Differences in the stock preferences of domestic and foreign investors

University Degree Business and Administrative studies

In resent years, due to the high return in a very short period, most investor tend to invest their money in stock, which lead the trading activity of stock markets growing at a rapid rate. Most previous researches have shown that there is a strong distinguish invest behavior between them. Kang and Stulz (1997) collect the data from Japanese equity holdings in the period from 1975 to 1991 and find that foreign investors are prone to invest in firms with higher quality accounting, low undiversified risk as well as low leverage and firms in the manufacturing sector. The further research was analyzed by Covirg, Lau and Ng (2006), who example the equity holdings figures of 11 developed countries to identify several similar and different stock preferences of domestic and foreign fund managers, the results shows that when domestic and foreign fund managers make investing decisions, the turnover rates, return on equity, and stock riskiness are considered by both of them. The purpose of this article is to further analyze the different stock preferences of domestic and foreign investors from various countries that include both developed and developing countries and what factors cause their different stock preferences. This article makes several contributions to the existing literature and I would like to separate this it into three different parts. In the first part, I discuss the implication of domestic and foreign funds and why they have different stock preferences. In second part, the preference of both domestic and foreign investors from same market will be discussed and compared. Afterwards, the conclusion and any further applications will be presented in the last section.

Mata, Portugal (2002) Classify funds into domestic and foreign funds. How to distinguish the domestic funds and foreign funds is to look at the located country of these funds. Take Canada for example, domestic funds are those funds which located in Canada, in contrast, if a fund is located in other country but invest in Canada, those funds are classified as foreign funds. Chan, Covrig and Ng (2005) further analyze that Domestic funds refer to those funds with more than 80% of their total net asset value invested in a country’s domestic stocks, while foreign funds are those funds invest in foreign stocks. They exam on 26 countries and show the result as whether foreign or domestic fund managers, share some common and different preferences on their stock investments.

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What cause the differential investment decisions between foreign and domestic funds managers? This question was discussed by Covirg, Lau and Ng (2006). From their point of view, they demonstrate that their differential fund mandates is a very important factor to drive their disparate investment preferences since if domestic and foreign investors have variable fund mandates, the marginal benefits and marginal costs of gathering and processing information to them would be different. If foreign investors hold small fraction stocks in a particular market, the manager should have lower marginal benefits of gathering and processing domestic information. On the other hand, if the foreign managers allocate more than 80% stocks in a particular market, the benefits are as same as domestic managers. The foreign investors work in many large organizations are more sophisticated than their domestic counterparts. The reason is that the foreign investors need to be more informed. They need master and analyze more information to make a decision which companies they will invest in. Because they want to choose companies with different features compared to those that domestic investors invest in (Grinblatt and Keloharju 2000).

The research on stock preferences of domestic and foreign investors has been considered particularly noteworthy. First of all, the most important distinguishing feature of domestic and foreign stock preferences is the corporate governance of a firm. Leuz, Lins and Warnock (2009) is the first to examine that the influence on investment behavior in terms of corporate governance. As a result, they state corporate governance plays a crucial role in the investment decisions of foreign investors. This is consistent with the finding in Ferreira, Matos (2008) who argue that foreign investors have a strong preference for firms with good governance. Furthermore, Bailey,Kumar and Ng(2008)believe that domestic funds pay more attention on some basic financial indicator such as the firm size and long-term liabilities paying capability rather than the firm’s corporate governance structure while foreign investors focus on financial features when they make investment decisions. For example, free cash flow as well as corporate governance structure. Similarly, compared to the domestic money managing-group, it is believed that foreign institutional investors are playing a more significant role in corporate governance practices. (Gillan and Starks, 2003).

Another contribution factor to differentiate between foreign and domestic funds behaviors are claimed by Ferreira, Matos (2008), they find that stocks with recent positive stock return performance seem to be more attractive for foreign funds to invest in, but domestic investors display a contrast behavior on this phenomenon. To be more specific, Firms with large Rate of Return on Common Stockholders’ Equity (ROE) are more attract foreign investment. By contrast, domestic funds are more likely to invest firms with smaller ROE. In addition, As Covirg,Lau and Ng(2006) have considered, the development of stock market and familiarity variable not only play a pivotal role in the domestic share preference but also have a vital but asymmetric influence upon the foreign biases. Specifically, the better developed the host country is, company with the larger in market capitalization and the less transaction cost of the country, the large proportion of foreign investors budget will be invest in this market but domestic investors will invest less. Correspondingly, when a host country shares the diverse language with the rest of the world and are distant from other countries, the result will be different from former, which means the domestic investors will invest more in the market than foreign investors. The evidence indicates that if a host country is more developed and not far away from the rest of the world, it will decrease the cost of deadweights, which make both foreign and domestic investors could benefit from investing.

Last but not least, there is a distinct differential behavior between foreign and domestic managers in terms of firm visibility. Covirg, Lau and Ng (2006) investigate foreign and domestic investment fund holdings across of 11 developed countries and find that domestic investors are prone to put majority of their funds in their local stock, but foreign investors prefer to invest in different stock. That is because compare with domestic investors, foreign investors are information disadvantages, which lead them are eager to invest in stocks they are familiar with. This is associated with the number of analysts following a stock, size of foreign sales, index membership and stocks with foreign listing. For example, firms have great visibility and stocks are widely known in the world. Ferreiraa, Matos(2008) also conclude firm’s visibility in many ways such as add vary number of analysts covering a firm, give the proportion of foreign sales and a proxy which is use for investors to get the level of information more early. As a result, they find that the firm’s visibility seem to be more attractive to foreign investors, but not domestic investors. Ferreira, Matos (2008) go on to say that domestic investors favor firms that have high dividend yields stocks and stocks with higher market-to-book equity，which is opposite to foreigners’ investment behavior. Covirg, Lau and Ng(2006)expands that high dividend yields is used to survey income appreciation and weather firms have high growth potential or low financial are relate to weather it have high market-to-book equity ratios or not. The investigate data reveals the tendency of the domestic funds are concentrating in shares of firms with high income appreciation and particularly those with high potential growth and low financial distress. Meanwhile, foreign managers are also more inclined to concentrate in stocks of firms with large market-capitalization. This finding is consistent with Dahlquist and Robertsson (2001), who consider that foreigners have a preference for firms paying low dividends. The reason they tend to averse to stocks with high dividend yields is owing to tax withholding concerns.

All in all, in this paper, I focus on Existing studies identify several distinctive differences between the preferences of foreign and domestic funds across both developed and developing countries. Though the results show that Domestic funds always allocate money to firms with high market-to-book equity ratios, large dividend yields and high turnover, while foreign funds generally concentrate more in shares of in firms with larger market capitalization and high turnover. Moreover, foreign funds are keen on firms that have great visibility and worldwide visibility but that play a weaker role in determining domestic investment decisions.

Bibliography

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Mata, J., Portugal, P. (2002) ‘The Survival of New Domestic and Foreign-Owned Firms’, Strategic Management Journal, 23 (4), pp. 323-343.

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