Why Don't Americans Hold More Foreign Stock?

Summary of working paper 8680
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A more accurate assessment of globally available shares would show that about 67 percent of a properly balanced U.S. portfolio would be invested in U.S. companies.

The fact that domestic companies represent 90 percent of the holdings in an average U.S. investor's stock portfolio -- even though U.S. stocks represent only 49 percent of the world market -- has prompted a range of theories, but no generally accepted explanation for this so-called "home bias." Some analysts have blamed market barriers. Others view U.S. investors as lacking sufficient information on foreign equities. And then there are those who see in this imbalance overly optimistic expectations about the performance of homegrown assets.

But in Corporate Governance and the Home Bias (NBER Working Paper No. 8680), authors Lee Pinkowitz, Rene Stulz, and Rohan Williamson assert that at least some of the oft-noted tilt is not a bias at all but simply a reflection of the fact that a sizeable number of shares worldwide are not for sale to the average investor. They find that comparisons of U.S. portfolios to the world market for equities have failed to consider that the "controlling shareholders" who dominate many a foreign corporation do not make their substantial holdings available for normal trading.

Take this into account, the authors argue, and as much as half of the home bias disappears. A more accurate assessment of globally available shares, they say, would show that about 67 percent of a properly balanced U.S. portfolio would be invested in U.S. companies.

"We show that the home bias is intricately linked to corporate governance," the authors write. "When companies are controlled by large investors, portfolio investors are limited in the fraction of a firm they can hold." For example, in examining 51 countries they find that, on average, 32 percent of the shares are not available for trading. The United States has the lowest percentage of controlling shareholders, with only 7.9 percent of domestic stocks "closely held" followed by the United Kingdom at 9.9 percent. But the authors note that, except for Ireland, Sri Lanka, the United States, and the United Kingdom, "no country has a...controlling ownership of less than 20 percent," and in 23 countries, controlling ownership exceeds 50 percent.

Pinkowitz, Stulz, and Williamson observe that controlling shareholders are not interested in selling off their stocks at the mere market price. The authors point to previous studies demonstrating that "the benefits from control are substantial in most countries," placing the value of such holdings above those of ordinary shares and thus not practical for the typical foreign investor.

Therefore, the authors believe efforts to make foreign stocks more attractive to domestic investors need to move beyond the current focus on market barriers. They conclude that considerably more attention must be given to how corporate governance repels investors who might otherwise replace some of their domestic stocks with foreign equities.

"With our results, the removal of barriers to international investment cannot make the home bias disappear," the authors conclude. "For the home bias to disappear it is necessary for investor rights to improve across countries where firms are mostly controlled by large shareholders...."

Pinkowitz, Stulz, and Williamson also believe their insights should prompt a re-evaluation of the notion that foreign investors sell their stocks more frequently than domestic investors. Such a conclusion, they state, is flawed because it includes in the equation controlling shareholders, a unique class of domestic investors who as a rule do not trade their stocks. Comparing their selling habits to foreign investors gives a misleading impression that foreign investors trade more frequently, when in fact the opposite may well be true.

Finally, Pinkowitz, Stulz, and Williamson note that stock holdings of controlling shareholders could explain why foreign investors seem to show a bias toward purchasing stock in large firms. The authors note that in the United States, the smaller the company, the more likely a large amount of its shares are controlled by "inside ownership."

"If this fact for the U.S. holds across countries, then the fraction of shares available to foreign investors is likely to be proportional to (a company's) size," they conclude.

-- Matthew Davis