Do Foreign Investors Improve Market Efficiency?

Marcin T. Kacperczyk is Professor of Finance at Imperial College London; Savitar Sundaresan is Assistant Professor of Finance at Imperial College Business School; and Tianyu Wang is a PhD candidate in Finance at Imperial College Business School. This post is based on their recent paper.

One of the key purposes of financial markets is to efficiently allocate capital to the real sector. Foreign investors have emerged as an important force in this process. As globalization has increased, financial markets have witnessed substantial inflows of capital from foreign investors. The empirical literature has studied the consequences of financial market liberalization for volatility and aggregate equity prices, but we know considerably less about the direct impact of foreign portfolio investments on market efficiency and welfare. Moreover, the evidence on aggregate efficiency and welfare in the international economics literature is either inconclusive or finds economically small gains. In this paper, we revisit efficiency and welfare gains due to foreign stock ownership using disaggregated panel data on firms and investors from 40 countries.

Whether and how foreign investors affect the price informativeness of local stocks is not obvious. On the one hand, information held by foreign investors could be a subset of the information held by domestic investors or corporate managers, which would imply limited impact on prices and real decisions. Even if such investors could produce unique information, their capacity to invest internationally could be constrained. On the other hand, foreign investors’ participation could indicate that the investment opportunity was too good to pass up, thus indicating their being more informed about individual investment opportunities. Further, they can provide unique expertise and better risk sharing, which would then lead to their higher impact on price informativeness and welfare.

In our paper, we construct a rich panel data set on institutional equity ownership worldwide. Our sample covers almost 24,000 firms from 40 countries, both developed and emerging, between 2000 and 2016. We supplement the data with macroeconomic, market, and accounting information. Following the literature, we define stock-level price informativeness as the predicted variation of cash flows using market prices—a welfare-based measure, which is relevant for real outcomes.

To allow for causal interpretation of our findings, we take advantage of the following institutional regularity: stocks that are added to the global MSCI index subsequently experience a strong increase in foreign ownership. The event generates an economically meaningful and reasonably exogenous variation in foreign ownership, which we exploit using the difference-in-differences estimation. The exclusion restriction is that price informativeness is not driven by forces other than index reconstitutions, which we believe is economically plausible. We use a multivariate regression approach, in which we can also use time-varying firm characteristics and various fixed effects, across firms, time, countries, and industries.

We find that prices of stocks that are added to the index become more informative about future fundamentals relative to a control sample of stocks. Further, the exogenous change in foreign ownership is predictive of future increases in capital expenditures, but not in R&D. We assess the robustness of our MSCI inclusion results by using alternative measures of price informativeness. Specifically, we consider post-earnings-announcement drift (PEAD), price nonsynchronicity, and the variance ratio. The results remain statistically and economically significant.

To zoom in on the underlying economic mechanism, we test whether index inclusion indeed generates improvements in information environment. We show that increased foreign ownership leads to (1) higher market liquidity thus reducing asymmetric information in the market, (2) an increase in analyst coverage, which leads to improvement in information production, (3) better market risk sharing resulting in reduced cost of capital in the market. At the same time, we find no evidence of improved firm governance due to increased foreign ownership.

In the last part of the paper, we study the cross-sectional variation in our main results using a number of economically plausible frictions. First, we show that investors’ activeness and expertise are relevant predictors of greater price efficiency, especially when capital flows from foreign institutions. Second, we show that foreign investors from countries with high financial development or under a common law system have greater effects on price informativeness, especially when they invest in countries with low financial development or under civil law. Third, we find that firms in countries with tighter capital constraints are associated with a weaker impact of foreign investors on the efficient allocation of capital. We thus propose a new angle through which to analyze the consequences of capital controls.

Overall, our results highlight an important role that foreign institutional investors play in driving price efficiency worldwide. They have a positive impact on the information environment, but less so on the underlying governance structure. Finally, the results show that institutional and legal frictions are important determinants of capital allocation efficiency.

The complete paper is available for download here.

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