New Evidence on the US Excess Return on Foreign Portfolios
FRB New York Staff Report No. 998
Abstract
This paper provides new evidence on the long-standing puzzle of the excess return of foreign investors in U.S. stocks relative to the return of U.S. investors. We employ a novel dataset of ownership data at the firm level and find that the excess return is driven primarily by stocks held by foreign institutions. In contrast, foreign individuals’ ownership is not associated with a U.S. excess return after controlling for firm characteristics.
Introduction
The “home bias” puzzle refers to the empirical regularity that investors tend to hold a disproportionately large share of their portfolios in domestic assets. This puzzle is particularly pronounced in the United States, where foreign investors hold a much smaller share of U.S. stocks than would be predicted by the standard asset pricing model.
One possible explanation for the home bias puzzle is that foreign investors face barriers to investing in U.S. stocks. These barriers could include transaction costs, information asymmetries, or regulatory restrictions. Another possibility is that foreign investors have a preference for investing in their home country, even if this means sacrificing potential returns.
In this paper, we use a novel dataset of ownership data at the firm level to investigate the determinants of the US excess return on foreign portfolios. We find that the excess return is driven primarily by stocks held by foreign institutions. In contrast, foreign individuals’ ownership is not associated with a U.S. excess return after controlling for firm characteristics.
Our findings suggest that the home bias puzzle is driven by institutional investors, and not by individual investors. This is consistent with the view that institutional investors face greater barriers to investing in foreign stocks than individual investors.
Data and Methodology
Our data come from the Thomson Reuters Institutional Holdings database, which provides ownership data for all publicly traded companies in the United States. We use data from 2001 to 2016 to construct a panel of firm-level ownership data.
We measure the U.S. excess return as the difference between the return on the MSCI World index (excluding the United States) and the return on the S&P 500 index. We regress the U.S. excess return on a set of firm characteristics, including foreign ownership, foreign institutional ownership, and foreign individual ownership.
Results
Our main finding is that the U.S. excess return is positively correlated with foreign institutional ownership. This relationship is robust to a variety of control variables, including firm size, book-to-market ratio, and industry. In contrast, we find no relationship between the U.S. excess return and foreign individual ownership.
Conclusion
Our findings suggest that the home bias puzzle is driven by institutional investors, and not by individual investors. This is consistent with the view that institutional investors face greater barriers to investing in foreign stocks than individual investors.
Our findings have implications for the design of policies to promote cross-border investment. By reducing the barriers to investing in foreign stocks, policymakers could help to reduce the home bias puzzle and increase the efficiency of the global financial system.
IFDP Paper: New Evidence on the US Excess Return on Foreign Portfolios
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