holdings into private benefits. We find strong evidence that the value investors attach to excess cash reserves is substantially larger for foreign firms listed on US exchanges and over-the-counter than for their domestic peers. Further, we show that this excess-cash premium stems not only from the strength of US legal rules and disclosure requirements, but also from the greater informal monitoring pressure that accompanies a US listing. Overall, because investors’ valuation of excess cash mirrors how they expect the cash to be used, our analysis shows that a US listing constrains insiders’ inefficient allocation of corporate cash reserves significantly.     

Exchange Rate Changes and the Operating Performance of Multinationals

Using a sample of 261 US multinationals over the period 1984–2002, we examine the relation between exchange rate changes and the profitability of foreign operations. We find that the impact of exchange rate changes on foreign operations’ profitability is not statistically significant in the majority of industries. Furthermore, according to our variance components analysis, exchange rate changes explain less than 2% of the variation in foreign operations’ profitability for most industries. We also find that the impact of exchange rate changes on foreign operations’ profitability is generally weak for non‐US multinationals from Australia, Canada, Japan and the UK. Our evidence is consistent with the finding of prior studies that the impact of exchange rate changes on firm value is not significant for most multinationals.     

Institutional Investors’ Reaction to SEC Concerns about IFRS and US GAAP Reporting

For the period of 2006 to 2008, we collect Comment Letters issued by the SEC that question the application of US GAAP by US firms or the application of IFRS by European firms registered with the SEC. We investigate whether institutional investors react to the letters by changing their holdings and whether their responses vary for US registrants and European registrants. We do this via a treatment‐effects model in which we test the hypothesis that institutional investors rebalance their portfolio holdings because they view Comment Letters as informative public signals. We find that institutional investors reduce their equity holdings when firms receive SEC Comment Letters, and their negative reactions are most marked for low turnover institutional investors, who we use to represent those informed investors most prepared to incur costs to closely monitor firms. Next, while noting that the number of Letters questioning application of IFRS are smaller in number relative to those questioning application of US GAAP, we investigate whether there are different reactions to Comment Letters questioning different standards. We show that there is a higher probability of the SEC questioning the application of IFRS as compared to US GAAP. After controlling for firm‐specific conditions that impact the issuance of a Comment Letter, we show that this higher probability has economic significance because institutional investors’ react more negatively to Comment Letters that question the application of IFRS as compared to US GAAP. A content analysis confirms the economic importance of the Comment Letters. We find that in almost half of all IFRS cases the Comment Letters request amendments to financial statements.     

The Cost of Capital of Cross‐listed Firms

This paper analyses the cost of capital of firms with foreign equity listings. Our purpose is to shed light on the question whether international and domestic asset pricing models yield a different estimate of the cost of capital for cross‐listed stocks. We distinguish between (i) the multifactor ICAPM of Solnik (1979) and Sercu (1980) including both the global market portfolio and exchange rate risk premia and (ii) the single factor domestic CAPM. We test for the significance of the cost of capital differential in a sample of 336 cross‐listed stocks from nine countries in the period 1980–99. Our hypothesis is that the cost of capital differential is substantial for firms with international listings, as these are often large multinationals with a strong international orientation. We find that the asset pricing models yield a significantly different estimate of the cost of capital for only 12% of the cross‐listed companies. The size of the cost of capital differential is around 50 basis points for the US, 80 basis points for the UK and 100 basis points for France.     

International portfolio diversification and multilateral effects of correlations

Not only are investors biased toward home assets, but when they do invest abroad, they appear to favor countries with returns more correlated with home assets. Often attributed to a preference for familiarity, this ‘correlation puzzle’ further reduces effective diversification. We use a multi-country general equilibrium model of portfolio choice to study how bilateral equity holdings are affected by return correlations among alternative destination and source countries. From the theoretical model, we develop an empirical approach to estimate a gravity equation for equity holdings that incorporates the overall covariance structure in a theoretically rigorous yet tractable manner. Estimation using this approach resolves the correlation puzzle, and finds that international investors do seek the diversification benefits of low cross-country correlations, as theory would predict.     

Home bias in portfolio choices: social learning among partially informed agents

Using an ‘incomplete information’ model, we explore the role of social learning in the global portfolio choices of stock market investors. When partially informed followers attempt to estimate true domestic (home) mean returns, they likely acquire private domestic signals from partially informed leaders. However, the calibration results indicate the existence of home bias when partially informed agents have poor quality information. Partially informed agents are prone to a learning bias; they overreact to new domestic information due to overconfidence in their domestic private signals, but they demonstrate a conservative response to new information in foreign markets. Links between the private signals of partially informed agents may lead to correlated foreign investment strategies among such agents through social learning. We suggest the acquisition of private signals, along with the dissemination of information, affect international portfolio decision rules and are determinants of the phenomenon of home bias.     

Share Repurchases,Dividends and Executive Options: the Effect of Dividend Protection

We study the determinants of share repurchases and dividends in Finland. We find that higher foreign ownership serves as a determinant of share repurchases and suggest that this is explained by the different tax treatment of foreign and domestic investors. Further, we also find support for the signalling and agency cost hypotheses for cash distributions. The fact that 41% of the option programmes in our sample are dividend protected allows us to test more directly the ‘substitution/managerial wealth’ hypothesis for the choice of distribution method. When options are dividend protected, the relationship between dividend distributions and the scope of the options programme turns to a significantly positive one instead of the negative one documented in US data.