Returns Achieved by International and Local Investors in Stock Markets: Comparative Study using Evidence from the MENA Region Conceptual Framework 1 st May 2016 1
RETURNS ACHIEVED BY INTERNATIONAL AND LOCAL INVESTORS IN STOCK MARKETS: COMPARATIVE STUDY USING EVIDENCE FROM THE MENA REGION-CONCEPTUAL FRAMEWORK Abstract Determining which investor group, foreign or local, performs better with respect to stock market returns remains a controversial issue. Information asymmetry remains the preferred theory for explaining superior returns. It is commonly assumed that a better informed investor will be able to perform better. The question then becomes who has better information, local or foreign investors? Empirical support for foreigners underperforming domestic investors is strongly present in the literature; however, many researchers have also concluded that foreign investors are able to outperform local investors due to their investment experience. Broker size and research coverage were also found to be relevant elements to this study as they impact the quality and quantity of information available to any investor group. Keywords: information asymmetry, investor returns, domestic versus foreign investors, investor group 2
Introduction Many of the stock exchanges in the MENA region allow trading to take place by domestic and foreign investors, one question that is frequently posed is who performs better? It is generally believed that the investor group with more information will enjoy higher returns. The question of which investor group performs better in national stock markets remains a controversial one. On one hand empirical support for foreigners underperforming domestic investors, due to their lack of local market knowledge, was supported by Brennan and Cao (1997), Hau (2001), Choe et al (2005), Dvorak (2005), Kalev et al (2008) and Agarwal et al (2009). Alternatively, Seasholes (2004) and more recently Huang and Shiu (2009) conclude that foreign investors are able to do better than local investors given their vast investment experience. International investors behave in a distinctly different way from local investors, as they tend to purchase local stocks following large local stock returns. Additionally, international investors have a tendency to enhance positions gradually; their net buying can be found from their own past buying. Albuquerque et al (2007) found that foreign investors easily sell and purchase a large number of equity shares in foreign markets within a quarter. According to Wharton (n.d.) an investor in an emerging stock market needs to be concerned with the market s liquidity and its depth. The market s depth will define spending opportunities in the market in question and can be measured by the concentration ratio of the country s stock market. The concentration ratio is frequently calculated to highlight the value of the 10 biggest traded stocks as a fraction of the total market capitalization of the country s traded equities. The higher the concentration ratio the shallower the market is. Liquidity on the other hand will ensure that a foreign investor can acquire in and out of a stock position rapidly without having to incur higher than expected transaction costs. Evans (2002) has stated that foreign investors demand better legal and regulatory frameworks; these requirements are chiefly concerned with information quality and quantity. The contradictory findings as stated by Froot and Ramadorai (2008) are fueled by one argument: information asymmetry. The assumption is that the investor group with more information about the stocks in question will achieve higher returns. Domestic investors can be thought to possess an advantage over foreign investors due to linguistic, cultural and geographical considerations (Hau, 2001). Moreover, local investors are better able to evaluate a local firm s governance structure (Leuz et al, 2008) and they incur lower transaction costs (Parwada et al, 2007). On the other hand, an argument that foreign investors have more expertise in trading and larger portfolios can be made. Therefore, they can employ these characteristics to profit from trading in small or emerging markets, where domestic investors are neither experienced nor sophisticated. Van Nieuwerburgh and Veldkamp (2009), Dziuda and Mondria (2009) and previously Brennan and Cao (1997), Kang and Stulz (1997) and Grehrig (1993) all used informational asymmetry as their preferred theory in explaining the home equity bias ; to explain the concentration of portfolio investments in domestic assets. Hau and Rey (2008) incorporated this information in a theoretical model that attempted to explain the empirical evidence on home bias. The assumptions 3
in these theoretical models go a step further stating that domestic investors could choose to remain uninformed about foreign stocks. Conversely, Seasholes (2004) takes an opposite stand on the issue stating that researchers fall into the fallacy of adopting intuitive assumptions without thoroughly testing them, referring to the inherent assumption that domestic investors are better informed compared to foreign investors in theoretical models of information asymmetry. This study aims to answer the question of which investor group, domestic or foreign, performs better. The study will investigate the information asymmetry hypothesis as the reason behind this performance. Hau (2001) states that information asymmetry between investors can be indirectly inferred from asset allocation decisions to learn more about information asymmetry, we must look directly at investment profitability. A direct analysis involving high frequency intraday transaction data from different stock markets in the MENA region will provide a diverse data set with different levels of information asymmetry only conditional upon the liberty provided by the individual stock markets; allowing foreign investors liberal access to equity investments through stock market trading and having no substantial barriers to foreign investment are key determinants of inclusion in the study. The Aims, Objectives and Importance of the Study The specific aims of this study are to: 1. Provide a concrete link between returns and information asymmetry which necessitates an in-depth analysis that can isolate the nature of differential information between domestic and foreign investors in the MENA region. 2. The study will use Bayesian statistics to incorporate in the analysis how an investor s past experience should rationally change to account for evidence. The theorem will be used to update the probability for my hypothesis as the same investor is tracked along with his/her transactions. If we assume that investors are actively learning through their own trading activity then this could mean that one important determinant of information asymmetry is not just between the groups of foreign and domestic investors but within the same group as well. This can be made possible by tracking the trader s identity to identify his purchases and trading profits. This is a major strength of this study since this information was not previously available for analysis. Kalev et al (2008) attempted to divide stocks into different information levels depending on whether they were foreign-listed or not but other factors, such as research coverage and the size of the broker were not incorporated into the analysis. 3. Each investor group will be subdivided into institutional or individual. 4. The size of the broker will also be a factor that will be incorporated in the model. The type of investor and the size of the broker used by the investor are factors that will have an impact on the information level enjoyed by the investor (Aragon et al, 2007). Previous empirical results suggest that individual investors are generally poor performers of equity trading (Barber and Odean, 2000; Barber et al., 2007) suggesting that a complete 4
analysis needs to include the type of investor. Unfortunately, the main issue with including the type of investor as a factor in the past has been data availability. The Literature Review There is no consensus in the determination of which investor group, local or foreign, is able to achieve higher returns in a given market. Chen et al (2009) argue that equity returns are more correlated with the markets where they are traded. Kalev et al (2007) found that international investors tend to choose stocks with an international profile and transparent information and they significantly outperform local investors in global stocks, however, they also find evidence that local investors gain more when global stocks are excluded. Foreign investors are normally thought to be sophisticated institutional investors who possess superior analytical skills and investment experience. Accordingly, they are able to analyze market conditions, make investment and trading decisions with the eventual outcome of outperforming local investors (Froot and Ramdorai (2001); Griblatt and Keloharju (2000) and Karolyi (2002)). An equally plausible argument that locals do not face distance, linguistic or cultural barriers can be made; the assumption here would be that local investors are more likely to have an information advantage which leads to better performance in the domestic stock market in comparison to foreign investors. This issue is related to the home bias, where investors overweigh their portfolios in domestic stocks (Levy and Sarnat (1970); Cooper and Kaplanis (1994); and Stulz (2005)). As a result, if local investors are able to outperform foreign investors then this would be a fundamental explanation of the home bias phenomenon, this explanation would be inadequate if foreign investors outperform local ones. One reason for the mixed conclusions reached by various researchers on the subject of who performs better, local or foreign investors, is the diverse methodology used to measure and account for information asymmetry. The choice of methodology depends heavily on the availability and characteristics of the obtained data set. Relevant past papers can be divided into two main categories (1) papers using international investment data and (2) papers using trading data. Brennan and Cao (1997) observe that US investors tend to purchase foreign equities if the foreign market return is high. Brennan et al (2005) extend the 1997 paper to analyze investors responses to information signals from foreign markets. They show that global financial institutions are more optimistic if the foreign market return increases. These findings lend to support to the notion that foreign investors are less informed, since their trades are based on lagged information. Froot and Ramadorai (2001) use an aggregate data approach; examining the impacts of US institutional equity flows on prices of closed-end country funds of 25 different countries. They show that foreign activities can predict the equity performance of these countries and prices of associated closed-end funds in the US market. Their findings support the notion that foreign investors are more informed. 5
Recent studies have shifted the focus from a macro analysis approach to one that is based on comparing trading behavior and performance between foreign and local investors in one particular market environment. The most straight forward approach was to compare trading profits. Hau (2001) and Dvorak (2005) apply the methodology from Hasbrouck and Sofianos (1993) to compare market-to-market profits of each investor group. Hau (2001) finds that foreign traders operating in the German market have significantly lower profits than domestic traders for all time horizons. Dvorak (2005) reaches a similar conclusion with domestic investors generally being more informed, with strong evidence for the medium-term horizon. Choe et al (2005) compare daily trading price differences between foreign and local investors in the Korean market. They show that foreign investors incur higher transaction costs and thus foreign investors are at a disadvantage compared to local investors. In a comprehensive analysis, Seasholes (2004) investigated information asymmetries in emerging stock markets. He used a combination of three different approaches to analyze the Taiwanese market. He concludes that foreign investors are better informed versus local investors. His results point to foreigners having better information processing abilities (particularly macrofundamentals). Conceptual framework of the study Information Foreign Investors Local investors Institutional Individual Institutional Individual Broker size 6 Research coverage
Development of the study s conceptual framework The researcher is looking forward to updating the conceptual framework of the study using the valuable feedback obtained from the conference participants. Any input pertinent to the methodology section, particularly Bayesian modelling, is very valuable and will contribute positively to the impact of the study in addressing some of the issues raised in the literature. Methodology Intraday trading data Intraday trading data will be used to compare the trading performance and the profitability of local and foreign investors using: 1. Trading profits (Hau, 2001; Dvorak, 2005): measures trading profits that each group of investors makes to assess which group performs better in the market. 2. Price ratio (Choe et al, 2005; Kalev et al, 2008): measures the volume weighted price ratio to see which investor group buys (sells) at a lower (higher) price, suggesting better performance. Long term performance and trading behavior Grinblatt and Keloharju (2000) compared between foreign and local investors and their tendencies to buy (sell) future winning (losing) stocks. This approach required a subjective judgment on the definition of winning/losing stocks and appropriate investment horizons. This study overcomes this issue by using Bayesian statistics where an assumption that investors are actively learning from their own trading experiences is employed and that future investments made by an investor will be based partially on information content from his/her previous trades. A comparison between domestic and foreign investors will be carried out, these two groups will then be subdivided based on their type (institutional or individual) and then finally a distinction between investor performance and profits by the size of the broker they use will be made. This distinction is required to test for information asymmetry to assert whether investors using big brokerage firms have an information advantage due to the quality of information that they receive from those brokers and are accordingly able to act on this information thus outperforming local investors. Structure of the thesis and timeline The thesis will be divided into six chapters. Chapter one will introduce the thesis, outlining the aims and objectives, chapter two will be the review of the literature, chapter three will assess the methodology with its limitations, chapter four will contain the empirical evaluations, chapter five 7
will outline any recommendations and chapter six will provide a conclusion. I propose to spend 3 months on background reading, 6 months on the literature review which will assist me in finding further gaps. I then will spend 3 months preparing my research methods, including ethical considerations etc. Three additional months will then be used for my transfer after hopefully establishing early results from my assessment. I will spend approximately 12 months on the examination and a further 6 months writing and finalizing the thesis. The remainder of the time, approximately 3 months will be spent revising for the viva voce. References Hau, H. (2001), Location Matters: An Examination of Trading Profits, The Journal of Finance, 56 (5), 1959-1983. Grinblatt, M, Titman, S., (1993), Performance Measurement without Benchmarks: An Examination of Mutual Fund Returns, Journal of Business, 66 (1), 47-68. Kalev, P.S., Ngugen, A. H., Oh, N. Y., (2008), Foreign versus Local Investors: Who Knows More? Who Makes More?, Journal of Banking and Finance, 32, 2376-2389. Chen, J., Yiuman, T., Williams, M., (2009), Trading Location and Equity Returns: Evidence from US Trading of British Cross-Listed Firms, Journal of International Financial Markets, Institutions and Money, 19, 729-741. Rhee, S. G., Wang, J., (2009), Foreign Institutional Ownership and Stock Liquidity: Evidence from Indonesia, Journal of Banking and Finance, 33, 1312-1324. Agarwal, S., Faircloth, S., Liu, C., Rhee, S. G., (2008), Why Do Foreign Investors Underperform Domestic Investors in Trading Activities? Evidence From Indonesia Choe, H., Kho, B. C., Stulz, R., (2005), Do Domestic Investors Have an Edge? The Trading Experience of Foreign Investors in Korea, The Review of Financial Studies, 18 (3), 795-829. Dvorak, T. (2005), Do Domestic Investors Have an Information Advantage? Evidence from Indonesia, The Journal of Finance, 60 (2), 817-839. Feng, L., Seasholes, M. S., (2004), Correlated Trading and Location, The Journal of Finance, 59 (5), 2117-2144. Seasholes, M. S. (2004), Re-examining Information Asymmetries in Emerging Stock Markets. Grinblatt M., Keloharju M., (2001), What Makes Investors Trade?, The Journal of Finance, LVI (2), 589-616. 8
Grinblatt, M., Keloharju, M., (2001), How Distance, Language, and Culture Influence Stockholdings and Trade, The Journal of Finance, LVI (3), 1053-1074. Hasbrouck, J., Sofianos, G., (1993), The Trades of Market Makers: An Empirical Analysis of NYSE Specialists, The Journal of Finance, 48 (5), 1565-1593. Albuquerque, R,, Bauer, G. H., Schneider, M., (2007), International Equity Flows and Returns: A Quantitative Equilibrium Approach, The Review of Economic Studies, 74 (1), 1-30. 9