institutional investors in global capital markets (international finance review)

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INSTITUTIONAL INVESTORS IN GLOBAL CAPITAL MARKETS

INTERNATIONAL FINANCE

REVIEW

Series Editor: J Jay Choi

International Finance Review is an annual book series in the international finance area (broadly defined) The IFR will publish theoretical, empirical, institutional, or policy-oriented articles on multinational financial management and strategies, global corporate governance and risk management, global capital markets and investments, emerging market finance, international financial economics, or related issues Each volume generally will have a particular theme Those interested in contributing an article or editing a volume should contact the series editor (J Jay Choi, Temple University, jjchoi@temple.edu).

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INTERNATIONAL FINANCE REVIEW VOLUME 12

INSTITUTIONAL

INVESTORS IN GLOBAL CAPITAL MARKETS

EDITED BY NARJESS BOUBAKRI School of Business and Management,

American University of Sharjah JEAN-CLAUDE COSSET

HEC Montre´al

United Kingdom – North America – Japan

India – Malaysia – China

LIST OF CONTRIBUTORS

Universidade do Porto, Porto, Portugal

University, Halifax, Canada

and Paris School of Economics, Paris, France

Christopher Balding HSBC School of Business, Peking

University, Beijing, China

American University of Sharjah, Sharjah, United Arab Emirates

Business, Dublin, Ireland Jean-Claude Cosset HEC Montre´al, Montre´al, Que´bec, Canada

Edmonton, Canada

African Development Bank, Tunis, Tunisia

South Carolina, Columbia, SC, USA

du Que´bec a` Montre´al, Montre´al, Que´bec, Canada

International Monetary Fund, Washington, DC, USA

ix

Maher Kooli E´cole des sciences de la gestion, Universite´

du Que´bec a` Montre´al, Montre´al, Que´bec, Canada

University, Hakozaki, Higashiku, Fukuoka, Japan

Business, University College Dublin, Blackrock, Dublin, Ireland

Valores Mobilia´rios, Lisboa, Portugal; CEFAGE-UE Universidade de E´vora, E´vora, Portugal

S V D.

Nageswara Rao

School of Management, IIT Bombay, Mumbai, India

Barcelona, Spain

Erasmus University, Rotterdam, the Netherlands

Hyacinthe Y Some´ HEC Montre´al, Montre´al, Que´bec, Canada Gohar G Stepanyan Faculdade de cieˆncias econo´micas e

empresariais, Universidade Cato´lica Portuguesa, Lisbon, Portugal

International Monetary Fund, Washington, DC, USA

Management, IIT Bombay, Mumbai, India

University, Rotterdam, the Netherlands

Thouraya Triki Development Research Department,

African Development Bank, Tunis, Tunisia

Hakozaki, Higashiku, Fukuoka, Japan

University, Beijing, China

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INTRODUCTION TO

INSTITUTIONAL INVESTORS IN GLOBAL CAPITAL MARKETS

Narjess Boubakri, Jean-Claude Cosset and

On the other hand, if all institutional investors react to the same information in

a timely manner, they are in fact helping to increase market efficiency byspeeding up the adjustment of prices to new fundamentals (for competingtheories on the role of institutional investors, see, e.g.,Lakonishok, Shleifer, &

Institutional Investors in Global Capital Markets

International Finance Review, Volume 12, 3–13

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ISSN: 1569-3767/doi:10.1108/S1569-3767(2011)0000012003

3

Vishny, 1992) This view of institutional investors as ‘‘efficiency drivers’’generated considerable debate for many years (see, e.g., Ferreira & Laux,

2007;French & Roll, 1986)

Another important question about institutional investors that has caughtthe attention of the academic world is their impact on corporate governancepractices Institutional investors are large entities with considerable amounts

of money to invest, and are thus more likely to buy sizeable blocks of atarget firm’s common stock In addition, given their informationaladvantage, these investors are likely to weigh more heavily on target firmswhile monitoring top management activities (Ferreira & Laux, 2007).Although corporate governance is mostly determined at the country level,institutional investors are considered major drivers of changes in corporategovernance systems (Gillan & Starks, 2003) In particular, the effectiveness

of institutional investors as a corporate governance mechanism will likelydepend on the level of shareholder protection in the country In this vein,Aggarwal, Erel, Ferreira, and Matos (2011)show that institutional investorsplay a crucial role in corporate governance practices of local firms, but only

in countries with strong investor protection In countries with weak investorprotection, the main drivers of corporate governance improvements areinstead foreign institutions that originate from countries with stronginvestor protection

The recent financial and economic crisis has also raised concerns aboutthe economic and social effect of institutional investment strategies On theone hand, while short-term investments provide market liquidity andaccountability, they may also lead to underinvestment in maintenance,customer loyalty, employment training, research and development owing totheir primary focus on labor-market reputation and stock prices On theother hand, long-term investments have at least two significant impacts oncorporations and the society as a whole: first, long-term investors can act as

a stabilizing force during economic downturns by buying securities whenliquidity dries up; second, long-term investors will lead firms to better aligntheir objectives and activities with long-term economic growth, particularlyfrom long-term environmental, governance, and social perspectives.According to the World Economic Forum report (2011), estimates ofglobal infrastructure needs have reached US$ 3 trillion per annum, a sumwhich public finances are increasingly unable to meet.1Although long-terminstitutional investors represent about half of the world’s professionallymanaged assets, the report shows that only 25% (about US$ 6.5 trillion as

of 2009) of their assets is used for long-term investment Given such asmall percent devoted to long-term investments, the role that institutional

NARJESS BOUBAKRI ET AL.4

investors might play in the global economy remains limited The purpose ofthis book is to shed light on the influence of institutional investors on globalmarkets over the recent decades, and to identify their perspectives for thefuture.

In this book, ‘‘institutional investors’’ refers to investments companies,mutual funds, pension funds, foundations, sovereign wealth funds (SWFs),insurance companies, and investment banks We shall particularly focus onSWFs defined as ‘‘a government investment vehicle that invests in foreigncurrency denominated assets and whose management is distinct from that ofofficial reserves’’ (Jen, 2007, p 1) A SWF is set up for a variety ofmacroeconomic purposes, which include short-term objectives (economicstabilization) and long-term investment (development funds and savings forfuture generations) According to theIMF (2008), SWFs probably managebetween US$ 2–3 trillion The increased importance of SWFs in the globalfinancial markets has recently fueled a heated debate on their size, lack oftransparency, and investment strategies, assumed by some to be driven bypolitical objectives Further, SWF investments are vulnerable to hostcountries’ regulations on capital mobility.2 The present book addressessome of these concerns

Overall, the purpose of this book, titled ‘‘Institutional investors in globalcapital markets,’’ is to investigate institutional investors’ portfoliopreferences, their influence on firm activities and local economies, and theirreaction to the recent financial and economic crisis The book is divided intofour parts Part I is an introduction to the book Part II covers threechapters which study the economic and financial impact of institutionalinvestors In Part III, four chapters analyze the investment preferences ofinstitutional investors Part IV has three chapters which focus on thebenefits of SWFs Finally, three chapters in Part V analyze the drivers of theasset allocation of SWFs

PART II: INSTITUTIONAL INVESTORS: THEIR ECONOMIC AND FINANCIAL IMPACT

This part starts with a chapter titled ‘‘Foreign institutional investors’’ byGohar Stepanyan who reviews the empirical literature on the process ofinternational financial integration and the growing role of foreigninstitutional investors Specifically, Gohar Stepanyan examines howinstitutional investors accelerate the development of capital markets and

Introduction to Institutional Investors in Global Capital Markets 5

economies abroad The author also investigates the determinants of theirinvestments, both in the domestic and foreign markets, as well as their role

in promoting good corporate governance practices worldwide In spite ofthe concern that short-term international capital flows could be harmful indeveloping market economies, the author reports limited academicevidence of a destabilizing effect of foreign investment activity Theauthor concludes that the presence of a ‘‘home bias’’ in internationalportfolio investment is probably due to the systematic preference ofinstitutional investors for common stocks of large and well-known foreignfirms

The second chapter, written by Najah Attig, Sadok El Ghoul and OmraneGuedhami, is titled ‘‘Institutional investment horizon and firm credit ratings.’’This chapter studies the impact of institutional investment horizons on firmcredit ratings The authors find that both the ownership stake and the number

of long-term institutional investors contribute to more efficient monitoring,and thus reduced managerial myopism and self-interested behavior, asreflected in higher firm credit ratings Further, the authors find that themonitoring incentive of institutional investors depends on their heterogeneity,

as evidenced by their different investment horizons From these results, theyclaim that focusing on institutional shareholdings masks important variations

in the governance role of institutional investors, which may help explain mixedevidence in the existing literature on the monitoring role of institutionalownership

The third chapter, ‘‘Divestment of foreign strategic investment in China’sbanking sector: Causes and consequences’’ by Yuhua Li and Konari Uchida,examines 10 foreign financial institutions’ divestments in the Chinesebanking sector The results of this study suggest that poor performance offoreign financial institutions, due to the global financial crisis, and theinstitutions’ regulated low-equity ownership are the primary causes ofdivestment In contrast, the authors report that Chinese banks’ poorperformance does not affect foreign divestments The authors also show thatbusiness cooperation is usually ended when a foreign financial institutionfully divests its equity stakes in a Chinese bank In addition, the authorsshow that the Bank of China and China Construction Bank, whichexperienced large H-share divestments, suffered from economically largedeclines in the A-share values (A-shares are traded in domestic stockmarkets while H-shares are traded in the Hong Kong stock exchange) Liand Uchida conclude that these results suggest that banking sectordevelopments that rely on foreign investments are vulnerable to aneconomic recession in developed countries

NARJESS BOUBAKRI ET AL.6

PART III: INVESTMENT PREFERENCES OF

INSTITUTIONAL INVESTORS

The first chapter of this part, written by Don Bredin and Ningyue Liu, istitled ‘‘Domestic and foreign institutional investor behavior in China:Financial Characteristics and Corporate Governance.’’ The authorscompare the financial characteristics and the corporate governanceindicators of the companies in which foreign funds operating in China (asQualified Foreign Institutional Investor (QFII)) and domestic Chinese fundshave invested The results of their analysis suggest that foreign funds prefer

to invest in transportation, metals, non-metals and machinery, and generallyavoid investing in real estate, construction, media, and culture, all of whichrequire a deep local knowledge The portfolios of domestic Chinese fundsare distributed more evenly across industries than are foreign funds Thecomparative analysis also reveals that the firms targeted by foreign funds aresignificantly different from those targeted by domestic funds, particularlywith respect to size, profit, and managerial compensation The authorsconclude that their findings on the differences between QFIIs’ and domesticfund investment preferences should have implications for policy makers whoaim to attract foreign investors to emerging markets

The authors of the second chapter of this part, titled ‘‘Institutionalinvestors’ participation in foreign firms: Evidence from ADRs,’’ are NarjessBoubakri, Olfa Hamza, and Maher Kooli The authors examine the firm- andcountry-level determinants of US institutional investors’ holdings inAmerican Depositary Receipts (ADRs) from emerging markets Using asample of 112 firms from emerging markets that were listed as ADRsbetween 1990 and 2005, the authors find that institutional investors holdhigher stakes in foreign firms that are listed on more restrictive exchangesand in large, privatized, more liquid, and more transparent firms Mutualinvestors and other institutional investors also favour firms from countrieswith weaker institutional environments and with a civil law legal tradition

As noted by the authors, these results have interesting implications formanagers of foreign firms which wish to attract capital from foreigninstitutional investors

In the third chapter, titled ‘‘Do foreign institutional investors exhibitherding and positive feedback trading in Indian markets?’’ Mangesh Taydeand Nageswara Rao study the behavior of foreign institutional investors(FIIs) in the Indian capital market This chapter constitutes the firstempirical study on whether FIIs in India follow herding and positivefeedback trading strategies To identify such behavior, the authors collected

Introduction to Institutional Investors in Global Capital Markets 7

data on the daily purchase and sale trades executed by the FIIs When theyconsider the complete sample period (i.e., 2003–2009) and the full sample offirms Tayde and Rao fail to find evidence of a strong herding behavior.Nevertheless, their results suggest that herding is stronger for largecompanies with better performance, most probably owing to the fact thatthey have higher liquidity and are more extensively followed by financialanalysts.

The fourth and last chapter of this part is written by Carlos Alves andVictor Mendes and is titled ‘‘Do financial conglomerates have an incentive

to prevent managers of other firms from pursuing their own interest?’’ Inthis chapter, the authors develop a theoretical model to analyze the role offinancial conglomerates in reducing agency costs in target firms They showthat, in certain conditions (e.g., if the fees charged by a bank are within acertain range) conglomerates will not oppose managers pursuing their owninterests at the expense of the shareholders However, if the bank is able toobtain capital inflows that react to mutual fund performance, we shouldobserve more converging interests between the conglomerate shareholdersand fund investors

PART IV: THE BENEFITS OF SOVEREIGN WEALTH

FUND INVESTMENTS

In the first chapter of Part IV, titled ‘‘The impact of foreign governmentinvestments: Sovereign wealth fund investments in the United States,’’Elvira Sojli and Wing Wah Tham show that foreign and politicallyconnected large investors like SWFs improve firm value In the short run,the market reacts positively to SWF investments in anticipation of enhancedmonitoring and increased benefits from internationalization In the longrun, the target firms’ degree of internationalization and Tobin’s q undergo amarked increase after SWF investments Interestingly, the authors showthat the increase in Tobin’s q is associated with the number of government-related contracts granted by SWF countries As Sojli and Tham point out,these results suggest that government-related contracts are a mechanismthrough which government connections can affect firm value

The second chapter of this part, titled ‘‘What do sovereign wealth fundsimply for financial stability?’’ and written by Tao Sun and Heiko Hesseexamines financial stability issues that arise from the increased presence ofSWFs in global financial markets To do so, the authors use an event-study

NARJESS BOUBAKRI ET AL.8

approach to determine whether and how stock markets respond to theannouncements of investments and divestments by SWFs Based on 166publicly traceable events of investments and divestments by major SWFsbetween 1990 and 2009, the authors evaluate the short-term financial impact

of SWFs on host public equity markets To do so, Sun and Hesse considerdifferent sectors (financial and nonfinancial), actions (buy and sell), markettypes (developed and emerging), and level of corporate governance (highand low score) Their results suggest that there was no significantdestabilizing effect of SWFs on equity markets, which is consistent withavailable anecdotal evidence

The third chapter of this part is titled ‘‘Africa’s quest for development:Can sovereign wealth funds help?’’ and is written by Thouraya Triki and IssaFaye This chapter discusses the potential role that SWFs could play inAfrican economies, both as recipient and home countries The authors usenew hand-collected data and therefore a unique database to describe thelandscape of African SWFs as well as SWF interventions on the Africancontinent Triki and Faye observe that African SWFs are relatively small,suffer from poor governance structures and focus on stabilizing localeconomies In light of these findings, the authors conclude that the potentialrole of SWFs as long-term institutional investors aimed at fosteringeconomic growth should be limited unless current practices are changed.However, Triki and Faye also observe that foreign SWFs show a growinginterest in Africa and could play a bigger role in supporting the continent’sgrowth provided African governments use the appropriate strategies toattract their funding

PART V: SOVEREIGN WEALTH FUNDS: DO POLITICAL OBJECTIVES DRIVE THEIR

ASSET ALLOCATION?

First chapter of this part is by Christopher Balding and Yao Yao and is titled

‘‘Portfolio allocation for sovereign wealth funds in the shadow ofcommodity-based national wealth.’’ The key point of this chapter is thatSWFs’ investment strategies should not resemble those of other institutionalinvestors The authors consider a balanced national wealth portfolio thataccounts for the implied national wealth of unmonetized natural resources.They then estimate the optimal portfolio for an oil exporting state managing

a SWF with a dataset including returns from 19 major assets (encompassing

Introduction to Institutional Investors in Global Capital Markets 9

equity, debt, and commodity holdings) The authors find that when thereturns and volatility from oil prices are included in the risk profile ofnational wealth, SWFs should invest in lower risk equity indices and high-quality debt like the S&P 500 and sovereign debt Further, as oil reservesdecrease over time, SWFs should diversify into more balanced portfoliosthough remaining over weighted in fixed income Finally, they find that thelong-term growth of SWFs depends more on the price of oil and prudentrisk management than on financial asset returns The authors conclude thatSWF managers and public policy makers should consider a larger picturethan the risk-return adjusted profile of a financial assets portfolio.

The second chapter is by Rolando Avendan˜o and Javier Santiso and istitled ‘‘Are Sovereign wealth funds investments politically biased? Acomparison with other institutional investors.’’ This chapter studies theobjectives of sovereign wealth funds (SWFs), which are often suspected ofgoing beyond risk-return objectives This study shows that the fear thatsovereigns with political motivations use their financial power to securelarge stakes in Western companies is unfounded Indeed, the authorsdocument that SWF investment decisions do not differ greatly from those ofother wealth managers, specifically mutual funds To do so, the authorsanalyze these investments on a geographical and sector basis They look atthe political regime characteristics of the target countries for both groups ofinvestors and they report that SWFs do not discriminate according to thisvariable when investing Both groups invest in democratic and nondemo-cratic regimes They also report that there is no significant gap in thecorporate governance characteristics of the firms both groups invest in.Finally, they provide a comparison of SWFs and other public funds based

on governance features related to investment Avendan˜o and Santisoconclude that financial strategies rather than political bias drive the assetallocation strategies of SWFs

The third and final chapter of this part is an empirical extension of theprevious chapter It is written by Narjess Boubakri, Jean-Claude Cosset, andNabil Samir and is titled ‘‘Sovereign wealth fund acquisitions: Acomparative analysis with mutual funds.’’ Focusing primarily on firm-levelcharacteristics, the authors show that SWFs have investment tastes that aredifferent from other institutional investors, including mutual funds Indeed,

at the firm level, SWFs, unlike mutual funds, prefer larger, less liquid, lessinnovative firms, as well as those with a more concentrated ownership.Further, SWFs invest more than mutual funds in firms that have atemporary financial constraint At the country level, the authors find that thecountry culture and religion as well as its level of investor protection are not

NARJESS BOUBAKRI ET AL.10

significant determinants of SWF investment choices, which adds to theevidence of Avendan˜o and Santiso What is important for SWFs is whetherthe host country is geographically close to the home country.

This book investigates the role of institutional investors in the globaleconomy Institutional investors are large corporations that invest largeamounts of capital As discussed earlier, institutional investors haveincreasingly gained in importance since the 1990s, as evidenced by thevalue of assets under their management (US$45 trillion in 2005 with overUS$20 trillion in equity) For the most part, institutional investors managethe equities of large, privatized, more liquid and transparent firms Theyalso tend to hold assets of ADR-listed foreign firms domiciled in weakerinstitutional environments (Boubakri, Hamza, and Kooli) Institutionalinvestors’ holdings are evenly distributed across their home country’sindustries However, foreign institutions investing abroad have a preferencefor industries that need less local knowledge, such as transportation andmachinery (Bredin and Liu) In India moreover, it appears that institutionalinvestors follow herding and positive feedback trading strategies (Taydeand Rao)

The studies covered in this book have also shown that institutionalinvestors contribute to more efficient capital allocation, more efficient risksharing, capital market development, and improvement in the structure ofexternal finance (Stepanyan) Specifically, institutional investors with long-term investment horizons contribute to more efficient monitoring and lessagency costs, and considerably improve the information environment (Attig,

El Ghoul, and Guedhami) Furthermore, under certain conditions,institutional investors like financial conglomerates can be active inmonitoring managers of listed companies, thereby reducing agency costs(Alves and Mendes) Finally, a firm’s value is strongly related to foreigninstitutional holdings in the firm Thus, in the Chinese banking sector, asignificant drop in foreign institutional holdings reduced the market value ofdomestic holdings (Li and Uchida)

The growing number of stock holdings held by institutional investors such

as SWFs raises concerns about the motivations behind their investmentstrategies These funds have not, however, been shown to have adestabilizing effect on equity markets (Sun and Hesse) Concerns thatSWFs have political motivations may therefore be exaggerated Investmentstrategies by SWFs do not differ significantly from those of otherinstitutional investors (Avendan˜o and Santiso) Like mutual funds, SWFsinvest in large and profitable firms However, unlike mutual funds, SWFsprefer less liquid, less-innovative firms and those with more concentrated

Introduction to Institutional Investors in Global Capital Markets 11

ownership They also invest in geographically close host countries(Boubakri, Cosset, and Samir).

SWF investments have a positive impact on firm performance Themarket reacts positively in the short-run to SWF investment in theexpectation of improved monitoring and an increase in internationalisation

In the long-run, firm value increases with the number of government-relatedcontracts granted by SWF countries (Sojli and Tham) In Africa, SWFsshould define clear objectives that account for the home as well as the hostcountries’ interests (Triki and Faye) Conflict of interests between the homeand host countries may undermine the return from SWF investments.SWFs that are based on commodities should diversify their portfolio toinclude low-risk debt and fixed-income assets to balance the higher volatility

of commodity prices (Balding and Yao) This will guarantee long-termgrowth of the funds and savings for future generations There is a growingneed for infrastructure investment as reported by the World EconomicForum (2011) SWFs and other institutional investors should devote a largeproportion of their assets to long-term investing, thereby contributing tosustained economic growth and financial stability

NOTES

1 In March 11, 2011 the Brookings Institution pointed out that sovereign wealthfunds (SWFs) may be a solution to fixing the broken infrastructures of the UnitedStates with its considerable public finance burden, i.e., a US$1.5 trillion deficit andUS$13.5 trillion total debt as of 2010

2 In 2008, these concerns led the International Working Group of SovereignWealth Funds to adopt and implement the Generally Accepted Principles andPractices (GAAP) – the Santiago principles (IWG-SWF, 2008)

REFERENCES

Aggarwal, R., Erel, I., Ferreira, M., & Matos, P (2011) Does governance travel around the world? Evidence from institutional investors Journal of Financial Economics, 100, 154–181.

Ferreira, M A., & Laux, P A (2007) Corporate governance, idiosyncratic risk, and information flow Journal of Finance, 62, 951–989.

Ferreira, M A., & Matos, P P (2008) The color of investors’ money: The role of institutional investors around the world Journal of Financial Economics, 88, 499–533.

French, K R., & Roll, R (1986) Stock return variances: The arrival of information and the reaction of traders Journal of Financial Economics, 17, 5–26.

NARJESS BOUBAKRI ET AL.12

Gillan, S., & Starks, L (2003) Corporate governance, corporate ownership, and the role of institutional investors: A global perspective Journal of Applied Finance, 13, 4–22 Gonnard, E., Kim, E J., & Ynesta, I (2008) Recent trends in institutional investors statistics Financial Market Trends, OECD.

International Monetary Fund (2008) Sovereign Wealth Funds – A work agenda.

IWG-SWF (2008) Sovereign wealth funds general accepted principles and practices, ‘‘Santiago Principles’’.

Jen, S (2007) Sovereign wealth funds: What they are and what’s happening World Economics, 8(4), 1–7.

Lakonishok, J., Shleifer, A., & Vishny, R W (1992) The impact of institutional trading on stock prices Journal of Political Economy, 32, 23–43.

World Economic Forum (2011) The future of long-term investing World Economic Forum report in collaboration with Olivier Wyman.

Introduction to Institutional Investors in Global Capital Markets 13

FINANCIAL LIBERALIZATION AND FOREIGN INSTITUTIONAL

INVESTORS: LITERATURE REVIEW

Methodology/approach – Review and synthesize recent academicliterature (1970–2011) on the process of international financial integra-tion and the role of foreign institutional investors in the increasinglyglobal financial markets

Findings – Despite the concern that short-term flow of internationalcapital can be destructive to the emerging and developing marketeconomies, academic evidence on a destabilizing effect of foreigninvestment activity is limited Institutional investors’ systematic pre-ference for stocks of large, well-known, globally visible foreign firms canexplain the presence of a home bias in international portfolio investment.Research limitations – Given the breadth of the two literature streams,only representative studies (over 45 published works) are summarized

Institutional Investors in Global Capital Markets

International Finance Review, Volume 12, 17–50

Copyright r 2011 by Emerald Group Publishing Limited

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ISSN: 1569-3767/doi:10.1108/S1569-3767(2011)0000012004

17

Social implications – Regulators of emerging markets should firstimprove domestic institutions, governance, and macroeconomic funda-mentals, and then deregulate domestic financial and capital markets toavoid economic and financial crises in the initial stages of liberalizationreforms.

Originality/value of paper – A useful source of information for graduatestudents, academics, and practitioners on the importance of foreigninstitutional investors

Keywords: Foreign institutional investors; global financial markets;cross-border capital flows

JEL classifications: F21; F32; G11; G15

INTRODUCTION

Liberalization efforts by both developed and emerging countries increasedaccess to financial markets around the globe and resulted in unprecedentedgrowth in international capital flows worldwide (see, e.g., Lewis, 1999;Errunza, 2001) Many countries have liberalized their capital markets tocomplement limited domestic sources of finance with foreign capital that hasbecome an increasingly important source of investment Both foreign directinvestment (FDI) and foreign portfolio investment (FPI) flows have reachedpeak levels in recent years, as more and more countries have opened theirmarkets to foreign investors According to the International Monetary Fund,total investment in financial assets by foreign investors exceeded US$53trillion in 2009, with over US$23 trillion invested in equities Of totalinvestment in equities, almost US$14 trillion represented cross-borderportfolio investment in over 200 countries around the world, whereas theremaining US$9.8 trillion was in the form of direct investment in 66 countries.Moreover, over the past decade, two-thirds of foreign direct investment, onaverage, has taken the form of cross-border mergers and acquisitions(M&As).1Such active role of international investors worldwide represents

an unprecedented internationalization of the shareholder base of corporationsworldwide

A key factor in the internationalization of global capital markets is thegrowing importance of foreign institutional money managers Institutional

GOHAR G STEPANYAN18

investors are major players not just in developed markets but also in rapidlygrowing emerging market countries (Ferreira & Matos, 2008;Li, Moshirian,Pham, & Zein, 2006).Table 1reports the average fraction of stock marketcapitalization of 26 countries around the globe that is held by domestic andforeign institutions as well cross-border M&As, as a percentage of all deals

in each country, over the first 5 years of the twenty-first century.Institutional money investors are most prominent in North America,holding over 70% of the stock market capitalization in the United Statesand 38% in Canada However, holdings of foreign institutional investorsare more pronounced in European countries such as Finland, Ireland,and the Netherlands, where 32.2%, 29.8%, and 21.2% of the stock marketcapitalization, respectively, are in the hands of foreign institutions,compared to only 3.3%, 0.6%, and 1.2% of the market held by localmoney managers.2 Cross-border M&A activity across countries alsodisplays large variation: firms in Japan, for example, are among the leasttargeted by foreign acquirers, with only 3.6% of all M&A deals being cross-border, whereas 100% of all completed M&As in Ireland and Luxemburginvolve foreign acquirer

In this chapter, I review the academic literature on the process ofinternational financial integration and the increasingly important role offoreign institutional investors Given the breadth of the two literaturestreams and my own space limitations, the purpose of this synthesis is not toprovide a comprehensive survey of all research in the area Rather, Isummarize representative studies, with apologies to the authors of manyimportant and useful papers that were excluded from this review

FINANCIAL LIBERALIZATION AND

INTERNATIONAL CAPITAL FLOWS

The concept of increased financial integration is central to the internationalfinance literature In financially integrated markets, domestic investors areable to invest in foreign assets and foreign investors in domestic assets;hence, assets of identical risk command the same expected return, regardless

of trading location, and are priced based on the global price of risk.Liberalization reforms reflect regulatory changes leading to increasedmarket integration (Bekaert, Harvey, & Lumsdaine, 2002) Before 1970s,most countries had restrictions on foreign investments that limitedcross-border capital flows Developed countries started eliminating such

Financial Liberalization and Foreign Institutional Investors 19

Table 1 Institutional Ownership and Mergers and Acquisitions by Country.

All M&A Ddeals Cross-Border M&A Deals

Sample of Firms Institutional

Total Domestic Foreign Number Percentage

Firms

Value Percentage

Market Capitalization

Number Percentage

Deals Value Percentage

Deals Value

Australia (AU) 1,753 584,469 6.4 0.9 5.5 195 11.1 77,389 13.2 35 17.9 18,484 23.9

Belgium (BE) 259 219,469 10.5 3.3 7.2 13 5.0 30,959 14.1 4 30.8 1,027 3.3 Canada (CA) 1,746 888,813 38.4 20.6 17.8 425 24.3 188,967 21.3 115 27.1 107,353 56.8 Denmark (DK)) 314 109,511 18.7 7.4 11.3 17 5.4 16,930 15.5 4 23.5 2,977 17.6 Finland (FI) 223 202,065 35.5 3.3 32.2 12 5.4 13,788 6.8 5 41.7 10,390 75.4 France (FR) 1,491 1,556,741 18.3 5.8 12.5 85 5.7 125,561 8.1 31 36.5 30,113 24.0 Germany (DE) 1,308 1,122,865 17.5 7.0 10.5 73 5.6 57,110 5.1 42 57.5 28,666 50.2

Poland (PL) 104 40,035 12.4 2.2 10.1 14 13.5 1,189 3.0 11 78.6 1,111 93.4

Singapore (SG) 617 168,734 8.8 1.0 7.7 25 4.1 16,773 9.9 6 24.0 3,904 23.3 South Africa (ZA) 772 220,671 9.5 2.3 7.1 34 4.4 9,603 4.4 7 20.6 5,999 62.5

Sweden (SE) 550 295,888 29.2 16.3 12.8 35 6.4 10,436 3.5 17 48.6 4,816 46.1 Switzerland (CH) 392 781,184 17.8 3.0 14.8 17 4.3 9,556 1.2 9 52.9 6,572 68.8 The United Kingdom 3,592 3,047,705 18.8 7.5 11.3 228 6.3 433,782 14.2 82 36.0 250,091 57.7 The United States 11,753 13,992,086 73.3 67.9 5.4 1,714 14.6 2,311,874 16.5 224 13.1 314,021 13.6 All countries 32,716 29,786,605 43.0 34.6 8.4 3,329 10.2 3,601,183 12.1 683 20.5 851,910 23.7 All countries

(ex-United States)

20,963 15,794,519 16.1 5.0 11.1 1,615 7.7 1,289,310 8.2 459 28.4 537,889 41.7

Other countries 7,340 2,333,791 17.0 0.1 16.9 302 4.1 140,430 6.0 106 35.1 97,973 69.8 All countries

(w/other)

40,056 32,120,396 41.1 32.1 9.0 3,631 9.1 3,741,613 11.6 789 21.7 949,883 25.4

Notes: This table is extracted from Ferreira et al.(2010) and presents institutional ownership and M&As for the 2000–2005 period by target country: average number of firms and market capitalization (in millions US$); average of total, domestic, and foreign institutional ownership as a percentage of market capitalization; number of completed M&A deals, percentage of listed firms targeted in deals, value of transactions of deals in millions US$ and as

a percentage of market capitalization; and number of completed cross-border deals, number of cross-border deals as a percentage of the total number of deals, value of transactions of cross-border deals in millions US dollars and as a percentage of total value of transactions.

Stock Market

Fig 1 Indexes of Financial Liberalization by the Level of Development,1973–2005 The Three Indexes Display Separately the Liberalization of the CapitalAccount, the Liberalization of the Domestic Financial Sector, and the Stock MarketLiberalization The Value 3 Means Repression, 2 Means Partial Liberalization, and

1 Means Full Liberalization The Indexes are a Cross-Country Average MatureMarkets are: Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan,Norway, Portugal, Spain, Sweden, the United Kingdom, and the United States.Emerging Markets are: Argentina, Brazil, Chile, Colombia, Hong Kong, Indonesia,Korea, Malaysia, Mexico, Peru, Philippines, Taiwan, Thailand, and Venezuela

Source:Kaminsky and Schmukler (2008)

GOHAR G STEPANYAN22

restrictions in the late 1970s and the early 1980s, followed by emergingcountries’ financial liberalization reforms in the late 1980s and early 1990s.Fig 1 captures the development of three main aspects of liberalizationprocess – deregulation of the domestic banking industry (financial sectorliberalization), removal of controls on international capital flows (capitalaccount liberalization), and the stock market liberalization, across 28emerging- and mature-market economies.

For illustrative purposes,Table 2provides a comparison of official equitymarket liberalization dates for 43 emerging countries across several studies

It is important to note that empirical studies examining the impact of theequity market liberalization use multiple indicators, not just the officialliberalization dates, given the difficulty in pinpointing the exact date whenthe market becomes open to foreign investment For example, investors canavoid capital controls and access foreign markets indirectly throughAmerican/Global Depositary Receipts (ADRs/GDRs) or country funds,even though the market itself is technically closed to foreign investors Thecapital market liberalization process is a complex process reflecting adecision by a country’s government to allow foreigners invest in domesticequity securities It may occur in stages and often be a part of more generalregulatory change aimed at removing restrictions on both capital inflowsand outflows Many authors emphasize the gradual nature of the shift fromclosed to open capital markets that usually coincides with other equallyimportant economic reforms such as macroeconomic stabilization, tradeliberalization, privatization, and the relaxation of exchange and productmarket controls (Bekaert & Harvey, 2000; Henry, 2000a, 2000b), and legalreforms such as insider trading (Bekaert et al., 2005) Liberalization reformsmay take many different forms, with some policy changes anticipated well inadvance while others lacking credibility, and not all reforms taking place atthe same time

The liberalization process might have drastic effect on the liberalizingcountry’s market activity and economy The arrival of foreign investors mayenhance market efficiency and liquidity, thereby reducing the cost of equitycapital and increasing the valuation of local companies The stock marketconcentration might decrease while trading volume may increase as a result

of these new entrants In addition, individual stocks might become lesssensitive to local information and more sensitive to world events, reflectinglocal market’s integration with the world markets

Financial Liberalization and Foreign Institutional Investors 23

Table 2 Comparison of Official Equity Market Liberalization Dates

across Studies

Henry (2000a)

Bekaert and Harvey (2000)

Kim and Singal (2000)

Bekaert et al (2005)

Liberalization and Market ActivityNumerous studies examine the impacts of increased capital marketintegration process and international capital flows.Henry (2000a)empiricallyestimates the influence of stock market liberalization on 12 emerging markets’equity prices across Latin America and Asia The author documents asubstantial appreciation of aggregate share prices, occurring both in themonths leading up to the implementation of a country’s initial stock marketliberalization as well as in the implementation month itself After controllingfor co-movements with world stock markets, macroeconomic fundamentals,and major economic policy changes, the average valuation increase stillremains large and statistically significant – 3.3% per month (or 26% overall)abnormal return over an 8-month window leading up to the implementation

of initial stock market liberalization Henry (2000a) also addresses thepotential endogeneity problem arising from the policymakers’ incentives toliberalize stock markets in response to prolonged run-ups in equity prices.These results indicate an upward revaluation of aggregate share prices inemerging markets in anticipation of future stock market liberalizations,consistent with the prediction of standard international asset pricing modelsthat stock market liberalization may reduce the liberalizing country’s cost ofequity capital by allowing for risk sharing between domestic and foreignagents.3

If liberalization of capital markets reduces the liberalizing country’s cost

of equity capital, then investment projects that had a negative net presentvalue (NPV) before liberalization will turn into positive NPV projectsafter liberalization, leading to a surge in private physical investment.Henry (2000b) studies whether stock market liberalizations are indeedassociated with increased investment by comparing the growth rate ofreal private investment on the heels of stock market liberalization in

11 emerging markets with the growth rate during nonliberalization periods

He finds that stock market liberalizations lead to private investmentbooms: the average growth rate of real private investment is 23%, 27%,and 17% in the first, second, and third year following stock marketliberalization, respectively Moreover, the positive correlation betweenprivate investment growth and stock market liberalization persists aftercontrolling for world business cycle effects, contemporaneous economicreforms, and domestic fundamentals.Henry (2000b)finds that the ratio ofFDI to private investment also tends to rise following stock marketliberalization, suggesting that the increase in private investment does notsimply substitute for FDI One explanation for why FDI increases during

Financial Liberalization and Foreign Institutional Investors 25

these episodes is that stock market liberalization may be positivelycorrelated with other economic reforms that reduce the operating risk offoreign multinationals with subsequent reduction in their cost of equitycapital.

Although one cannot necessarily conclude that stock market izations cause investment booms – the political decision to liberalize acountry’s stock market may be endogenous4 – the evidence presented inHenry (2000b)is relevant for the debate on whether liberalization reformshave any effect on real investment The fact that stock market liberalizationsare followed by a surge in private investment that cannot be explained byworld business cycle effects, contemporaneous economic reforms, ordomestic aggregate demand conditions suggests that liberalization ofemerging capital markets may matter for investment after all Using amore comprehensive sample of both developed and emerging countries,Bekaert et al (2005) show that equity market liberalizations increasesubsequent average annual real economic growth by about 1% This growtheffect is robust to alternative definitions of the liberalization, is distinct fromthe effects of capital account liberalization, and does not reflect variation inthe world business cycle Other simultaneous reforms only partially accountfor the equity market liberalization effect Interestingly, the growth effectdepends positively on development levels – the countries that benefit themost in terms of growth are those that are further along in terms of financialdevelopment, have English instead of French or other legal origins, goodinstitutions, favorable conditions for foreign investment, better protection

liberal-of shareholder rights, and higher accounting standards It is evident thatboth firms and economies, as a whole, enjoy better growth opportunitiesafter liberalizations

In a related paper, using a sample of 20 emerging markets across theglobe,Bekaert and Harvey (2000)show that liberalization tends to decreaseaggregate dividend yields and argue that this price change reflects both achange in the cost of capital and changes in growth opportunities The cost

of capital always decreases after capital market liberalization, with the effectvarying between 5 and 75 basis points In contrast, the effect of theliberalization on the investment activity of the country is positive – anincrease of 75 basis points in the investment to gross domestic product(GDP) ratio At the same time,Bekaert and Harvey (2000)document thatthe magnitude of the increase in correlation between emerging markets andthe world market return is small and, thus, is unlikely to deter foreigninvestors attracted to developing markets by the gains of internationaldiversification In a subsequent study,Bekaert et al (2002)confirm that the

GOHAR G STEPANYAN26

emerging markets’ integration with the world market, post liberalization,leads to permanent appreciation in equity prices that decrease dividendyields and expected returns; in addition, integration brings about or isaccompanied by increased stock market development – significantly highermarket capitalization to GDP ratio, increased U.S holdings of the localmarket capitalization, sizable jumps in trading activity and liquidity, andhigher correlation of local stock returns with respect to the world marketreturn.Bekaert et al (2002)also document that integration with the globalmarket is associated with a lower cost of capital, improved credit ratings,appreciation of local currency, and increased real economic growth.Kim and Singal (2000) examine changes in the level and volatility ofstock returns, inflation, and exchange rates around removal of restrictions

on capital flows in 20 emerging markets They find that stock returnsincrease immediately after market openings, indicating greater demand forthe domestic securities by foreign investors, yet without accompanyingincrease in the volatility of stock returns After this upward adjustment,stock returns fall, reflecting lower expected returns For the sample as awhole, stock markets become more efficient in impounding informationover longer horizons, evidenced by reduction in predictability of stockreturns The improvement in market efficiency and lower predictability instock prices is consistent with increasing integration with the worldmarket – as the foreign investors take advantage of emerging marketinefficiencies, those inefficiencies decrease and the prices react morequickly to new information.Kim and Singal (2000)find no evidence of anincrease in inflation or an appreciation of exchange rates Moreover,volatility of inflation, nominal exchange rates, and real exchange rates allshow a decrease following stock market liberalizations Overall, there is adistinctive pattern of a decrease in volatility after the opening ofemerging markets to foreign participation, suggesting that new capitalinflows are not disruptive to the economy Although the authors’ resultsvary across countries, liberalization of capital markets, on average,appears to have favorable effects on the emerging countries’ stock marketsand economies

Liberalization and Home Bias in Portfolio Investment

As previously mentioned, deregulation of capital markets and the relaxation

of capital controls lead to a dramatic decline in restrictions to internationalinvestment, resulting in substantial cross-border flows Although not all

Financial Liberalization and Foreign Institutional Investors 27

obstacles have disappeared, investors in most countries can now investabroad either directly or through financial intermediaries such as mutualfunds to diversify their investments internationally Yet, investors assignonly a very small fraction of their wealth to foreign assets despite thewell-documented benefits of cross-border diversification of portfolioallocations.5 This evidence constitutes what is generally referred to as a

‘‘home bias’’ – national equity portfolios are concentrated in the domesticequity market of the investor, and foreign ownership of shares is muchsmaller than one would expect in the presence of international diversifica-tion For example, Kang and Stulz (1997) document that the weight ofJapanese equities in portfolios of foreign investors from 1975 to 1991 wasdisproportionably lower than the weight of Japan in the world marketportfolio, thus confirming the existence of a substantial home bias in theJapanese market

Home bias must be caused by some feature of international portfolioinvestment that offsets gains from diversification Explanations offered tojustify this bias include both explicit and implicit barriers to internationalcapital flows; although, so far, no explanation emerges as generally accepted(Karolyi & Stulz, 2003; Lewis, 1999) Explicit barriers to internationalinvestment are those that are directly observable and quantifiable Amongthem are the costs associated with cross-border investing such as taxes(withholding taxes on dividends or tax differential on domestic versusforeign interest-rate and equity income) and foreign securities transactioncosts, restrictions on foreign exchange transactions, differential access tomarkets, institutional constraints, inflation risk and foreign exchange raterisk Cooper and Kaplanis (1994) argue that explicit barriers to interna-tional investment are not large enough to explain the observed portfolioallocations of investors; the home-bias puzzle cannot be explained byneither inflation hedging nor direct observable costs of internationalinvestment, such as withholding taxes on dividends, unless investors exhibitrisk aversion that is below conventional levels French and Poterba (1991)make a similar point and claim that incomplete diversification is theconsequence of investor choices rather than institutional constrains,whereas Tesar and Werner (1995) convincingly refute transaction costs as

a likely cause of the observed reluctance of investors to diversify theirportfolios internationally by pointing to the high level of internationalmarket activity, reflected both in the level of cross-border flows and the rate

of turnover on foreign assets In sum, the composition of the portfolio offoreign securities of a typical investor seems to reflect factors other thandiversification of risk

GOHAR G STEPANYAN28

Implicit barriers to international investment, however, are not directlyobservable or quantifiable and include such barriers as political risk,informational asymmetries between domestic and foreign investors,differences in language and culture, and behavioral biases affecting investorreturn expectations in foreign markets For example,Kang and Stulz (1997)present empirical evidence that foreign investment in Japanese equities isconcentrated in the largest firms, consistent with foreign investors havingrelatively less information about small firms than local investors and, thus,preferring equities of well-known firms The use of informationaldisadvantage and political risk as explanations for the home bias, though,

is difficult to reconcile with the evidence of a dramatic home bias in the U.S.market, where information disclosure standards are high and the risk ofexpropriation by the government is low As demonstrated in Fig 2,although the home bias in the United States decreased substantially over thepast three decades of the twentieth century, as of 2001 foreign stocks stillconstituted only 10% of U.S investors’ portfolio holdings This stands insharp contrast to the dominance of the U.S market, as a whole, in the worldmarket capitalization (seeTable 1)

Fig 2 U.S Home Bias, 1973–2000 This Figure is Extracted from Karolyi andStulz (2003) and Compares Foreign Equities Share in U.S Investors’ PortfolioHoldings to the Foreign Equities Share of World Market Portfolio Source: Flow

of Funds Accounts of the United States, Flows and Outstandings, Federal

Reserve Board

Financial Liberalization and Foreign Institutional Investors 29

Although neither direct nor indirect barriers to international investmentand ownership can explain the home bias per se, they appear to capturesome portion of the cross-sectional variation in the home bias Chan,Covrig, and Ng (2005)examine cross-border investment behavior of morethan 20,000 mutual funds from 26 developed and developing countries,using a breakdown of the market value of their equity holdings across

48 countries for 1999 and 2000 Interestingly, all 26 countries exhibitdomestic bias – the share of mutual fund holdings in the mutual fund’sdomestic market is much larger than the world-market capitalization weight

of the country, yet foreign mutual funds invest more in markets that aremore developed, less remote from the rest of the world, larger in marketcapitalization, and have lower transaction costs and similar language.Factors such as economic development, capital controls, withholding taxesand investor protection have a less pervasive impact on the investmentdecisions of foreign institutional money managers

There is some evidence that institutional investors are more sophisticated

in diversifying their investments.Hau and Rey (2008) present data on thedegree of home bias at the fund level over the period of 1998–2002, using adetailed dataset on global equity holdings of mutual equity fundsincorporated in the most developed 16 financial markets Mutual fundsappear to be home biased, but to a lesser degree than other investors

FOREIGN INSTITUTIONAL INVESTORS

Foreign investor as a category encompasses both institutional andindividual investors However, the cross-border investment activity is likely

to be dominated by sophisticated and professionally more skilled tional investors with relatively low transaction costs and large trades tojustify the documented high volume of international capital flows and highforeign investment turnover rates relative to domestic turnover rates (see,e.g., Tesar and Werner (1995).6In this section, I integrate the theoreticalliterature with the available empirical evidence on foreign investors’investment strategies and discuss whether their trades are destabilizing tothe developing country’s market and economy

institu-Are Foreign Investors Momentum or Contrarian Investors?

Numerous studies document that the trades of foreign investors are affected

by past returns, so that they buy when prices have increased and sell when

GOHAR G STEPANYAN30

they have fallen For example,Bohn and Tesar (1996)develop and test anintertemporal, international capital-asset-pricing model, where net pur-chases are decomposed into (i) transactions required for maintaining abalanced portfolio of securities and (ii) transactions triggered by time-varying investment opportunities, and find that over the 1980–1994 periodU.S investors tend to acquire stocks abroad when returns in a particularforeign market were high, rather than sell off ‘‘winning stocks’’ to maintainbalanced portfolio weights These results suggest that U.S transactions inforeign equities were primarily driven by return-chasing – that is, movinginto markets where returns were expected to be high and retreating frommarkets when expected returns were low Interestingly, Bohn and Tesar(1996) find that the return-chasing strategy pursued by U.S investorsresulted, on average, in a return that was lower than what could have beenobtained by holding a market-weighted portfolio of foreign equities.Moreover, this loss in return was not compensated by a reduction in risk –the mean return per unit of risk on the market portfolio was higher thanthe one on the portfolio selected by U.S investors Apparently, U.S.investors were chasing returns, but not in the right markets and at theright time.

Brennan and Cao (1997)develop a model of international equity portfolioinvestment flows that is based on informational differences between foreignand domestic investors The main empirical implication of the model is thatpurchases of foreign equities will be a linear function of returns on theforeign equity markets since foreign investors are less informed thandomestic investors and, thus, are inclined to pursue momentum strategies.Brennan and Cao (1997)test the model by examining equity flows betweenthe United States and 4 developed countries, and net U.S purchases ofequities in 16 emerging markets The authors find some evidence that U.S.purchases of equities in foreign developed markets tend to be positivelyassociated with the concurrent return in that market, consistent with U.S.investors being less well informed about those markets than local investors.However, there is no indication that investors in these four developedmarkets are less well informed than U.S residents about the returns on U.S.equities When the authors examine U.S portfolio investment in emergingmarkets, they find strong evidence that U.S purchases are positivelyassociated with both the lagged and contemporaneous returns on the localmarket index Thus, equity capital flows from the U.S to emerging marketsare consistent with a model in which U.S investors are at an informationaldisadvantage relative to locals In sum, Brennan and Cao (1997)concludethat when domestic investors possess a cumulative information advantage

Financial Liberalization and Foreign Institutional Investors 31

over foreign investors about the payoffs on the domestic market, foreigninvestors tend to purchase assets in periods when the return on those assets

is high and to sell when the return is low

Choe, Kho, and Stulz (1999) use a large sample of Korean stocks toexplore how foreign investors trade and how they impact stock prices.Before Korea’s dramatic economic crisis of the late 1997, the authors findstrong evidence of positive feedback trading and herding by foreigninvestors – foreign investors buy (sell) more Korean stocks on daysfollowing positive (negative) market return; moreover, they buy (sell)Korean shares that outperformed (underperformed) the market over theprevious day Furthermore, foreign investors trade similarly over a shortperiod of time During the crisis period, however, herding falls and positivefeedback trading by foreign investors mostly disappears One possiblereason for the decrease in herding is that lower liquidity during the crisismay have limited the trading of foreign investors

Grinblatt and Keloharju (2000)use detailed transaction data on stocktrades for both individuals and institutional investors from Finland overthe two-year period of 1995–1996 and also document that foreign investorspursue momentum strategies, buying past winning stocks and selling pastlosers Portfolios of foreign investors outperform those of households,even after controlling for behavior differences In contrast toBrennan andCao (1997), Grinblatt and Keloharju (2000)claim that both momentumbehavior with respect to near- and intermediate-term past returns andsuperior investor performance are driven by the level of sophistication ofthe investor The most sophisticated players in the Finish financial marketare foreign investors – often well capitalized foreign financial institutionswith a long history of successful investment in other stock markets such asprofessionally managed mutual funds, hedge funds, and investment banks.Institutional investors generally take larger positions than individuals,have more resources to expend on research, and in many cases, viewinvestment as a full-time career Consequently, it is reasonable to viewforeign institutional investors in Finland as more sophisticated than all ofthe other investor categories Thus, investors perceived as sophisticatedfollow momentum strategies and exhibit superior performance, whereasinvestors perceived as naive follow contrarian strategies and exhibitinferior performance, consistent with momentum being a behaviorallydriven anomaly in which ‘‘smart’’ investors take advantage of ‘‘naive’’investors in equilibrium

Froot, O’Connell, and Seasholes (2001)explore daily data from State StreetBank & Trust, one of the world’s largest custodian banks, on international

GOHAR G STEPANYAN32

portfolio flows into and out of 16 developed and 28 emerging countries from

1994 through 1998 State Street’s clients are predominantly large institutionalinvestors from developed countries, including pensions, endowments, mutualfunds, and governments, and thus can be thought of as a large sample ofsophisticated international investors

The authors document several important observations First, net inflowsare strongly influenced by lagged equity and currency returns, once againconfirming international investors’ engagement in positive feedback trading.There is also very strong trend following international inflows, but themajority of the co-movement of flows and returns can be attributed toreturns predicting future flows Second, international portfolio inflows areslightly positively correlated across countries, and are more stronglycorrelated within regions The correlation of flows in most regions,particularly within Asia, rises strongly during the Asian crisis, but notduring the Mexican crisis Third, international inflows have positiveforecasting power for future equity returns in emerging markets, whichcan occur either due to superior information held by international investors

on emerging markets, who reach their desired positions slowly to mitigatetransaction costs and price impact of large trades, or due to price pressure ofpersistent capital flows

Do Foreign Investors Destabilize Developing Markets?

It has been frequently argued by academics, political leaders as well as in thepopular press that foreign investors can exert a destabilizing influence ondeveloping countries’ economies Foreign investors were often blamed for thedramatic difficulties of the Asian and Latin American countries and thecollapse of their currencies and stock markets in the late 1990s As alreadydiscussed earlier, academics have pointed out that foreign investors do notfollow ‘‘buy and hold’’ strategies; their trades are highly correlated, reflectingpositive feedback trading and herding Investors pursuing such strategies areoften viewed as destabilizing since, if they trade as a group, their purchasescan overheat the markets that they enter, increasing prices further and leading

to bubbles, whereas their sales can create disarray and panic in the marketsthat they exit, causing prices to fall further and leading to market crashes Ifforeign investors can indeed destabilize economies, the benefits from openingmarkets to investors around the globe are questionable

For one reason, however, positive feedback trading and herding are notnecessarily destabilizing – local investors trading on fundamentals may be

Financial Liberalization and Foreign Institutional Investors 33

sufficiently powerful to prevent prices from moving away from fundamentalvalues For example,Choe et al (1999)use order and trade data to examinewhether large trading imbalances by foreign investors in Korea are followed

by price continuations and an increase in volatility They find no evidence ofdestabilizing effect of foreign investors’ trades on Korea’s stock market overthe period of late 1996 to the end of 1997 In particular, Korean marketadjusted quickly and efficiently to large sales by foreign investors, and thesesales were not followed by negative abnormal returns Choe et al (1999)conclude that the impact of domestic buying on stock returns dominates theimpact of foreign selling

Consistent with Choe et al (1999), Karolyi (2002) finds no evidence ofany destabilizing effect of foreign investors’ trading activity on stock andcurrency returns in Japan around the time of the Asian crisis in 1997 Thecrisis likely reflected structural and policy distortions in the countries of theAsia-Pacific region, although foreign investors were often blamed forexerting a destabilizing influence on stock prices and foreign currencyvalues The investment behavior of foreigners in Japan was distinctlydifferent from that of each of the domestic investment groups Foreigninvestors were consistently positive-feedback traders before, during, andafter the Asian crisis, buying (selling) on Nikkei index increases (decreases)and yen/dollar appreciations (depreciations), whereas Japanese banks,financial institutions, investment trusts and corporations were negative-feedback, or contrarian, investors The Asian financial crisis did scareforeign investors out of Japan as they became net sellers of Japanese equitiesduring this turbulent period However, this shift in aggregate foreignportfolio investment activity did not aggravate the effect of the crisis on themarket The sales by foreigners as a group during the crisis period wereabsorbed by increases in purchases by Japanese corporations, banks andother financial institutions Interestingly, Karolyi (2002) presents evidence

of the success of the foreigners’ positive-feedback trading strategy – theywere able to accumulate over 1,250 billion yen (US$12.1 billion) over theentire period, including 210 billion yen (US$1.8 billion) during the crisisperiod, reflecting foreigners’ good market timing skills

In their examination of daily international portfolio flows worldwidefrom 1994 through 1998, Froot et al (2001)point to an interesting fact –international investors did not abandon emerging markets during the Asiancrisis They remained net buyers of emerging market equities over the July1997–July 1998 period, simply at a reduced rate The reduced level of netflows may explain why equity prices in most emerging markets declinedduring the Asian crisis The persistence that characterizes international

GOHAR G STEPANYAN34

portfolio flows suggests that prices in the emerging region had been bid up

as a result of high volume of past inflows and in anticipation of furtherinflows When these future inflows failed to materialize, prices declined.Although the academic evidence on the adverse effects of foreign investorcapital flows on developing economies and markets is weak, Stiglitz (2000)calls for a greater regulation of short-term speculative capital flows, arguingthat the volatile nature of these flows can give rise to economic instability andtrigger financial and economic crises At the same time, he states thatineffective regulatory policies and weak financial institutions were at the core

of the crises in East Asia, Latin America, and Russia Before initiating theprocess of increased financial liberalization and open market economy,emerging market countries should have strong legal and financial framework

Target Firm Characteristics

A number of studies highlight the importance of firm characteristics in theinvestment decisions of foreign investors, suggesting that institutionalmoney actively selects which foreign firms to invest in, beyond just followingcountry-level allocations for diversification purposes

For example, in their study of stock ownership in Japanese firms by Japanese investors from 1975 to 1991, Kang and Stulz (1997) find that

non-Financial Liberalization and Foreign Institutional Investors 35

foreign investors in Japan have disproportionately high holdings of firms inmanufacturing industries (compared with utilities) and in firms with goodaccounting performance, high market-to-book ratio, low unsystematic riskand low leverage, relative to the weights of the Japanese market portfolio.Although foreign investors prefer primarily large Japanese firms, there issome evidence that small firms that export more have greater foreignownership, whereas firms with low share turnover, regardless their size, havelower foreign ownership, consistent with the notion that foreigners arereluctant to hold securities of firms they are not familiar with or equitieswith high transaction costs Cross listing on a U.S exchange is also related

to foreign ownership since cross-listed firms have more of an internationalpresence and, thus, attract foreign investors due to lower informationasymmetries and transaction costs.7 The cost to foreign investors ofoverinvesting in Japanese firms that they were better informed about washolding a portfolio with much greater volatility than that of the marketportfolio, without any gain in expected return

Dahlquist and Robertsson (2001) analyze a detailed dataset of equityownership of Swedish firms for the period 1991–1997 to identify thecommon firm-specific determinants of foreign ownership Their overallresults support the findings ofKang and Stulz (1997)that foreign investorstend to prefer firms with certain attributes: firms that are large, have highamount of cash on their balance sheets and low dividend yields When theyfurther investigate what drives the foreigners’ preference for large firms,Dahlquist and Robertsson (2001) find that market liquidity of a firm’sshares and presence in international goods and services markets, measuredthrough either export sales or listings on other international stockexchanges, seem to characterize foreign holdings in Swedish equities betterthan firm size alone Foreigners also tend to underweight firms with highlyconcentrated ownership An important contribution of Dahlquist andRobertsson (2001) is that most of the features associated with foreignownership are driven by the fact that the typical foreign investors in Sweden

is a large institution; hence, they conclude that they do not find a foreignerbias per se, but rather that institutional investors in general deviate fromholding the market portfolio

Aggarwal, Klapper, and Wysocki (2005)also confirm the importance offirm visibility in foreign investment decisions of institutional investors Theyfind that firm size and number of analysts following are two of the mostimportant drivers of U.S actively managed mutual funds’ investmentdecisions in 30 emerging markets The U.S funds tend to significantlyoverweight their holdings to larger firms, firms with lower leverage and

GOHAR G STEPANYAN36

higher price-to-book ratios, and firms that have ADRs The U.S fundsinvest in unlisted ADRs only when these firms adhere to high-qualityfinancial disclosure standards such as consolidated financial statementsbased on internationally recognized accounting standards or a clean opinionfrom an internationally recognized auditor Therefore, emerging marketfirms, unlisted on the U.S stock exchanges, can capture similar foreigninvestment benefits as firms with listed ADRs if they adopt high-qualitydiscretionary disclosure practices.

In a comprehensive study of the role of institutional investors from

27 countries,Ferreira and Matos (2008)record substantial diversity in therevealed stock preferences of various groups of institutional investors,depending on their geographic origin Although all institutional investors,regardless their geographic origin, have a strong preference for the stock oflarge, widely held firms and firms with strong governance indicators, foreigninstitutions avoid high dividend-paying stocks and are biased towards firmsthat are cross-listed in the United States, have high external visibilitythrough high foreign sales and analyst coverage, and are members of theMorgan Stanley Capital International World Index Interestingly, U.S.institutions diverge from non-U.S foreign institutions in their preference forvalue over growth stocks, and a tendency to hold stocks in English-speakingcountries and emerging markets

Market Characteristics

As already stated earlier, foreign institutions can play an important role infunding corporations, especially in countries in which domestic sources ofoutside finance are limited However, poor corporate governance can oftenact as a substantial deterrent to foreign investment Leuz, Lins, andWarnock (2009)study 4,409 firms from 29 countries to assess whether andwhy concerns about both firm- and country-level corporate governanceresult in fewer foreign holdings Building on the notion that foreigninvestors are often at an informational disadvantage relative to localinvestors, the authors conjecture that these information asymmetries areparticularly pronounced with respect to the evaluation of a firm’sgovernance and ownership structures and the scope for expropriation bycontrolling insiders In many countries around the world, businesstransactions, financing arrangements, ownership structures, and, ultimately,corporate governance are shaped by relationships among a tightly knitgroup of economically and politically powerful controlling shareholders,

Financial Liberalization and Foreign Institutional Investors 37

such as families, state, corporations or financial institutions, and managers(La Porta, Lopez-de-Silanes, Shleifer, & Vishny, 2000;La Porta, Lopez-de-Silanes, & Shleifer, 1999) Understanding these relationships and assessingwhether they pose a threat to outside investors require intricate social,political, and institutional knowledge, which foreigners lack or find costly toobtain As a consequence, firms with potentially problematic governancestructures are particularly taxing to foreign investors in terms of theirinformation and monitoring costs.

Leuz et al (2009) find that foreigners invest less in firms that reside incountries with weak disclosure requirements, securities regulations and poorshareholder protection, and have ownership structures that are conducive togovernance problems and expropriation of outside investors by controllingmanagers and their families In contrast, firms with substantial managerialand family control do not experience less foreign investment when theyreside in countries with extensive disclosure requirements and stronginvestor protection Information problems faced by foreign investors infirms with potentially problematic governance structures play a central role

in this result Stringent disclosure rules make it less costly to evaluate firms’potential governance problems – they level the playing field amonginvestors, making it less likely that locals have an informational advantage,whereas well-enforced investor protection rules make knowledge aboutprivate benefits of control and expropriation less important In contrast, lowdisclosure requirements and weak investor protection worsen informationproblems and their consequences – thus, foreign investors face largerinformation problems relative to local investors in countries with lowdisclosure requirements, weakly enforced governance rules and poorinvestor protection

The findings on the importance of strong shareholder rights and legalframework and high-quality accounting and disclosure practices at thecountry level to attract foreign investment is in line with the evidence inLaPorta, Lopez-de-Silanes, Shleifer, and Vishny (1997, 2000), who emphasizethe role of stronger investor protection laws and enforcement in fosteringcorporate governance climate that attracts outside investors Interestingly,Aggarwal et al (2005)present evidence that firm-level discretionary policiessuch as those related to greater accounting transparency and the issuance of anADR, are also important in foreign institutional investors’ portfolioallocation choices Their examination of U.S mutual funds’ investmentdecisions in 1,280 firms across 30 emerging markets after the financial marketcrises of the 1990s highlights the important role of voluntary disclosurechoices, including internationally recognized accounting standards, auditor

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