Equity Home Bias in International Finance

A Place-Attachment Perspective

Kavous Ardalan

• Publisher: Routledge
• Year: 2019
• ISBN:
  9781000008272
• Edition: 1
• Topic: Commerce
• Subtopic: Finance

This book provides a comprehensive and critical analysis of research outcomes on the equity home bias puzzle – that people overinvest in domestic stocks relative to the theoretically optimal investment portfolio. It introduces place attachment – the bonding that occurs between individuals and their meaningful environments – as a new explanation for equity home bias, and presents a philosophically multi-paradigmatic view of place attachment.

For the first time, a comprehensive and up-to-date review of the extant literature is provided, demonstrating that place attachment is a contributing factor to 22 different topics in which variations of home bias are present. The author also analyses the social-psychological underpinnings of place attachment, and considers the effect of multi-culturalism on the future of equity home bias.

The book's unique approach discusses the issues in conceptual terms rather than through data and statistical methods. This multi- and inter-disciplinary book is an invaluable resource for graduate students and researchers interested in economics, finance, philosophy, and/or methodology, introducing them to a new line of research.

1 The equity home bias puzzle

This chapter reviews the literature on “equity home bias” – the empirical finding that people overinvest in domestic stocks relative to the theoretically optimal investment portfolio. It reviews six broad classes of explanation of this puzzling phenomenon: (1) hedging home risks; (2) barriers to foreign investments; (3) information asymmetries; (4) risk-aversion instability; (5) corporate governance and transparency; and (6) behavioral factors. The consensus is that none of the proposed theories can explain the full extent of the bias by itself, thus the international portfolio choice should be explained by a mixture of rational and behavioral factors.

Standard finance theory predicts that investors hold a diversified portfolio of equities across the world if capital is fully mobile across borders. More specifically, in a world with frictionless financial markets, the most basic international capital asset pricing model (CAPM) with homogenous investors across the world would predict that the representative investor of a given country should hold the world market portfolio. In other words, the share of his/her financial wealth invested in local equities should be equal to the share of local equities in the world market portfolio. This prediction contradicts the most casual observation of the data on portfolio holdings, which is the well-known home equity puzzle in international finance: Because foreign equities provide great diversification opportunities – a point made by DeSantis and Gerard (1997), Eldor, Pines, and Schwartz (1988), Grauer and Hakansson (1987), Grubel (1968), Kaplanis and Schaefer (1991), Lessard (1976, 1983), Levy and Sarnat (1970), Solnik (1974a) – falling barriers to international trade in financial assets over the past thirty years should have led investors across the world to rebalance their portfolio away from national assets toward foreign assets. The process of financial globalization fostered by capital account liberalizations, electronic trading, increasing exchange of information across borders, and falling transaction costs has certainly led to a large increase in cross-border asset trade (Lane and Milesi-Ferretti 2003). However, investors seem still reluctant to reap the full benefits of international diversification, and hold a disproportionate share of local equities. Despite better financial integration, the home bias has not decreased sizably: in 2007, U.S. investors still held more than 80% of domestic equities, a much higher proportion than the share of U.S. equities in the world market portfolio. Such home bias is often labelled as investors’ suboptimal decision (Feldstein and Horioka 1980; Li, Sarkar, and Wang 2003). Indeed, home bias in equities is still observed in most countries and tends to be higher in emerging markets. Since the seminal paper of French and Poterba (1991), the home bias in equities has continued to intrigue and fascinate both financial economists and international macroeconomists. After French and Poterba (1991) brought home bias to prominence, Obstfeld and Rogoff (2001) nominated home bias as one of the six major puzzles in international macroeconomics.

Papers such as Tesar and Werner (1995) show that home bias appears in bonds as well as equity, further deepening the home bias puzzle. Most of the literature has studied the more general case where individuals may invest in multiple assets in many countries (Adler and Dumas 1983; Stulz 1981a). It has been shown that home bias is not restricted to an international setting. Even within borders, there seems to be a tendency for investors to bias their portfolios towards firms that are situated in their own region.

Many explanations have been put forward in the literature to explain this very robust portfolio fact, and these alternatives contribute to explaining parts of the gap. A number of studies have documented a significant yet slowly falling home bias in international financial portfolios among industrialized countries (Baele, Pungulescu and Ter Horst 2007; Cooper and Kaplanis 1986, 1994; French and Poterba 1990, 1991; Golub 1990; Heathcote and Perri 2013; Kang and Stulz 1997; Lane and Milesi-Ferretti 2006; Lewis 1995; Obstfeld 1995, Solnik 1991; Tesar and Werner 1994, 1995, 1998). This chapter reviews both the finance literature and the open economy financial macroeconomics literature, which has embedded nontrivial portfolio choices in standard two-country general equilibrium macro models – dynamic stochastic general equilibrium (DSGE) models.¹

Cooper and Kaplanis (1994) report for several countries the proportion of equity investment in domestic equities and the domestic market capitalization as a proportion of the world equity market capitalization. For example, as of December 1987, U.S. investors placed 98% of their equity portfolios in domestic equities, against a figure of 36.4% for the U.S. market as a proportion of the world equity market capitalization. Comparative figures for other countries were: 78.5% against 10.3% for the United Kingdom; 86.7% against 43.7% for Japan; and averages of 85% against 1.9% for five continental European countries.

French and Poterba (1991) document the domestic ownership of shares across countries. Using data for the United States, Japan, the United Kingdom, France, and Germany, they show that investors hold a disproportionate share of domestic assets in their equity portfolios. In 1989, 92% of the U.S. stock market was held by U.S. residents. Analogous numbers for Japan, the United Kingdom, France, and Germany were 96%, 92%, 89%, and 79%, respectively. Bohn and Tesar (1996) estimated the share of foreign equities in the U.S. portfolio to be still very low in 1995, equal to 8%.

Tesar and Werner (1998) show that by the end of 1996 the fraction of stock-market wealth invested in foreign assets was 10% for the United States, 11% for Canada, 18% for Germany, and 22% for the United Kingdom. These numbers have increased from a decade ago. In 1987 U.S. residents invested 4% abroad, Canadian investors 6%, and British investors 17%.

Lewis (1999) reports that during 1970–1996 the correlation between the monthly returns on the U.S. and EAFE (Europe, Australia, and Far East) stock market indices was only 0.48. This modest correlation implies an allocation of at least 40% of the U.S. investors’ portfolio to foreign stocks. The actual U.S. allocation to foreign stocks is 8%.

Ahearne, Griever, and Warnock (2004) show that at the end of 1997, U.S. stocks comprised 48.3% of the world market portfolio. At that time, foreign stocks represented only 10.1% of the stock portfolios of U.S. investors.

Kollmann (2006a), based on the portfolio data from Kraay et al. (2005), shows that the average locally owned capital share for 17 Organisation for Economic Co-operation and Development (OECD) countries was 91% in 1997.

Sercu and Vanpee (2007) analyze the data from the Coordinated Portfolio Investment Survey (held by the International Monetary Fund) and find that on average 70% of the total equity portfolio was invested in domestic stocks in all developed countries at the end of 2005.

Sercu and Vanpee (2007) show that, at the end of 2005, all of the countries investigated held significantly home-biased equity portfolios. The equity home bias was lowest in the Netherlands, where only 32% of the total equity portfolio is invested in domestic stocks; and highest in Indonesia, where nearly all equity investments are domestic. In general, the equity home bias is lower in developed countries and higher in emerging markets.

Coeurdacier and Rey (2013) note that in 2008, domestic equities constituted around 77.2% of equity portfolios of investors in the United States. This value is significantly larger than the United States’ 32.6% share in world equity market capitalization.

Warren (2010) shows that, based on Australian Bureau of Statistics data, Australian superannuation fund assets as of December 2008 consisted of 82% in local assets, with an estimated 73% of the equity component comprised of local securities. At the same time, Australian equities comprised only 2.6% of the Financial Times Stock Exchange (FTSE) Global Equity Index Series.

Evidence also points toward significant domestic bias in international bond portfolios. For example, Burger and Warnock (2003) find that foreign bonds comprised about 6% of U.S. investors’ bond portfolios in 1997, and 4% in 2001. Corroborating this evidence further, Fidora, Fratzscher, and Thimann (2007) show that there is substantial home bias in bond holdings for several advanced countries: Japan, the United Kingdom, Germany, Italy, and France.

A measure of equity home bias that is most commonly used is the difference between actual holdings of domestic equity and the share of domestic equity in the world market portfolio. When the home bias measure for a country is equal to one, there is full equity home bias; when it is equal to zero, the portfolio is optimally diversified according to the basic international CAPM.

On average, the degree of home bias across the world is 0.63 (lower in Europe where monetary union after 1999 appears to have had an effect (see Coeurdacier and Martin 2009 and Fidora et al. 2007 for studies on the impact of monetary union on cross-border equity diversification; Kalemli-Ozcan, Papaioannou, and Peydro 2010 show that the euro’s impact on financial integration was primarily driven by eliminating the currency risk). For the developed world, this means that the share of foreign equities in investors’ portfolios is roughly a third of what it should be if the benchmark is the basic international CAPM. Emerging markets have less diversified equity portfolios than developed countries and do not exhibit any clear downward trend in home bias. The average degree of home bias in these countries is 0.9 (smaller in emerging Asia and larger in Latin America), and investors in these countries hold one-tenth of the amount of foreign equities they should be holding according to the basic international CAPM model. Hau and Rey (2008) provide facts and relationships on home bias at the fund level.

This robust evidence has received considerable attention in both the finance literature and the macroeconomics literature. The main difference between these two literatures relies on some modeling assumptions. To simplify, the traditional finance literature has tried to rationalize the equity home bias in multi-country models of portfolio choice where asset prices and their second moments are given (in particular in these models the risk-free interest rate is given exogenously). The finance models that use the portfolio approach to explain the home bias all proceed similarly. They posit an indirect utility function that depends on wealth and state variables. The investor maximizes the expected indirect utility function based on their expectation of the joint distribution of asset returns and state variables. Investors differ across countries because indirect utility functions and/or expectations of the joint distribution of returns and state variables differ across countries. These differences lead to a home bias. The macroeconomics literature has tried to integrate international portfolio decisions in otherwise standard DSGE models of the international economy. These models have a fully general equilibrium structure and asset prices and their second moments are determined endogenously. The finance literature tends to focus on the diversification gains, looking at asset price data to evaluate how an increase in the share of foreign equities would improve the portfolio performance, based on some criteria. The macrofinance literature tends to use consumption data to measure the potential welfare gains from international risk-sharing. The motivation is, however, the same: foreign equities seem to offer diversification benefits that are not reaped by investors, and both financial economists and macroeconomists are intrigued by this fact.

The theoretical macroeconomic literature points toward potential gains from international diversification to hedge national production risk. In the presence of imperfectly correlated productivity shocks or output shocks across countries, owning foreign equity could help to smooth consumption. This is most obvious in the context of a two-country model with one single tradable good, as for example in Lucas (1982): in such a world, domestic and foreign investors hold an identical portfolio of claims to output (equities), the market portfolio, thus diversifying optimally national output risks. As in the textbook finance portfolio theory, in such a world the home bias in equities is seen as a failure of the standard diversification motive. However, one should be cautious: investors across the world would hold the same portfolio, only if they were homogenous. In reality, heterogeneity across investors from different countries leads to departure from the world market portfolio and potentially a bias toward national assets. Various sources of heterogeneity leading to equity home bias have been explored in the macro literature. They fall into two broad classes of explanation: hedging home risks – deviations from purchasing power parity (PPP) and nontradable assets risk; and barriers to foreign investments – such as transaction costs, differences in tax treatments and in legal frameworks, and other policy-induced barriers to foreign investment.

The remainder of this chapter reviews the six broad classes of explanation for the equity home bias that have been brought forward in the literature. Section 1.1 discusses hedging home risks (deviations from PPP; nontradable assets risks; liabilities risks); Section 1.2 presents barriers to foreign investments (capital controls; transaction costs); Section 1.3 covers information asymmetries; Section 1.4 discusses risk aversion instability; Section 1.5 considers corporate governance and transparency; and Section 1.6 discusses behavioral factors. Section 1.7 concludes the chapter by summarizing the consensus that no single explanation can capture the full extent of international underdiversification on its own. Home bias is probably caused by a mixture of both institutional and behavioral factors, and therefore it is a very complex task to find a theoretical model that correctly describes actual portfolio choice.

1.1 Hedging home risks

One potential explanation for the home bias in equity portfolios is that domestic assets serve as a better hedge for risks that are home country-specific. This is because investments in domestic assets are likely to follow the performance of the domestic market in general. Six home country-specific risks are considered that fall into three categories: deviations from PPP risks (inflation risk, real exchange rate risk, domestic consumption risk, nontradable goods risk); nontradable assets risk; and liabilities risk.

1.1.1. Deviations from purchasing power parity risks

To understand the first source of risk, note that the framework used in the literature assumes that all investors perceive the same real returns as currency-adjusted inflation rates are equalized through PPP (Solnik 1974b). However, a large empirical literature has decisively rejected the hypothesis of PPP except perhaps in the very long run (Froot and Rogoff 1995). Thus, it would seem important to allow goods prices, and hence inflation rates, to differ across countries.

Adler and Dumas (1983) point out an important feature that appears in international portfolio theory but not in domestic portfolio theory. Investors in different countries consume different bundles of goods. With inflation risk and deviations from PPP, investors in different countries are induced to hold portfolios that differ by a component designed to hedge inflation risk (Adler and Dumas 1983; Stulz 1981a). Thus, the home bias could be explained, as discussed by Sercu (1980) and Solnik (1974b), if domestic equities provide a hedge against inflation risk for some inve...