Equity Flows and Returns: a Quantitative Equilibrium Approach

4 Non-technical summary 5 1 Introduction 7 2 Related literature 11 3 The model 14 3.1 Setup 14 3.2 Stationary equilibria 18 4 Characterizing equilibrium flows and returns 19 4.1 The evolution of beliefs 20 4.2 Optimal portfolio choice 22 4.3 Equilibrium prices, predictability and hedging 24 4.4 Equilibrium flows and returns 26 5 Data 29 5.1 Dividends 29 5.2 Equity flows 32 5.2.1 Data sources 32 5.2.2 Matching model and 5.2.2 data flows 32 5.2.3 Summary statistics 34 6 Quantitative analysis 36 6.1 Calibration 36 6.2 Further predictions for flows and returns 40 6.3 Interpretation 43 Appendices A Proof of Theorem 1 46 B Detrending 48 C The dividend process 50 References 53 Figures 58 European Central Bank working paper series 66 46 Abstract This paper considers the role of foreign investors in developed-country equity markets. It presents a quantitative model of trading that is built around two new assumptions: (i) both the foreign and domestic investor populations contain investors of different sophistication, and (ii) investor sophistication matters for performance in both public equity and private investment opportunities. The model delivers a unified explanation for three stylized facts about US investors’ international equity trades: (i) trading by US investors occurs in bursts of simultaneous buying and selling, (ii) Americans build and unwind foreign equity positions gradually and (iii) US investors increase their market share in a country when stock prices there have recently been rising. The results suggest that heterogeneity within the foreign investor population is much more important than heterogeneity of investors across countries.This paper considers the role of foreign investors in developed-country equity markets. It presents a quantitative model of trading that is built around two new assumptions: (i) both the foreign and domestic investor populations contain investors of different sophistication, and (ii) investor sophistication matters for performance in both public equity and private investment opportunities. The model delivers a unified explanation for three stylized facts about US investors’ international equity trades: (i) trading by US investors occurs in bursts of simultaneous buying and selling, (ii) Americans build and unwind foreign equity positions gradually and (iii) US investors increase their market share in a country when stock prices there have recently been rising. The results suggest that heterogeneity within the foreign investor population is much more important than heterogeneity of investors across countries. JEL Classification: F30, G12, G14, G15. Keywords: Asymmetric information, heterogenous investors, asset pricing, international equity flows, international equity returns. 4 ECB Work ing Paper Ser ie s No . 310 February 2004 The role of foreign investors in …nancial markets is an important unresolved issue in international …nance. Does participation of foreigners destabilize a stock market, or does it make that market more e¢ cient? Or does participation of foreigners not really change how the market operates? An answer to these questions must take a stand on motives for trade, and hence on how investors di¤er. Existing literature on international equity markets argues that cross-country heterogeneity of investors is important: foreign investors are homogenous, but they know less about domestic stocks than local investors. This paper reconsiders the link between di¤erences in investor sophistication and international equity ‡ows using a dynamic general equilibrium model that is calibrated to data from the G7 countries. In this paper we allow for within-country di¤erences in investor sophistication. This alternative view is supported by recent empirical studies on individual trading behavior and performance which highlight investor heterogeneity. But in our view the best (and worst) foreign and local traders have very similar backgrounds and skills. This second assumption is particularly suitable for modern industrial-country stock markets: indeed, the big players like ABN Amro, Bank of America, Citibank, Deutsche Bank, JP Morgan Chase and UBS among others, participate in equity markets around the globe. Finally, sophisticated investors are better at collecting information about stocks, but also in locating o¤-market private investment opportunities. This is in the spirit of Merton’s (1987) investor recognition hypothesis: some investors scan the economy more carefully for investment opportunities than others. Under these assumptions, asking about the role of foreign investors is essentially asking whether within-country or cross-country di¤erences in sophistication are more important. To provide a quantitative answer, we construct a model of the stock market in a small open economy, with both types of heterogeneity present. We then calibrate this model to quarterly data on dividends, returns, volume, and US investors’ aggregate gross and net trades in the G7 countries. Our main …nding is that within-country heterogeneity is much more important than cross-country heterogeneity. We do …nd that foreign and domestic investor populations di¤er: in line with previous literature, the average US-based participant in a foreign market appears somewhat less sophisticated 5 ECB Work ing Paper Ser ie s No . 310 February 2004 Non-technical summary than the average local participant. However, for all countries, a model that matches the data well must have the property that cross-country di¤erences between average trades are much smaller than within-country di¤erences between trades of sophisticated and unsophisticated investors. We verify that our calibrated model account for key stylized facts on the joint distribution of equity ‡ows and returns. In particular, our approach delivers a uni…ed explanation for two regularities that are prominent in the empirical literature. On the one hand, it generates realistic amounts of ‡ow momentum – persistence in net purchases of foreign equity by US investors. In all G7 country stock markets, Americans build and unwind foreign positions gradually: a net purchase of foreign equity by US investors in some quarter predicts further net purchases at least over the following two quarters. On the other hand, net ‡ows exhibit return chasing –both current and lagged local stock returns are positively correlated with current net purchases by US investors, normalized by foreign market capitalization. US investors thus chase returns: when they see foreign stock prices increase, they buy foreign shares from local investors. Persistence and return chasing are both facts about net equity ‡ows, the series that existing literature has focused on. Net ‡ows are due to cross-country heterogeneity. Within-country heterogeneity matters for gross ‡ows. To see this, consider a shock that makes sophisticated investors buy shares from unsophisticated investors. This shock will generate a burst of simultaneous buying and selling by the population of Americans, which contains members of both groups. Within-country heterogeneity thus induces substantial positive contemporaneous correlation in US investors’aggregate gross purchases and sales of foreign equity. We document this new stylized fact for all G7 countries. To see how our model accounts for the stylized facts, consider the beginning of a typical boom in our small open economy. As good news about the business cycle arrives, all investors update their assessment of future cash ‡ows and stock prices begin to rise. At the same time, sophisticated investors increasingly locate pro…table o¤-market opportunities. To exploit private opportunities without unduly increasing exposure to business cycle risk, they begin to sell stocks. With heterogeneous investor populations, this generates both volume and, in international data, a burst of gross trading activity. Moreover, since the average American is less sophisticated than the average local investor, the US population is buying foreign stocks as prices are rising. These trades are slowed down by disagreement: unsophisticated investors who have less information about the state of the business cycle are initially less optimistic and will only buy stocks at a discount. However, a string of favorable returns can help convince them that a boom is under way. This predictably leads to more net purchases by unsophisticated investors and hence more net purchases by Americans. In contrast, sophisticated investors sell more and more stocks as the peak of the boom is approached. Only as the economy weakens and pro…table private opportunities dry up do sophisticated investors return to the market. Again, the transition is slow as unsophisticated investors, who were overly optimistic at the peak, gradually revise their opinion. 6 ECB Work ing Paper Ser ie s No . 310 February 2004