It has been widely documented that US investors’ net purchases in a foreign equity market co-move positively with returns there. This comovement has been labelled “return chasing”: US investors tend to be net buyers of equity in a foreign country when stock prices there are rising. A common explanation for return chasing is based on the assumption that US investors lack the private information of local investors in foreign markets. In the presence of local private information, less informed US investors react more strongly to public signals than better informed local investors, even if all investors have rational expectations. If public signals are sufficiently important drivers of returns, this mechanism generates both return chasing and under performance of US investors in foreign markets.
While the private information view of international equity markets helps explain return chasing and also equity home bias, it has been challenged by recent empirical findings on investor performance. If local private information were important, domestic investors should make higher trading profits than foreign investors. However, the evidence on the performance of foreign and local investors is mixed, with a number of studies suggesting that foreign investors outperform their domestic counterparts.2 In light of models with local private information, it is puzzling why foreigners should sometimes have country-specific private information that is not available to local investors.
This paper proposes to broaden the private information view of international equity markets by considering “global” private information that is relevant for trading in many foreign countries simultaneously. As a concrete example, consider market research about the technology sector. Insights about the future of this sector in the United States, a country that dominates growth in the sector, are likely to be important for the valuation of tech-stocks in Europe as well. Experience gained in the US market may thus give sophisticated US investors an advantage in recognizing global trends in technology and lead them to outperform domestic investors in Europe. More generally, the presence of global factors in international equity returns is a robust stylized fact and in many empirical studies global factors are captured by US-specific variables (e.g., Campbell and Hamao (1992) and Harvey (1991)). This suggests that US investors’ local private information could be valuable in foreign markets as well.
The presence of global private information reconciles the private information view with mixed evidence on investor performance and also helps explain new evidence we present on the cross-country correlation of returns and flows. To show this, we first set out a theoretical model of international equity trading and derive its implications for returns and equity flows. Stock returns in our model are driven by both local and global factors. We view the world as a set of regions, a subset of which makes up the United States. In every region, local investors receive signals about local factors and some investors also receive signals about global factors. The key assumption is that the fraction of investors who receive global signals is larger in the US than in the rest of the world. With this information structure, local private information leads to home bias (in fact, to regional “home bias at home”). At the same time, global private information generates return chasing that reflects superior performance of US investors. This is because local investors abroad underreact to movements in global factors, about which they know less than US investors.
Analysis of the model leads to three new predictions. First, if global information is important, we should observe “global return chasing:” US investors’ net purchases in any given country should co-move positively not only with returns in that country, but also with returns in other countries. We document this new fact in a monthly dataset of US investors’ equity purchases in eight developed countries. Second, the model suggests that it is natural to find mixed evidence on the performance of foreign investors relative to local investors. Indeed, while local shocks — which are reflected in local private signals — favor local investors, global shocks — which are reflected in global private signals — favor US (i.e., foreign) investors. Empirical studies may thus uncover under- or overperformance of foreigners depending on the particular time period and country studied.
The third prediction is that global private information induces positive correlation in US investors’ trades across countries. To assess it, we construct empirical measures of US investors’ trades due to private information. If most private information were local, then the correlation of such trades across countries should be low. For example, private information generated by market research about France that leads sophisticated US investors to purchase French equities should not help forecast returns in Germany, and therefore should not entail purchases of German equities. In contrast, the more private information is global, the higher the crosscountry correlation of trades due to private information. We find that a global factor accounts for slightly more than half of the variation in trades due to private information across the eight countries we study. At the same time, private information accounts for about one half of the overall variation in trades. Global private information thus plays an important role in international equity markets; it explains approximately 30% of US investors’ trades abroad. To the best of our knowledge, this paper is the first to document global return chasing and global private information in international markets.
In our model, the key feature that allows both home bias and return chasing to obtain is the presence of asymmetric information. A benchmark symmetric information model cannot account for either fact. Indeed, under standard assumptions — all investors have identical hyperbolic absolute risk aversion (i.e., HARA) preferences and all assets are tradable — two fund separation obtains in equilibrium. Under two fund separation all investors hold all risky assets in the same proportions. As a result, there is no bias towards home assets, and there are no equity flows across borders that are systematically related to country returns.
A deviation from this benchmark that can lead to global return chasing is a gradual, simultaneous opening of equity markets in many countries to US investors. If markets become gradually more accessible, US investors increase their positions. At the same time, the marginal investor becomes more diversified and requires lower risk premia, which raises stock prices. Integration could thus lead to positive comovement of US net purchases and returns at low frequencies. However, we show that most global return chasing occurs at high frequencies: the correlations between detrended flows and returns are very similar to the raw correlations. This high frequency correlation is unlikely to be due to gradual market integration. However, it is consistent with an asymmetric information setup.
The new feature of our model is that it allows for private and public information about both local and global factors in asset payoffs. We build on the static model of asset trading with asymmetric information in Admati (1985). Brennan and Cao (1997) also provide an extension of Admati’s model to multiple periods. However, their setup precludes global factors. Our closed form solution also goes beyond theirs in that we show how different types of shocks contribute to return chasing, with individual contributions expressed as tractable functions of exogenous fundamentals. Our solution thus also clarifies the role of local private information. More generally, it allows us to trace out how public and private signals are used by investors and then become observable in equity flows and returns.
In particular, our solution highlights that the relationship between trades, returns and information is quite different when information is global rather than local. With local private information, there is a natural tension between the presence of private information and observed return chasing. Indeed, the arrival of local private signals induces negative correlation between US investors’ purchases and returns. This is because a private signal that brings good news and is partly reflected in a price increase, also leads local informed investors to buy from US investors. The later underreact relative to a symmetric information benchmark and sell. In a model with local private information, return chasing can only come from local public signals, which must be important enough to outweigh the opposing effect from local private signals.
In contrast, both public and private global signals contribute to global return chasing. The arrival of a good global private signal is partly reflected in price increases in many countries, and also leads the US investors who receive the signal to buy in those countries, while local investors underreact and sell. The arrival of a good public signal has two effects. On the one hand, it reduces US investors’ information advantage with respect to the global factors. One might thus expect local investors in the other countries to overreact to the signal and become net buyers. On the other hand, the signal reduces local investors’ information advantage about payoffs. Our analysis shows that in a world where local private information is strong enough that home bias holds, as in the data, the second effect is always stronger, and both types of signals induce US investors to buy when prices rise.
The existing empirical literature on foreign investors’ trading behavior focuses on data sets from a specific country or short time period. In contrast, we use data on US investors’ monthly purchases and sales of equities in the eight major foreign markets between 1977 and 2003. This allows for a comparison of trades across markets, which is required to identify global return chasing and trades due to global private information. In particular, we can examine the factor structure of private information. Previous analyses of international expected return variation try to separate the influence of global and local risk factors. Here, we are interested in describing the extent to which measured private information also displays significant global components.
The paper proceeds as follows. In Section 2, we develop our model of international equity flows with global private information. In Section 3, we present our data and results on global return chasing. In Section 4, we introduce the empirical models of the expected components of international equity flows and returns and show that there is significant common variation in US private information trades. In Section 5, we document that our measures of private information can be used to forecast returns. Section 6 concludes. The appendix contains proofs to the propositions in the main text and details on the empirical estimable models.
Download
PDF Ebook Global Private Information in International Equity Markets
