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The liability of foreignness in international equity investments: Evidence from the US stock market

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Abstract

Using foreign institutional ownership data in the US from 1990 to 2007, we examine whether foreign institutional investors face liabilities of foreignness (LOF) in the US stock market. We find that foreign institutional investors prefer low information asymmetry stocks more than domestic institutional investors do, and this preference for low information asymmetry stocks is particularly strong among foreign institutional investors from countries with high LOF. More importantly, we find that a change in foreign institutional ownership is negatively related to future returns, whereas this relation does not exist for domestic institutional ownership. The negative relation between the change in foreign institutional ownership and future returns is more pronounced when investors face a greater LOF in the US stock market – for instance, when they are from countries with higher institutional distance, information asymmetry, unfamiliarity, and cultural differences. The negative effect of country-specific LOF factors on the return-forecasting power of foreign institutional investors is more evident when they trade stocks with higher information asymmetry. Overall, these findings suggest that foreign institutional investors face significant LOF costs in the US stock market, resulting in their poor ability to forecast returns.

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Notes

  1. Despite extensive evidence on the existence and sources of LOF in host-country product markets, we are unaware of any research that examines the LOF of foreign institutional investors in host-country stock markets. One notable exception is Bell et al. (2012), who extend the LOF theory to foreign capital markets. They argue that since capital markets are more information sensitive than product markets, and capital market participants can rely on endorsements by third parties such as investment bankers and investment analysts for information production, the nature of LOF could be different between product and capital markets.

  2. For instance, Choe, Kho, and Stulz (1999) examine the information advantage of foreign money managers in Korea during a sample period in which foreign investors were not allowed to purchase more than 10% of a firm's total shares outstanding.

  3. There is a possible counter-argument that the USA is not the optimal country to test LOF in host-country stock markets, because the US market is among the most open markets in the world, and thus the LOF would be fairly low in this market. Coval and Moskowitz (1999) and Ivković and Weisbenner (2005), however, show that domestic US investors located near a firm's headquarters have an informational advantage relative to other US investors, suggesting that information asymmetries matter even for US domestic investors.

  4. It is possible that information search costs do not necessarily increase with distance, owing to advances in information technology. However, prior studies suggest that the information advantages associated with distance can still exist even in the presence of advances in information technology. For example, geographically proximate investors are more likely to have informal access to information about local firms, through conversations with employees, managers, suppliers, and customers. They can also visit geographically proximate firms and meet CEOs of these firms face to face at lower cost. It is also possible that, compared with remote investors, investors located near firms expend less time collecting information about their firms, since they are on-the-spot. This value-relevant private information about the firm allows local investors to make informed trades.

  5. According to the SEC, foreign institutions are required to file Form 13F if they: (1) use any means or instrumentality of US interstate commerce in the course of their business; and (2) exercise investment discretion over $100 million or more in Section 13(f) securities. Since foreign investors have no way to buy US stocks without using any means or instrumentality of US interstate commerce, 13F filing requirements are likely to be equally binding for both foreign and domestic institutional investors. We thank an anonymous staff person at the SEC for the discussion on 13F filing requirements by foreign institutional investors.

  6. Untabulated analysis for final communality estimates shows that Earnings Quality plays the most important role in creating Composite LOF Factor (0.57), followed by Disclosure Quality (0.54), Investor Protection (0.51), English (0.45), GAAP Difference (0.37), Export (0.26), and Cultural Distance (0.04). Distance (0.01) plays the least role in creating the Composite LOF Factor. We also examine the correlations among firm-specific characteristics, and find that the change in domestic institutional ownership (ΔDomestic Institutional Ownership t ) is not significantly related to future returns (RET t , t +3), while the change in foreign institutional ownership (ΔForeign Institutional Ownership t ) is significantly negatively related to future returns (p-value<0.01). These results suggest that foreign institutional investors have poor stock-picking ability compared with domestic institutional investors in general. The correlations between other firm-specific control variables and future returns are largely consistent with those in prior research (Gompers & Metrick, 2001).

  7. The LOF view of foreign investors suggests that to overcome their disadvantages and execute profitable future trades or exit the market with minimal cost, foreign investors have a strong demand for liquidity in their international equity investments. In untabulated tests, we experiment with other alternative liquidity measures such as the inverse of the average price and the proportion of zero returns in quarter t−1 and find that the results are similar.

  8. However, we find that the coefficient estimate on Return Volatility in column 3 is significantly negative, but its magnitude is significantly smaller than that in column 2, suggesting that although both matching domestic and foreign institutions prefer high-liquidity stocks, such preference is weaker for foreign institutions than for matching domestic institutions. We also find that the coefficient estimate on R&D in column 3 is significantly smaller than that on R&D in column 2, suggesting that foreign institutions prefer R&D-intensive firms to matching domestic institutions.

  9. Untabulated tests show that when we include both total institutional ownership and domestic institutional ownership in the regression, the median variance inflation factors (VIFs) in 71 quarterly regressions are 116.13 for domestic institutional ownership and 122.95 for total institutional ownership. These high values of VIF indicate that multicollinearity can be a problem.

  10. In untabulated tests, we split our sample period into two subperiods, 1990–2000 and 2001–2007, and separately re-estimate the regressions. We find that the negative relation between the change in foreign institutional ownership and future returns exists in both subperiods, suggesting that our results are not time-specific.

  11. An exception is the Non-English indicator variable, which equals 1 if the foreign institutions are from countries whose primary language is not English, and 0 otherwise.

  12. In untabulated tests, we experiment with an alternative measure of LOF costs, the ratio of the number of cross-listed firms in the US to the total number of publicly listed firms in that country. We find that this listing ratio is negatively related to our LOF measures. We also find that foreign institutional investors who are from countries with a lower listing ratio have inferior stock-picking ability to those who are from countries with a higher listing ratio.

  13. Untabulated analysis for final communality estimates shows that Return Volatility plays the most important role in creating Composite Information Asymmetry Factor (0.35), followed by Size (0.21), R&D (0.19), and Analyst Forecast Dispersion (0.14).

  14. As shown in Figure 1, foreign institutional ownership was relatively small and stable in the early years of our sample period, particularly during the 1990–1995 subperiod. Since this scarcity and stability of foreign ownership distort our decile portfolios, we examine portfolio returns after omitting the 1990–1995 subperiod. In untabulated tests, we re-estimate the regressions in Table 5 using the 1996–2007 subperiod, and find that our key results for the negative (positive) relation between the change in foreign institutional ownership (level of domestic institutional ownership) and future returns does not change.

  15. To the extent that SEC Form 13F filings are updated at the end of every quarter, and foreign intuitions are able to rebalance their stock holdings every quarter (particularly stocks with large losses), the results may suggest that long-term returns such as two- and three-quarter-ahead returns are a noisy measure of institutional investors’ return-forecasting ability. Because of this potential problem, previous studies, including Gompers and Metrick (2001), Yan and Zhang (2009), and Baik et al. (2010), use one-quarter-ahead returns in their analyses. There is also another potential problem in using quarterly holding data. SEC's Form 13F requires disclosure of the number of shares as of the end of the calendar quarter for which the report is filed. Hence the data on institutional holdings will capture only positions at quarter-end. Therefore the periodicity of the data may obscure the true performance of institutions.

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Acknowledgements

We thank two anonymous referees, Young Soon Cheon, and David Reeb (the editor) for many detailed and helpful comments. Baik, Kang, Kim, and Lee acknowledge financial support from Seoul National University, Nanyang Technological University Academic Research Fund Tier 1, Rutgers Business School, and SMU School of Accountancy Research Center (SOAR), respectively.

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Authors and Affiliations

  1. College of Business, Seoul National University, Seoul, South Korea

    Bok Baik

  2. Nanyang Business School, Nanyang Technological University, Singapore

    Jun-Koo Kang

  3. Rutgers Business School, Rutgers University, New Jersey, USA

    Jin-Mo Kim

  4. School of Accountancy, Singapore Management University, Singapore

    Joonho Lee

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  1. Bok Baik
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  2. Jun-Koo Kang
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  3. Jin-Mo Kim
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  4. Joonho Lee
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Correspondence to Jun-Koo Kang.

Additional information

Accepted by David Reeb, Area Editor, 27 February 2013. This paper has been with the authors for three revisions.

APPENDIX

APPENDIX

Table A1

Table A1 Variable definitions: This appendix provides a detailed description of the construction of all the variables used in the tables
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Baik, B., Kang, JK., Kim, JM. et al. The liability of foreignness in international equity investments: Evidence from the US stock market. J Int Bus Stud 44, 391–411 (2013). https://doi.org/10.1057/jibs.2013.13

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