Foreign Ownership Restriction and Momentum – Evidence from Emerging Markets

• Date: 01 June 2014
• Author: Min Bai,Yafeng Qin
• Published date: 01 June 2014
• DOI: http://doi.org/10.1111/irfi.12019

Foreign Ownership Restriction and

Momentum – Evidence from

Emerging Markets

YAFENG QIN†AND MIN BAI‡

†School of Economics and Finance (Albany), Massey University and

‡Finance Department, Auckland University of Technology, Auckland, New Zealand

ABSTRACT

This study investigates the impact of foreign investors on stock price effi-

ciency and return predictability in emerging markets. It finds that stocks fully

investible for foreign investors exhibit stronger price momentum than non-

investible stocks. The difference in momentum effects between stocks with

different levels of investibility cannot be fully explained by world market

risk, size, turnover, or country-specific factors. Further tests show that fully

investible stocks have no post-earnings-announcement drift (PEAD), and

their short-term momentum reverses over a longer horizon. These results

show that the stronger momentum of highly investible stocks does not

appear to be driven by foreign investors’ underreaction to firm-specific infor-

mation, but is more likely to be generated by their positive feedback trading.

JEL Classification: G02, G14, G15, G17

I. INTRODUCTION

There is a common perception that the liberalization process improves the

information efficiency of emerging markets. Such a perception is mainly driven

by the belief that foreign investors are better informed than domestic investors,

because they tend to be large and professional investors, and they outperform

local investors (Grinblatt and Keloharju 2000; Karolyi 2002; Seasholes 2004;

Chen et al. 2009). A recent study by Bae et al. (2012) shows that prices of stocks

that are highly open to foreign investors incorporate global market information

faster than those of stocks that are less or not investible to foreign investors.

Their finding is consistent with the theoretical prediction of Albuquerque et al.

(2009), and Basak and Cuoco (1998). These studies suggest that foreign inves-

tors facilitate the diffusion of information among investors and the incorpora-

tion of information into prices. According to them, stocks with higher foreign

investor participation should have more efficient prices. That is, their prices are

closer to a random walk.

Some other researchers believe, however, that foreign investors are generally

less informed than their local counterparts due to geographical, linguistic and

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International Review of Finance, 14:2, 2014: pp. 237–261

DOI: 10.1111/irfi.12019

© 2013 International Review of Finance Ltd. 2013

cultural barriers (Gehrig 1993; Brennan and Cao 1997; Kang and Stulz 1997;

Grinblatt and Keloharju 2001b). Hence, they underperform local investors (Hau

2001; Choe et al. 2005; Dvorak 2005) and their investments are geographically

biased toward the home of the fund (Coval and Moskowitz, 1999). Share prices

will reflect new information more slowly when the number of uninformed

investors increases (Holden and Subrahmanyam 1992; Foster and Viswanathan

1993). If foreign investors are less informed than domestic investors, their

participation in emerging markets will impede the diffusion of information

among investors and the incorporation of the information into stock prices.

According to Hong and Stein’s (1999) gradual information diffusion model, a

slow spread of information tends to induce momentum in stock returns. Mean-

while, another stream of research suggests that, as foreign investors are less

informed than local investors, they tend to pursue simple trading strategies

such as positive feedback strategy (Brennan and Cao 1997; Grinblatt and

Keloharju 2001a, 2001b; Konukoglu 2010). The positive feedback trading of

foreign investors will also generate momentum in stock returns (DeLong et al.

1990; Shu, 2010). What is more, Sias and Starks (1997) argue that when insti-

tutional investors, including foreign investors, spread their trading over time to

conceal information or to minimize transaction costs, their correlated trading

patterns contribute to serial autocorrelation in stock returns. Hence, stocks with

higher foreign ownership are more likely to have autocorrelation in prices than

are stocks with low, or no, foreign ownership.

This study investigates the two seemingly contradictory arguments men-

tioned earlier by examining how foreign investors’ participation impacts the

pricing efficiency of the stocks. Emerging markets provide an ideal setting to

look into such an issue. Since the mid-1980s, the majority of emerging markets

have started liberalizing their equity markets and allowing for foreign investor

participation. Most emerging markets, however, still impose limitations on the

level of foreign ownership in securities, with the level of constraints varying

across countries, industries, and securities. Therefore, not all stocks in emerging

markets are accessible to international investors. The main objectives of this

study are: (i) to test whether higher foreign ownership is associated with higher,

or lower, momentum profits in emerging markets; and (ii) to explore the

underlying forces that lead to these effects.

The variable we use to proxy the openness of the stocks to foreign investors,

or the foreign ownership, is the Foreign Investable Weight Factor (IWF) from the

Standard & Poor’s Emerging Market Database (EMDB). The IWF is a degree-open

factor, representing the degree to which foreign investors may access the stock1.

IWF varies substantially across markets and stocks. For all of the countries in our

sample, the IWF of individual stocks varies from 0% to 100%. The mean IWF

1 If foreign institutions can invest in listed shares, S&P then investigate each security in the

S&P/IFCG Index to determine whether there are any corporate by-laws, corporate charters, or

industry limitations on foreign ownership of the stock. S&P then creates a variable called the

‘degree of open factor’ with values from 0 to 1, that indicates the amount of the security

foreigners may legally own (0.00 indicates that the stock is not legally available to foreigners).

International Review of Finance

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