In the field of international finance, it has been long questioned whether domestic investors have the advantage of trading domestic stocks in their home markets over foreign investors. To this day, the answers have been inconclusive for conflicting r ...
In the field of international finance, it has been long questioned whether domestic investors have the advantage of trading domestic stocks in their home markets over foreign investors. To this day, the answers have been inconclusive for conflicting results from previous empirical studies. For instance, Brennan and Cao (1997), Hau (2001), Choe et al. (2005), and Dvořák (2005) find evidence supporting that foreign investors are disadvantageous of trading domestic stocks. The findings are broadly consistent with the notion that foreign investors’ accessibility to domestic information is constrained to some degree by geographical, linguistic, and cultural distances. Put differently, one may deduce from the observations that the information set faced by domestic and foreign investors is not homogeneous, perhaps the former with a bigger and finer set and the latter with a smaller and coarser set. On the other hand, a series of studies find the opposite evidence (Grinblatt and Keloharju (2000), Seasholes (2000), and Froot and Ramadorai (2008)). This evidence is well cited to argue that foreign investors may have an edge since they are equipped with investment experience and expertise at advanced level. In other words, these studies could convey a message that foreign investors are better to process information and utilize it to implement a profitable trading strategy.
Although it is largely ignored in the previous studies, the mixed results aforementioned are anticipated by nature. The reason is that both the information set and the ability of processing information are likely to determine the trading and performance of domestic versus foreign investors in a simultaneous and complicated manner. To see it, consider a simple case in which a foreign investor participates in a segmented stock market of country A as well as an integrated market of country B. Since information accessibility is increasing with the degree of market integration, the foreign investor would perform better in country B than country A, all else being equal. As a matter of fact, this differential of information accessibility between domestic and foreign investors could explain why the previous empirical results differ by country. Compared to the Finnish stock market studied by Grinblatt and Keloharju (2000), for example, the Indonesian stock market studied by Dvořák (2005) certainly exhibits higher direct/indirect investment barriers to foreign investors, which would lead to the conflicting conclusions in the two studies. With the mixed results, therefore, it may be possible to deepen our understanding of the relative trading advantage of domestic versus foreign investors by taking account of the two factors, the information set and the information-processing ability, appropriately.
The present paper aims to reconcile the mixed evidence of the previous studies by adjusting for the heterogeneity of information set. In specific, this paper investigates whether and how different domestic and foreign investors are in the Korean stock market if they were playing on the same ground in terms of information. Suppose that there is an ideal circumstance in which information asymmetry between the two groups of investors is absent. Under the circumstance, any differential of trading and performance, if it is present, can be solely attributable to the different level of the information-processing skills among the investors. As shall be described later, this exercise could provide an enlightening viewpoint on the conflicting results from the previous studies, which is the most significant contribution of the present paper. To be concrete, the bottom line of this study is to show that the previous results may critically depend on the country-specific level of information asymmetry arising between domestic and foreign investors, thereby bringing forth the country-by-country results by nature. To my best knowledge, a direct and systematic test on this intuition is rare in a current literature.