Factor Exposures of Foreign Equity Capital in a Domestic Stock Market: Evidence from Korea

• Author: Dong Wook Lee,Lingxia Sun
• Published date: 01 December 2017
• Date: 01 December 2017
• DOI: http://doi.org/10.1111/irfi.12129

Factor Exposures of Foreign Equity

Capital in a Domestic Stock Market:

Evidence from Korea*

LINGXIA SUN

†

AND DONG WOOK LEE

‡

†

Business School of Nankai University, Nankai University, Tianjin, China and

‡

Korea University Business School, Seoul, Korea

ABSTRACT

In this paper, we examine the factor exposures of foreign equity capital in a

domestic stock market in order to understand its risk‐taking behavior and

sources of returns in the market. Using data from Korea for the 1999–2013

period, we find that foreigners are strongly exposed to the idiosyncratic

volatility (IVOL) factor, which is long on low‐IVOL stocks and short on

high‐IVOL stocks. That is, foreign equity capital is typically allocated to low‐

IVOL stocks and profits from the return differential between low‐IVOL and

high‐IVOL stocks. We also find that foreign equity capital moves in a way that

it is loaded more on the IVOL factor when the IVOL factor premium is larger.

We discuss the comparative advantage of foreign equity capital in bearing the

IVOL factor risk and the role of information asymmetry between locals and

foreigners in this risk sharing. We also provide additional empirical results that

support our interpretation.

JEL Codes: F30; G11; G15

I. INTRODUCTION

In this paper, we examine the factor exposures of foreign equity capital in a

domestic stock market in order to understand its risk‐taking behavior and sources

of returns in the market. Our investigation is motivated by the notion that,

despite the globalization over the past several decades and the resulting

elimination of formal restrictions on foreigners accessing domestic stocks,

various informal barriers—such as physical distance, linguistic and cultural

differences, and even unfamiliarity—are still at work and put foreigners at an

* We are grateful to two anonymous referees, Chunmei Lin and Cheol‐Won Yang, and the seminar

participants at Korea University Business School, the 2013 Fall KFA conference, the 2014 EMG‐ECB

conference, the 2014 CAFM conference, the 2014 FMA conference, and the 2015 Asian FA conference

for comments. Dong Wook Lee recognizes financial support from the Asian Institute of Corporate

Governance (AICG) at Korea University.Dong Wook Lee is also grateful for the KUBS Faculty Research

Grant. This paper is a significantly revised version of the earlier paper titled “Factor exposures of

foreign investors: Are they well‐informed as a portfolio investor?”

© 2017 International Review of Finance Ltd. 2017

International Review of Finance, 2017

DOI: 10.1111/irfi.12129

International Review of Finance, 17:4, 2017: pp. 561–596

DOI: 10.1111/irfi .12129

© 2017 International Review of Finance Ltd. 2017

informational disadvantage.

1

When an investor lacks private information,

stock‐picking is no longer an option for her, and she is left with the other

option—namely, taking on risks and earning risk premiums. Thus, it is natural

to ask what risks foreign investors take on and what risk premiums they earn.

While foreigners might be well informed at the market level and engage in

“market‐picking”(Curcuru et al. 2011), they still need to decide on the allocation

of funds within the market. Thus, it remains instructive to see whether foreign

equity investors—when investing in a given market—deviate from the local

market portfolio or, equivalently, whether foreigners take on other factor risks

besides the market factor (MKT).

2

To measure risk factors and foreigners’exposures to those factors, we use the

ones based on firm characteristics, such as size factor (SMB) and BM factor (HML)

(e.g., Fama and French 1993). The key feature of those characteristic‐based factors

is that they are long–short portfolios along a given firm attribute that are designed

to generate a positive average return. In other words, unlike macro factors

covering the market as a whole, those characteristic‐based factors represent a

within‐market “spread”that is associated with a significant average‐return

differential. Hence, they are useful in detecting the deviations of foreign equity

capital from the market average (i.e., local market portfolio), the dimensions

and directions of those deviations, and their contribution to the returns accruing

to foreign equity capital.

Our experimental setting is the Korean stock market. While fully accessible to

nonresidents since the 1997–1998 Asian Financial Crisis, this market has been

shown by prior studies to put foreign investors at an informational disadvantage

at the individual stock level (e.g., Choe et al. 2005). Still, foreign equity capital

continues to maintain an imposing presence in Korea. For example,

approximately one‐third of the total market’s capitalization has been in the

hands of foreigners (Figure 1). Thus, it is an ideal settin g to study the behavior

of foreign investors who have no formal restrictions but are still informationally

disadvantaged. Put differently, it should be instructive to see how foreign

investors in Korea have managed to remain in the market despite their

informational disadvantages. For them to be able to do so, there must be some

sustainable sources of returns, and we examine those return sources through

foreigners’exposures to characteristic‐based factors.

Our specific empirical strategy is to construct a portfolio that replicates the

allocation of foreign equity capital within a domestic stock market and examine

the portfolio’s factor loadings by regressing its returns on a large set of

characteristic‐based factor returns. For the period from January 1999 to August

2013, we find that the foreigner‐mimicking portfolio, named FOREIGN, deviates

1 Some of the informal barriers might be psychological (e.g., familiarity), but they also lead to a

smaller set of usable information, thereby forcing foreign investors to be informationally

disadvantaged.

2 For example, foreigners might begin with some large, representative companies in a local

market, which would effectively equip them with the market‐risk exposure. Our question is

whether foreigners are exposed to other risk factors besides the market factor.

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from the domestic market portfolio by being heavily loaded on the idiosyncratic

volatility (IVOL) factor, which is long on low‐IVOL stocks and short on high‐

IVOL stocks. In other words, foreign equity capital is tilted toward low‐IVOL

stocks and profits from the return differential between low‐IVOL and high‐IVOL

stocks.

3

Besides the IVOL factor, FOREIGN is heavily exposed to the size and the

book equity‐to‐market equity (BM) factors. However, the signs of those loadings

and the magnitudes of the corresponding factor premiums suggest that, besides

the baseline exposure to the MKT factor, the loading on the IVOL factor is the

main source of returns for foreign equity capital. We also find evidence that

foreign equity capital moves into (out of) low‐IVOL stocks when their volatility

gap against high‐IVOL stocks widens (narrows).

4,5

Having found the exposure of foreign equity capital to the IVOL factor, we

interpret it in the context of information asymmetries between locals and

foreigners, the very motivation for our study. Specifically, we interpret our finding

as an outcome of domestic and foreign equity capital having differential access to

3 Bae et al. (2004) find a positive relationship between the extent to which a stock is available to

foreign investors and its return volatility.The study of Bae et al. is different from ours, because

they examine a stock’s availability to foreigners and not the actual allocation of foreign equity

capital to the stock. Besides, they measure the availability using the number of shares that can

be held by foreigners, whereas our measure is based on the market capitalization held by

foreign investors.

4 As a complement to foreign equity capital in constituting the market, domestic equity capital

—which we mimic by another portfolio named LOCAL—holds high‐IVOL stocks and moves in

the opposite direction to foreign equity capital. Domestic equity capital profits primarily from

its exposure to the BM factor—that is, it tilts toward value stocks.

5 Section E of Section III ensures the robustness of this result including the endogeneity issue.

Figure 1 Stock market capitalization held by foreign equity investors.

This figure shows the fraction of the Korean stock market capitalization that is held by

foreign investors. For this figure, we use the stocks listed on the so‐called KOSPI market,

the main stock exchange in Korea. The study period is from January 1999 to August 2013.

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