Clay House Case Study and Comparison of Two Behemoths ofEC term

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1 Drk Schoenmaker (Netherlands), Thjs Bosch (Netherlands) Is the home bas n equtes and bonds declnng n Europe? Abstract Fnance theory suggests that nvestors should hold an nternatonally dversfed portfolo. In practce, nvestors show a strong preference for domestc securtes (equtes and bonds). One of the explanatons for ths home bas s the exstence of exchange rate rsk. Ths paper tests whether the arrval of the euro has caused a declne n the home bas, and whether a possble declne s temporary or permanent. Our emprcal fndngs suggest that the home bas has declned n Europe and that ths declne s a permanent phenomenon. As expected, ths declne s stronger n the EMU countres than n the non-emu countres. We also fnd that EMU-based nvestors have swtched from home to euroarea securtes (regonal bas). Fnally, we test for the mpact of nsttutonal nvestors, as professonal partes. Countres n whch nsttutons manage a larger part of the fnancal assets exhbt larger nternatonal dversfcaton. Keywords: nternatonal nvestments, portfolo choce, home bas. JEL Classfcaton: F30, F36, G11. Introducton There s robust evdence across a large range of countres for the exstence of a home bas n equty and bond nvestments (Chan, Covrg and Ng, 2005). Ths means that nvestors tend to overweght domestc assets n ther nvestment portfolo, whle ths mght not be optmal from a dversfcaton pont of vew. The nternatonal captal asset prcng model (CAPM) suggests that nvestors should hold a globally dversfed portfolo (Solnk, 2000). Global dversfcaton should generate a better rsk/return profle than domestc dversfcaton, as the world captal market entals lower systematc rsk than any domestc captal market. By elmnatng dosyncratc rsk, nvestors would obtan a better return whle decreasng rsk. Estmates suggest that holdng the optmal portfolo generates an extra return for European nvestors n the range of 2 to 3 percent per year (Schröder, 2003). The nternatonal CAPM s derved under the assumpton that captal markets are perfect, that s wthout any barrers. In practce, there are several barrers to nternatonal captal flows (Karoly and Stulz, 2003). Tradtonal barrers nclude captal controls and tradng costs. Whle captal controls have been abolshed over the past three decades, cross-border tradng costs are stll hgher than domestc tradng costs n Europe. But cross-border tradng costs are declnng and are expected to converge towards the domestc level wth further European ntegraton. Next, barrers can be related to dfferent expectatons about stock returns, volatltes and covarances. In partcular, nvestors can be more uncertan about the expected returns of foregn stock. An mportant rsk n the cross-border settng s exchange rate rsk. Drk Schoenmaker, Thjs Bosch, The am of ths paper s to nvestgate the mpact of the euro. The arrval of the euro n 1999 elmnated exchange rate rsk n the euro area. Ths would reduce the home bas. The euro-effect can be measured by contrastng changes n the home bas n the EMU countres and non-emu countres. To our knowledge, only one prevous study (De Sants and Gérard, 2006) has nvestgated the drect mpact by comparng the home bas 2 years pror to the ntroducton of the euro (1997) wth the home bas 2 years after (2001). The research queston n ths paper s to nvestgate whether the euro-effect s temporary or permanent. We therefore compare the 1997 and 2001 data on the home bas wth more recent 2004 data. Our fndngs ndcate a strong decrease n the home bas confrmng the results from De Santes and Gérard (2006). Moreover, our results suggest that the declne n equty and bond home bas s not a temporary phenomenon. To the contrary, the home bas has further decreased from 2001 to 2004 n the EMU regon. A second research queston s whether European nvestors prefer European securtes n ther foregn securtes portfolo n comparson to, for example, US securtes. Ths effect s the regonal bas. De Sants and Gérard (2006) fnd an ncrease n the regonal bas for both the EMU and non-emu countres. Whle our 2001 data confrm ths fndng, our more recent 2004 data ndcate a strong ncrease n the regonal bas for the EMU regon and a small decrease for the non-emu regon. The latter results are n lne wth predctons from theory. The elmnaton of exchange rate rsk nduces EMU-based nvestors to swtch from home to euro area securtes. Ths effect s not expected for non-emu based nvestors. Several papers have nvestgated the determnants of the home bas (e.g. Lews, 1999; Chan, Covrg and Ng, 2005). A relatvely recent phenomenon s the emergence of nsttutonal nvestors. The assets of

2 penson funds, lfe nsurance companes and mutual funds n Europe have trpled from 44% of GDP n 1985 to 122% n 2004 (OECD). As professonal partes, nsttutonal nvestors may have better means to overcome the barrers to nternatonal nvestment. They employ, for example, analysts that can reduce the nformaton asymmetres between nvestors and entrepreneurs. And as large partes they can negotate lower tarffs for large (crossborder) deals. Our emprcal results suggest that the relatve sze of the nsttutonal sector has a negatve and statstcally sgnfcant effect on the home bas. Countres n whch nsttutons manage a larger part of the fnancal assets exhbt larger nternatonal dversfcaton. The paper s organzed as follows. Secton 1 ntroduces the nternatonal captal asset prcng model. The nternatonal CAPM serves as theoretcal benchmark for nternatonal dversfcaton of nvestments. Next n secton 2, we derve a measure for the home bas. Secton 3 provdes evdence on the home bas n European nvestments. In secton 4, we conduct a regresson analyss to explore whch factors nfluence the sze of the home bas. The last secton concludes. 1. Portfolo theory The nternatonal verson of the Captal Asset Prcng Model (CAPM) suggests that nvestors should hold an nternatonally dversfed portfolo (Solnk, 2000). The formal nternatonal CAPM model can be derved from the standard mean-varance framework modfed to nclude foregn securtes (Lews, 1999). Suppose domestc nvestors have access to two rsky assets, a domestc stock and a foregn stock. The domestc nvestor chooses the proporton of hs wealth portfolo that he holds n foregn stocks, x (wth 0 x 1 ). The nvestor s objectve s to ncrease the mean of wealth, E ( W1 ), and decrease the varablty of wealth, var( W 1). Hs objectve functon s gven by maxv V ( E( W 1 ), var( W1 )) subject to V, V 0, (1) where W 0 current wealth, W 1 next-perod wealth, and E the expected value condtonal upon nformaton known at tme 0. V 1 s the partal drectve of V wth respect to the frst term, and V 2 wth respect to the second term. The oneperod return s a combnaton of the foregn return earned on the fracton of foregn stocks, denoted by x, and the domestc return earned on the fracton of domestc stocks, denoted by (1-x), and s gven by W 1 f h h W0 (1 x ( r r ) r ), (2) f where r foregn return, and r h domestc return. The varance of the one perod return s gven by 2 0 var( W ) W ( x var( r r ) 1 2 f h 2 h 2 h 2 x ( ) ), (3) fh 2 h f h where h var( r ) the varance of the domestc stock return, 2 f var( r f ) the varance of the foregn stock return to the domestc nvestor, and f h fh fh f h cov( r, r ) the covarance between the domestc and foregn returns. The optmal fracton of foregn stock x can be calculated * by dervng the frst order condton of the objectve functon V. After re-arrangng terms, the frst order condton s gven by 2 f h * ( r r ) / h fh x, (4) f h f h var( r r ) var( r r ) where s the parameter of relatve rsk averson 2 V W V The nterpretaton of the demand functon for foregn stock s straghtforward. The frst term on the rght-hand sde of equaton (4) represents the demand arsng from hgher potental returns from the foregn stock. The lower s the rsk averson,, the greater the response of demand to hgher expected returns. On the other hand, as ncreases, the mportance of relatve returns across countres declnes. In the lmtng case when equals nfnty and nvestors are nfntely rsk averse, the frst term dsappears and the demand for foregn stock reduces to the second term. The second term s the portfolo share that mnmzes the varance of the wealth portfolo. Ths portfolo s llustrated by pont B n Fgure 1 below. Thus, n general, the demand for foregn stock depends on a combnaton of the rsky portfolo share gven by the frst term and the mnmum varance portfolo gven by the second term. The theory behnd nternatonal dversfcaton can be graphcally explaned wth Fgure 1. Fgure 1 plots the mean and standard devaton of annualzed monthly returns from January 1980 to December 2005 for two dfferent equty portfolos. The frst s the MSCI (Morgan Stanley Captal Internatonal) USA ndex, whch s a proxy for the US stock market. The second s based on the MSCI Europe ndex, whch s a proxy for the European stock market. Movng along the curve from 100 percent US stocks to 100 percent Euro- 91

3 pean stocks, the lne plots the mean returns and standard devatons from holdng an ncreasng proporton of European stocks. Ths s a smplfed verson of the so-called effcent fronter and ndcates the portfolo wth the mnmum standard devaton for a gven return. 14,0% 100% Europe C Mean return 13,8% 13,6% B A A 100% US 92 13,4% 14,1% 14,3% 14,5% 14,7% 14,9% 15,1% 15,3% 15,5% 15,7% Standard devaton Note: Ths graph s based on returns from the MSCI USA Index and MSCI Europe Index over the perod of Source: Datastream. Fg. 1. The smplfed effcent fronter for US and European equtes The mean of the MSCI USA s lower than portfolo C whch has the same standard devaton but ncludes a fracton of European stocks. In fact as long as nvestors prefer hgher returns and lower varance, the mnmum varance portfolo at pont B (wth 40 percent European equty) must be preferable to the US portfolo alone. However, Secton 3 below (see Table 1) ponts out that n a unverse of European and US stocks, US nvestors hold only 7 percent of ther equty portfolo n European stocks, whch s ndcated by pont A. The equty home bas s the phenomenon that foregn equty holdngs of domestc nvestors are below pont B Gans from nternatonal dversfcaton. When nvestors dversfy ther portfolo nternatonally followng the nternatonal CAPM, they can generate an extra return. Lews (1999) calculates that US nvestors can generate an extra return of about 50 bass ponts per year whle also decreasng rsk (movng to pont B n Fgure 1), or 80 bass ponts per year wth no change n rsk (movng to pont A n Fgure 1). Emprcal evdence concernng European nvestors shows an even stronger effect. Schröder (2003) fnds that a Brtsh nvestor, holdng the optmal portfolo of 80 percent non-domestc assets nstead of a portfolo of 20 percent nondomestc assets, generates an extra return of 2.2 percent per year. A German nvestor, holdng the optmal portfolo, generates an extra return of 3 percent per year. The excess return for European nvestors s larger than for US nvestors because the US market s very large and well-dversfed, whch provdes less upsde potental from nvestng n foregn markets. By the same token, nternatonal dversfcaton reduces the cost of captal (Stulz, 1999). The expected return that nvestors requre for nvestng n equty to compensate them for the rsk they bear generally falls. The result s a lower cost of captal for companes Barrers to nternatonal dversfcaton. The nternatonal CAPM s derved under the assumpton that captal markets are perfect. Perfect captal markets mply a world wthout any barrers. In practce, there are several barrers to nternatonal captal flows (Karoly and Stulz, 2003). Tradtonal barrers nclude captal controls and tradng costs. Whle captal controls have been abolshed over the past three decades, cross-border tradng costs are stll hgher than domestc tradng costs n Europe (Govannn, 2001). Next, barrers can be related to dfferent expectatons about stock returns, volatltes and covarances. In partcular, nvestors can be more uncertan about the expected returns of foregn stock. An mportant rsk n the cross-border settng s exchange rate rsk. The degree of rsk averson s captured by n equaton (4). Fnally, barrers can emerge from dfferences n nformaton between local and foregn nvestors. A new strand of lterature s emergng under the name of corporate nsder theory (Stulz, 2005). Ths theory states that f t s optmal for nsders to have large ownershp stakes n corporatons n a specfc country, t s not possble for the home bas towards that country to fall sharply as long as foregn nvestors are not corporate nsders. The exstence of nsder ownershp thus lmts the holdngs of foregn nvestors.

4 What s the outlook for these barrers? Cross-border tradng costs are declnng and are expected to converge towards the domestc level wth further European ntegraton. Moreover, exchange rate rsk s elmnated wthn the euro area. Ths would reduce the home bas, n partcular n the euro area. Fnally, the emergence of nsttutonal nvestors may reduce the home bas. As professonal partes, they may have better means to overcome the barrers to nternatonal nvestment. They employ, for example, analysts whch can reduce the nformaton asymmetres between nvestors and entrepreneurs. And as large partes they can negotate lower tarffs for large (cross-border) deals. Secton 3 produces some emprcal evdence on the mpact of nsttutonal nvestors on the home bas. 2. Measurng the home bas The observaton that nvestors underweght foregn assets n ther portfolo s known as the home bas. There s robust evdence across a large range of countres for the exstence of the home bas (Chan, Covrg and Ng, 2005). Ths means that nvestors tend to overweght domestc assets n ther nvestment portfolo, whle ths mght not be optmal from a dversfcaton pont of vew. Global dversfcaton should generate a better rsk/return profle than domestc dversfcaton, as the world captal market entals lower systematc rsk than any domestc captal market. Global dversfcaton apples to dfferent degrees for varous asset classes. Dversfcaton va nvestments n foregn equty seems to be most applcable to nsttutonal nvestors. Shocks to equty markets tend to be country specfc, although downsde market movements occur much more n parallel than upsde ones (Solnk et al., 1996). After the ntroducton of the euro n 1999, shocks n the EMU regon are more sector specfc than country specfc. Bond portfolos should be dversfed because of credt rsk. Investors hedge the exchange rate rsk (and related nterest rate rsk) of ther bond portfolo, whle dversfyng the credt rsk of bonds among varous countres. It s expected that nvestors dversfy less wthn ther bond portfolo than they do for ther equty portfolo, as bonds markets are more globally ntegrated (especally between the euro area and other major bond markets), whch makes nternatonal dversfcaton less proftable. Secton 3 analyzes to whch extent (nsttutonal) nvestors n Europe dversfy ther nvestments geographcally. By comparng the levels of the home bas from 1997 to 2004, we can analyze whether there s a declne n the home bas over tme. To derve the home bas theoretcally, the nternatonal CAPM s used. The optmal portfolo wth no bas can be calculated under strct assumptons (Solnk, 2000). In the nternatonal settng, these assumptons nclude fully ntegrated captal markets and purchasng power party. Fully ntegrated captal markets mply that nvestors can buy and sell securtes n foregn markets wthout any restrctons or extra transacton costs. Purchasng power party apples the long-run equlbrum exchange rates of currences to equalze the currences purchasng power. It s based on the law of one prce, whch means that dentcal goods (ncludng securtes) n dfferent markets must have only one prce. When purchasng power party holds, exchange rate rsk s no longer relevant. If there are homogeneous expectatons, all nvestors select the same optmal portfolo. Equlbrum n the nternatonal settng s acheved when all nvestors hold the world market portfolo n whch each country portfolo s weghted by ts market captalzaton. The equty home bas labelled EHB s measured as the dfference between the relatve weght of domestc equty n the portfolo of country and the relatve weght of country n the total world market portfolo. The country portfolo s calculated as follows: domestc market captalzaton plus foregn equty holdngs mnus foregn owners of domestc equty. The equty home bas s gven by EHB Foregn Equty 1, (5) Foregn Equty to Total Market where Foregn Equty - share of country -th holdngs of foregn equty n country -th total equty portfolo (1 - share of domestc equty); Foregn Equty to Total Market - the share of foregn equty n the world portfolo avalable to country (1 - share of country n the total market captalzaton). Equaton (5) measures to whch extent domestc equty s overweghed compared to foregn equty n the nvestment portfolo. From the nternatonal CAPM, the rato s expected to be 0 as full geographcal dversfcaton (that s holdng the world market portfolo) s benefcal. In other words, a country wll have an EHB equal to 0 f nvestors show no preference for equty ssued domestcally. If domestc nvestors have a preference for domestc equty, the rato wll be between 0 and 1. Let us llustrate the home bas formula wth an example. Country nvestors allocate 15 percent of ther portfolo to foregn equty, whle the total world market portfolo comprses 75 percent of foregn equty and 25 percent of domestc equty. Country nvestors thus only explot nternatonal dversfcaton to oneffth (15/75) and thus have a home bas of four- 93

5 ffths. EHB s normalzed to 1.0 f domestc nvestors nvest 100 percent of ther equty portfolo domestcally. In a smlar ven, the preference of nvestors for domestc debt securtes can be measured. Ths home bas measure for bonds s labelled the bond home bas BHB. Fnally, the Regonal Bas (RB) can be measured. The queston s whether European nvestors show a preference for European securtes n ther foregn securtes portfolo n comparson to US securtes. Wthn the part of the nvestment portfolo whch s nvested n foregn equty and bonds, EU nvestors should, accordng to the ICAPM, show no preference for ether European or US equtes and bonds. In a smlar way as the analyss concernng the domestc home bas, we test whether European nvestors show a regonal bas towards European equtes and bonds. The regonal bas for equtes s gven by US Equty REB 1, (6) US Equty to Foregn Market Portfolo where US Equty - share of country -th holdngs of US equty n country -th total foregn equty portfolo (1 - share of EU equty n foregn portfolo); US Equty to Foregn Market Portfolo - share of US equty n the foregn equty portfolo whch s avalable for country. The avalable foregn portfolo for country s total domestc market captalzaton of EU and US mnus domestc market captalzaton of country. The foregn market portfolo dffers per country. For example, as the UK comprses a large part of total EU equty, the foregn equty portfolo for the UK s smaller than for other countres. The same apples to the foregn bond portfolo. It s expected that the Regonal Bond Bas s hgher than the Regonal Equty Bas for the EMU countres, because there s no exchange rate (and nterest rate rsk) nvolved, and nternatonal dversfcaton of bonds focuses prmarly on credt rsk. 3. Evdence on the home bas n European nvestment Some recent emprcal studes measure the development of the home bas n the EU-15 (De Sants and Gérard, 2006). Data concernng foregn equty and bond holdngs are extracted from a countrylevel dataset of the IMF, the Coordnated Portfolo Investment Survey (CPIS). Luxembourg and Ireland are excluded from the database as they are outlers. These countres attract large amounts of foregn mutual fund nvestment due to favorable tax polces. For comparson reasons the US s added to the dataset. Ths results n a sample of 14 countres, whch conssts of EU-13 and the US. A proxy for the world market portfolo s the domestc market captalzaton of the EU-13 and the US. In ths way, we analyze to whch extent the EU-13 countres and the US overweght domestc equty n ther portfolo compared to foregn equty. We start wth an overvew of the equty and bond market portfolos of the EU-13 countres and the US. To measure the mpact of the euro n 1999, we take data 2 years before the ntroducton of the euro (1997) and 2 years after the ntroducton (2001). In addton, we take more recent data (2004) to nvestgate whether a possble euro-effect s temporary or more permanent. Tables 1 and 2 present the foregn holdngs of both the equty and bond portfolos (only 1997 and 2004 data are presented to save on space). The total portfolo s calculated by addng the domestc holdngs of foregn equty (bonds) to the domestc market captalzaton mnus the foregn holdngs of domestc equtes (bonds). The total equty (bond) market n ths analyss conssts only of EU-13 and US equtes (bonds). Table 1. Equty portfolo of EU-13 countres and the US (n bln EUR) Domestc market captalzaton Holdngs of foregn equty Foregn holdngs of domestc equty Total equty portfolo Austra Belgum Denmark Fnland France , ,069.7 Germany Greece Italy

6 Table 1 (cont.). Equty portfolo of EU-13 countres and the US (n bln EUR) Domestc market captalzaton Holdngs of foregn equty Foregn holdngs of domestc equty Total equty portfolo Netherlands Portugal Span Sweden Unted Kngdom 1, , , ,969.8 Unted States 9, , , ,274.0 Note: Total equty portfolo s calculated by addng foregn holdngs (n EU-13 and US) to the domestc market captalzaton and subtractng foregn holdngs (by EU-13 and US) of domestc equty. Sources: FIBV, IMF Coordnated Portfolo Investment Survey (CPIS). Table 2. Bond portfolo of EU-13 countres and the US (n bln EUR) Domestc market captalzaton Holdngs of foregn equty Foregn holdngs of domestc equty Total equty portfolo Austra Belgum Denmark Fnland France 1, , , ,900.7 Germany 1, , , ,613.4 Greece Italy 1, , , ,527.1 Netherlands Portugal Span Sweden Unted Kngdom Unted States 10, , , ,716.6 Note: Total bond portfolo s calculated by addng foregn bond holdngs (n EU-13 and US) to the amount of domestcally ssued bonds and subtractng foregn holdngs (by EU-13 and US) of domestc bonds. Sources: BIS, IMF Coordnated Portfolo Investment Survey (CPIS). Table 3 gves an overvew of the equty and bond home bas n 1997, 2001 and All countres see a sharp declne of the equty home bas from 1997 to Most countres also show a steady decrease of the home bas after 2001, though a number of countres (e.g., Austra, Denmark, Italy and Span) see an ncrease n the home bas after The Netherlands has the lowest home bas n the sample wth a value of 0.43 n 2004 and has also notced the largest declne from 1997 to The South-European countres, Italy, Span, Portugal and Greece, have the hghest bas around The equty home bas for the Anglo-Saxon countres, the UK and the US, has decreased a lttle from 1997 to 2004, but s stll relatvely hgh wth 0.80 and 0.81 respectvely. Table 3. Development of the equty and bond home bas Equty home bas Bond home bas Austra Belgum

7 Table 3 (cont.). Development of the equty and bond home bas Equty home bas Bond home bas Denmark Fnland France Germany Greece Italy Netherlands Portugal Span Sweden Unted Kngdom Unted States EU EMU Non-EMU Note: EU-13, EMU and non-emu are calculated as a weghted average. Source: IMF Coordnated Portfolo Investment Survey (CPIS). The weghted average bas for the EU-13 ndcates a declne of 0.07 from 1997 to 2001, after whch the bas remans stable at It s nterestng to see that the EU bas has decreased after the ntroducton of the euro, wthout a sgnfcant change of the US bas over ths perod. Whle the weghted average bas for the EMU countres was hgher n 1997 than the bas of the non-emu countres, the bas for the EMU countres has decreased wth 0.09 from 1997 to 2004 n comparson wth 0.05 for the non-emu countres. Table 3 also llustrates that the BHB has declned n all countres n the sample, and ths reducton s n general larger than for the EHB. In 2004, the BHB s the lowest for the Netherlands wth only 0.17, followed by Austra and the UK. Denmark, Sweden, Greece and Italy stll exhbt a large BHB relatve to the other EU countres. Compared to the EHB, the BHB s on average lower for the EU-13 countres. The weghted average BHB for the EU-13 s 0.60 n 2004, a reducton of 0.26 snce The dfferences between the EU countres are larger for the BHB than for the EHB. The US has an exceptonally hgh BHB wth It can be concluded that US nvestors are very domestcally focused wthn ther long-term debt portfolos, and allocate only a small percentage of ther bond portfolo to EU bonds. Ths s partly n lne wth theory. As the US economy s very large, there s more scope for US nvestors to dversfy credt rsk domestcally wthout occurrng exchange rate rsk. For the EU countres, the largest declne has taken place n the perod from 1997 to 2001, whch s related to the ntroducton of the euro. The BHB decrease from 1997 to 2004 s larger for the EMU countres (0.27) than for the non-emu countres (0.19). The reported results for the EHB and BHB are largely n lne wth the fndngs of De Sants and Gérard (2006). They also fnd a declne n the home bas from 1997 to 2001 for the countres n the sample. However, our more recent data for 2004 show a stronger declne for both the EHB and BHB n the EMU regon than the data for 2001, as reported by De Sants and Gérard (2006) Regonal bas. As llustrated above, all countres n the sample exhbt a home bas towards domestc equtes and bonds. The percentage of foregn securtes s thus underweghted compared to domestc securtes. Wthn the portfolo of foregn securtes of the 14 countres n the sample, a dstncton can be made between nvestments n European and US securtes. If the home bas puzzle s manly a geographcal phenomenon, ths mples that wthn ther foregn portfolo European nvestors overweght European securtes. Ths s n lne wth the fndngs of Coval and Moskowtz (1999), who fnd that even wthn a country nvestors show a preference for local stocks. Table 4 reports the output concernng the Regonal Bas for equtes and bonds. Investors n all Euro- 96

8 pean countres n the sample overweght European equtes relatve to US equtes. Ths means that the home bas also perssts on a regonal level, as European nvestors nvest a relatvely larger part of ther foregn portfolo wthn Europe. The weghted average Regonal Equty Bas (REB) for the EU-13 has ncreased from 1997 to The splt between the EMU and non-emu countres dentfes an nterestng pattern. The REB has ncreased wth 0.08 for the EMU countres, whle the bas has declned wth 0.09 for the non-emu countres. Investment Management and Fnancal Innovatons, Volume 5, Issue 4, 2008 The Netherlands has the lowest REB of the EU-13 countres, wth a value of only 0.11 n 2004, followed by Sweden and Greece (both 0.23). Denmark has notced the largest absolute declne (0.19) from 1997 to Portugal, Span, Belgum and France show a hgh preference for European equtes n ther foregn nvestment portfolo. It s remarkable that the bas of Portugal, Span and France has ncreased strongly from 1997 to Investors n these countres have evdently moved to a euro area nvestment strategy and thereby reduced ther foregn (US) equty holdngs. Table 4. Development of the regonal equty and bond bas of European nvestors Regonal bas towards EU-13 equtes Regonal bas towards EU-13 bonds Austra Belgum Denmark Fnland France Germany Greece Italy Netherlands Portugal Span Sweden Unted Kngdom EU EMU Non-EMU Note: EU-13, EMU and non-emu are calculated as a weghted average. Source: IMF Coordnated Portfolo Investment Survey (CPIS). Table 4 also reports the Regonal Bond Bas (RBB) of European nvestors. The weghted average for the EU-13 countres has ncreased from 1997 to The ncrease n the RBB s drven by the EMU countres. The RBB has ncreased wth 0.09 for the EMU countres and has declned wth 0.02 for the non- EMU countres. The absolute value of the bas n 2004 s twce as large for the EMU countres (0.82 vs. 0.41). The UK has the lowest RBB, followed by Sweden and Denmark (whch are all non-emu countres). Whle the Netherlands had the lowest bas n all prevous tables, ts RBB s equal to the EU-13 weghted average, at EMU countres such as Austra, Belgum and Fnland (whch have a low BHB) have notced a large ncrease n the RBB towards values of around 0.90 n It can be concluded that for these countres the declne n the BHB s caused by a shft from domestc towards European bonds, and not to US bonds. These countres dversfy the credt rsk of the bond portfolo to a sgnfcant extent, but wthn the EU. The nterest rate rsk s hedged by nvestng prmarly n European bonds, whch have nterest rates whch are dentcal (EMU) or lnked (non-emu) to domestc rates. Moreover, exchange rate rsk s largely elmnated. Table 4 llustrates that the medum-term mpact of the euro (from 1997 to 2004) dffers from the short-term mpact (from 1997 to 2001). Whle the regonal bas for equtes and bonds s ncreasng n the non-emu countres n the short term, the regonal bas s decreasng for the medum term n these countres. The dfference between the EMU regon (strong ncrease 97

9 n regonal bas) and the non-emu regon (decrease n regonal bas) s thus more pronounced over the medum term. In ths way, our fndngs dffer from De Sants and Gérard (2006), who report a short-term ncrease n the regonal bas for the EMU as well as the non-emu regon Graphcal llustraton of the development of the home bas. The nternatonal dversfcaton strategy of nsttutonal nvestors s graphcally llustrated n Fgures 2 and 3. Data for 1997 and 2004 are compared for four economc regons: the US, the EU-13, the ten EMU countres and the three non-emu countres wthn the EU- 100% 13. Fgures 2A and B llustrate that the declne n the home bas s larger for the EU than for the US. Wthn the EU-13 countres, the ten EMU countres notce on average a larger declne n the home bas than the three non-emu countres. The graphcal results from Fgure 2 can be lnked to the development of the regonal bas (RB) n the European regons (EU-13, EMU and Non-EMU). The graphs n Fgure 2 show that countres n the EU have shfted from a country-based nvestng strategy, towards a sector-based strategy. Ths has resulted n a declne of the home bas. The change n the RB from 1997 to 2004 for these regons s llustrated n Fgure 3. 90% Equty home bas n % 80% 70% 60% 50% 40% 30% 20% 10% 0% U.S. EU-13 EMU Non-EMU Fg. 2A. Equty home bas per regon (1997 vs. 2004) 100% 90% 80% Bond home bas n % 70% 60% 50% 40% 30% 20% 10% 0% US EU-13 EMU Non-EMU Fg. 2B. Bond home bas per regon (1997 vs. 2004) 100% 90% Regonal equty bas n % 80% 70% 60% 50% 40% 30% 20% 10% 0% EU-13 EMU Non-EMU Fg. 3A. Regonal equty bas per regon (1997 vs. 2004)

10 100% 90% 80% Regonal bond bas n % 70% 60% 50% 40% 30% 20% 10% 0% EU-13 EMU Non-EMU Whle the equty and bond home bas n the EMU regon has declned faster than n the non-emu regon, the reverse s true for the regonal bas. In fact the regonal bas has ncreased for both equty and bonds n the EMU regon, but has decreased on average for the three non-emu countres. These results are consstent wth the theory of economc ntegraton. Snce the ntroducton of the euro n 1999, nvestors n the EMU countres have allocated a larger part of ther portfolo n foregn assets than non-emu countres and the US. At the same tme, the regonal bas of the EMU regon has ncreased, as nvestors n EMU countres have nvested ther foregn assets manly n ther own economc regon. Ths can be ndcated as the EMU effect as the euro caused a decrease of the home bas, but an ncrease of the regonal bas. The regonal bas decreased for the non-emu regon, whch means that they partly shfted ther foregn assets towards US assets compared to European assets. 4. Explanng the home bas In ths secton, we conduct a regresson analyss to explore whch factors nfluence the sze of the equty home bas. Both the tradtonal theory and the more recent corporate nsder theory try to explan the home bas (see Secton 1). In ths analyss varables from both theores are used to explan the exstence and persstence of the home bas n the equty portfolos of nsttutonal nvestors n Europe. Ths regresson analyss s not performed for the home bas n bond portfolos, due to a lack of data and theory concernng the explanaton of ths bas. As there are only developed countres n the sample, t s assumed that nvestment barrers and nformaton dfferentals play a mnor role. The followng explanatory varables are used n the analyss: Export Export to GDP; IIGDP assets of nsttutonal nvestors to GDP; Fg. 3B. Regonal bond bas per regon (1997 vs. 2004) Insder % of shares whch are held by corporate nsders; MCap Sze of the domestc equty market to GDP. Export to GDP: Openness effect. The rato of total exports to GDP can be consdered as a proxy for trade. One would expect that nvestors n countres wth a large export to GDP rato have a lower need for nternatonal dversfcaton, as the companes n these countres are already dversfyng va ther nternatonal busness. However, ths rato could also be a proxy for the mndset of nvestors n a country, that s the openness of the specfc country. If companes tend to do busness abroad and dversfy ther busness geographcally, nvestors could act n the same manner. Export data are taken from Eurostat. Assets of nsttutonal nvestors to GDP: Professonalsm effect. The sze of the nsttutonal sector could have a mtgatng mpact on the home bas (Davs and Stel, 2001). As nsttutonal nvestors (penson funds, nsurance companes and mutual funds) can be expected to nvest n a sophstcated manner, they mght exhbt a lower equty home bas than non-nsttutonal nvestors. In a dfferent context, Chan, Leung and Wang (2004) fnd that the Monday seasonal (that s the mean return on Monday s lower than on other weekdays) s related to the tradng actvtes of less sophstcated ndvdual nvestors. The Monday seasonal s stronger for stocks wth low nsttutonal holdngs. Data on nsttutonal nvestors are taken from OECD and Eurostat. Insder ownershp: Insder effect. The percentage of shares whch s held by corporate nsders s estmated for the EU-13 and the US Insder ownershp s expected to ncrease the home bas n two ways. Frst, domestc nvestors hold shares whch foregn 99

11 nvestors cannot own. Second, domestc nvestors allocate a lower amount to foregn equty, as they have locked-up a part of ther portfolo n domestc assets. It should be noted, however, that the theory concernng nsder ownershp s developed to explan the bas towards a country (Kho et al., 2006), but not necessarly the home bas of a country tself. Fracton of shares held by corporate nsders s obtaned from Karoly and Stulz (2003), Kho et al. (2006) and Stulz (2005). Closely-held shares correspond to shares held by nsders. Insders are consdered to be offcers, drectors, and ther mmedate famles, shares held n trusts, shares held by another corporaton (except shares held n a fducary capacty by fnancal nsttutons), shares held by penson beneft plans, and shares held by ndvduals who hold 5% or more of the outstandng shares. Domestc market cap to GDP: Avalablty effect.the sze of the domestc stock market to GDP s 100 a proxy for the relatve sze of the domestc market. It s expected that the home bas s hgher n countres wth a large relatve sze of the domestc stock market, whch can be explaned by the avalablty of domestc stocks for domestc nvestors. Ths means that nvestors tend to nvest n domestc stocks f these stocks are more readly avalable. Domestc market captalzaton data are obtaned from FIBV and Eurostat Regresson model. The regresson analyss s done wth a panel dataset consstng of the EU-13 countres and the US for the years 1997, 2002 and Va a panel regresson ths yelds 42 observatons. Data concernng nsder ownershp are not avalable for 2001 and A sngle-equaton regresson framework s used n order to estmate the relatonshp between the equty home bas and a set of explanatory varables for the sample of 14 countres. Table 5 summarzes the descrptve statstcs for the varables whch are used. Table 5. Descrptve statstcs of panel data (14 countres for 1997, 2002 and 2004) Varable Mean Std. dev. Mn. Max. Obs. Equty home bas Export/GDP Assets of nternatonal nvestors/gdp Fracton of shares held by corporate nsders Domestc market cap to GDP The followng equaton descrbes the econometrc specfcaton employed: EHB Insder Export IIGDP MCap, (7) where EHB equty home bas for country ; constant; Export export to GDP for country ; IIGDP total assets of nsttutonal nvestors to GDP for country ; Insder percentage of equty whch s controlled by corporate nsders for country ; MCap domestc market captalzaton to GDP for country ; classcal dsturbance term. The panel regresson s estmated wth fxed effects whle accountng for heteroscedastcty by means of the Whte adjusted covarance matrx. Table 6 presents the regresson results. The adjusted R-squared has a value of 0.69, whch s reasonable, especally when one consders the fact that there are other (unobservable) factors whch nfluence the home bas of a country. The F- statstc of the regresson s sgnfcant at the 1 per cent level wth a value of All explanatory varables have the sgns whch could be expected. Export to GDP has a sgnfcant negatve effect on the home bas, whch supports the theory that countres wth relatvely large trade volumes can be consdered as more open and have a lower bas due to the openness effect. The domestc companes n these countres have sgnfcant exposure to the world market due to ther level of nternatonal trade. However, nvestors n these countres are subject to a lower EHB, as they also tend to trade (nvest) nternatonally. Table 6. Determnants of the Equty home bas (OLS regresson) Independent varables Expected sgn Coeffcent t-value Constant 0.915*** 17.3 Export +/ *** 3.9 Insttutonal nvestors ** 2.4 Insder Market cap * 2.0 N 42

12 Table 6 (cont.). Determnants of the Equty home bas (OLS regresson) Independent varables Expected sgn Coeffcent t-value Adj. R F-statstc Notes: OLS panel regresson usng EHB as the dependent varable. Data of 1997, 2002 and 2004 for the EU-13 and the US are used for ths analyss. Perod-specfc fxed effects are ncluded n the regresson. ***, ** and * ndcate statstcal sgnfcance at the 1 percent, 5 percent and 10 percent levels, respectvely. The relatve sze of the nsttutonal sector also has a negatve and sgnfcant effect on the home bas. Countres n whch nsttutons manage a larger part of the fnancal assets exhbt larger nternatonal dversfcaton. Indeed, t can be assumed that nsttutonal nvestors, as professonal asset managers, are subject to a lower home bas than non-fnancal corporatons or households. Ths s the so-called professonalsm effect. Our fndng s consstent wth studes on the behavoral dfferences between professonal and amateur nvestors after the weekend. Chan, Leung and Wang (2004) and Veneza and Shapra (2007) document that ndvdual nvestors trade relatvely more on Mondays and that the returns on Mondays are lower than those n other weekdays. The relatve sze of the domestc stock market has a postve and sgnfcant effect on the home bas. Thus, nvestors are more domestcally orented f ther domestc stock market s well developed. Ths could ndcate that nvestors are subject to the avalablty effect, whch means that nvestors are more eager to nvest n domestc assets when these domestc assets are relatvely better avalable. The share of corporate nsders s the only varable whch s not sgnfcant, although t has ts expected postve sgn. Ths ndcates that ths theory mght help to explan the home bas towards a country (as shown by Kho et al., 2006), but does not explan the home bas wthn a country. Conclusons Fnance theory suggests that nvestors should am for nternatonal dversfcaton of ther nvestment portfolo to maxmze returns gven a certan rsk References Investment Management and Fnancal Innovatons, Volume 5, Issue 4, 2008 profle. Nevertheless, there s a strong home bas n equty and bond portfolos. One of the barrers for nternatonal nvestment s exchange rate rsk. The man am of ths paper s to nvestgate the effect of the euro. Earler studes have measured the euroeffect just before and after the ntroducton of the euro n 1999 (De Sants and Gérard, 2006). The contrbuton of ths paper s to examne whether the effect s temporary or permanent. Our results are more pronounced than earler fndngs. The declne n the equty home bas s qute smlar when measured n 2001: an 8% declne for the EMU regon from 1997 to 2001 and a 6% declne for the non- EMU regon. Recent fgures show a 9% declne for EMU-countres from 1997 to 2004 and only a 5% declne for non-emu countres. The elmnaton of exchange rate rsk followng the ntroducton of the euro has thus led to a further declne of the home bas n the euro area. The declne n the home bas s benefcal for nvestors and entrepreneurs. Internatonal dversfcaton reduces dosyncratc rsk (Solnk, 2000). Investors generate a hgher return wth no change n rsk. By the same token, nternatonal dversfcaton reduces the cost of captal (Stulz, 1999). The expected return that nvestors requre for nvestng n equty (or bonds) to compensate them for the rsk they bear generally falls. The result s a lower cost of captal for companes. The arrval of the euro has mproved the allocatve effcency of the economy. A second major trend for nvestments n Europe s the emergence of nsttutonal nvestors. The assets of penson funds, nsurance companes and mutual funds have trpled from 44% of GDP n 1985 to 122% n The future outlook for nsttutonal nvestment s postve. Both the demand sde (growng nvestments by penson funds to cater for agng and by mutual funds to accommodate wealth accumulaton of households) and the supply sde (shft from bank fnancng to market fnancng va equty and bonds) pont to future growth of nsttutonal nvestment. Ths paper shows that the ncreasng professonalsm of nsttutonal nvestors (as compared to ndvdual nvestors) has led to a declne n the home bas n Europe. Ths supports evdence from other studes (e.g., Chan, Leung and Wang, 2004) that tradng patterns of nsttutonal and ndvdual nvestors dffer and that nsttutonal nvestors realze on average hgher returns. 1. Chan, K., M.V. Covrg and L.K. Ng (2005), What Determnes the Domestc Bas and Foregn Bas? Evdence from Mutual Fund Equty Allocatons Worldwde, Journal of Fnance 60, pp Chan, S.H., W.K. Leung and K. Wang (2004), The Impact of Insttutonal Investors on the Monday Seasonal, Journal of Busness 77, pp Coval, J.D. and T.J. Moskowtz (1999), Home Bas at Home: Local Equty Preference n Domestc Portfolos, Journal of Fnance 54, pp

13 4. Davs, E.P. and B. Stel (2001), Insttutonal Investors, MIT Press: Cambrdge, MA. 5. De Sants, R.A. and B. Gérard (2006), Fnancal Integraton, Internatonal Portfolo Choce and the European Monetary Unon, ECB Workng Paper No. 626, European Central Bank: Frankfurt am Man. 6. Govannn Group (2001), Cross-Border Clearng and Settlement Arrangements n the European Unon, European Economy Economc Papers, No. 163, Brussels. 7. Karoly, A. and R.M. Stulz (2003), Are Assets Prced Locally or Globally?, n: G. Constantndes, M. Harrs and R.M. Stulz (eds.), The Handbook of the Economcs of Fnance, North-Holland Publshers: New York. 8. Lews, K.K. (1999), Tryng to Explan Home Bas n Equtes and Consumpton, Journal of Economc Lterature 37, pp Schröder, M. (2003), Benefts of Dversfcaton and Integraton for Internatonal Equty and Bond Markets, ZEW Economc Studes No 19, Hedelberg/New York. 10. Solnk, B.H. (2000), Internatonal Investments, 4 th edton, Addson Wesley: Boston, MA. 11. Solnk, B.H., C. Boucrelle and Y. Le Fur (1996), Internatonal Market Correlaton and Volatlty, Fnancal Analysts Journal, September-October, pp Stulz, R.M. (1999), Globalsaton of Equty Markets and the Cost of Captal, NBER Workng Paper No. 7021, Natonal Bureau of Economc Research: Cambrdge, MA. 13. Stulz, R.M. (2005), The Lmts of Fnancal Globalsaton, Journal of Fnance 60, pp Veneza, I. and Z. Shapra (2007), On the Behavoral Dfferences Between Professonal and Amateur Investors After the Weekend, Journal of Bankng & Fnance 31, pp