NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Global Diversification Through Multinational Shares

"The home bias puzzle is overstated by quantifying the foreign exposure U.S. investors obtain through the holdings of U.S. multinationals."

Numerous studies have established that investors are biased against foreign securities and tend to undervalue them when assembling their portfolios. In International Diversification at Home and Abroad (NBER Working Paper No. 12220), Fang Cai and Francis Warnock show that if the basis for defining a "foreign" firm is changed from the location of the firm's headquarters to the locations of its operations, the home bias seen in many studies is reduced considerably. By studying a unique dataset, Cai and Warnock in fact show that institutional investors overweight domestic multinationals (MNCs) relative to purely local domestic firms. That is, such investors exhibit a bias in favor of the domestic firms that may provide the greatest international diversification benefits.

This is significant in that evidence for investors' diversification motives is hard to come by. It is generally accepted that investors overweight the familiar (domestic securities) at the expense of less familiar (foreign securities). Even within their foreign portfolios, investors seem to prefer the stocks of foreign countries that are closer and whose equity markets are most nearly correlated with their own. Within foreign countries, investors prefer large, familiar stocks. Even within their domestic portfolios, investors much prefer the familiar and tend to avoid stocks that are less correlated with the rest of their portfolios - exactly those stocks that would provide the greatest diversification benefits.

Cai and Warnock's study reaffirms that investors favor the familiar. Moreover, their evidence reveals that foreign investors overweight large firms, those that trade the most, and those with foreign operations - in other words, firms with the highest profiles. But most importantly, the authors find evidence of the international diversification motive. They find that domestic institutional investors show a decided preference for domestic multinationals. Even after controlling for familiarity, size, inclusion in major indexes, product tradability, and turnover, Cai and Warnock find that the bias for domestic firms with overseas operations remains.

The researchers' finding of a diversification motive arises from their analysis of the security-level U.S. equity holdings of domestic institutions (from SEC data) and, for the first time, foreigners' holdings (obtained from comprehensive benchmark surveys). Cai and Warnock are able to rethink how holdings of "foreign" equities are typically calculated, and in doing so, they conclude that the home bias puzzle is overstated by quantifying the foreign exposure U.S. investors obtain through the holdings of U.S. multinationals.

Statistics on international equity positions are not designed to capture these indirect foreign holdings. One way to compute the foreign exposure obtained from holding domestic MNCs is to reconsider the notion of "country" and to redefine the term "foreign." A firm's country is typically determined by the location of its corporate headquarters. Procter & Gamble, for example, is viewed as a U.S. firm because its headquarters is in Cincinnati. But one could also define a firm's country by the location in which it operates. For many firms, these two methods of definition would yield the same result. But based on the distribution of their operations around the world, some firms would be residents of many countries. By this definition, for example, Proctor & Gamble, with about half of its sales originating from U.S. operations, would still be primarily a U.S. firm, but would also be "part Filipino, part Argentinian, and a bit of the other 67 countries in which P&G operates."

The preference for domestic MNCs implies that U.S. investors achieve substantial international diversification through their holdings of U.S. multinationals. This is confirmed using an international factor model that indicates that, while U.S. factors are more important for the returns of U.S. firms, the influence of foreign factors increases with the extent of the firm's foreign sales. Cai and Warnock use the relationship between foreign sales and foreign beta to form their estimate of the dollar value of home grown foreign exposure - the foreign exposure U.S. investors obtain by holding U.S. equities. The amount of home grown foreign exposure is comparable in dollar value to direct foreign exposure (through holding foreign equities), implying that the international diversification of U.S. investors has been substantially underestimated.

Cai and Warnock caution that while their results suggest the typical measures overestimate the extent of home bias, even with their adjustments a substantial underweighting of foreign equities remains. They suspect this arises mainly from the lack of investor protection regulations in many countries and from the fact that the typical shareholder in many countries is a large insider. Foreigners' investments in U.S. equities are not restricted by U.S. laws, but because the typical foreign country lacks an established class of equity shareholders, foreign investment in the United States are limited. Similarly, U.S. investors might fear investing in countries where the rules are not designed to protect outside shareholders. If investor protection regulations were strengthened, Cai and Warnock believe, and if more countries developed a class of equity shareholders, then the home bias would likely decrease in both directions.

-- Matt Nesvisky

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