An academic paper awaiting publication poses a
multi-trillion-dollar question: What are the most important
determinants of U.S. investment in the equity of foreign
firms?
Two of three favorite explanations for home bias do not
withstand scrutiny, claim the report’s co-authors.
John Ammer at the Federal Reserve Board, Sara Holland at the
University of Georgia, and David Smith and Frank Warnock at the
University of Virginia base their findings on U.S. Treasury
data used to calculate foreign holdings by U.S. residents. They
relied on a confidential benchmark survey of company-level data
conducted in 1997 by the U.S. Treasury Department and the
Federal Reserve. Such granular detail on investor behavior is
extremely rare and it cried out for the scholars’
attention. Conclusions shed overdue light and stand the test of
time, they insist.
Despite such enormous stakes in foreign stocks, the
co-authors cite a gap in research on what governs the level of
U.S. investment in foreign firms. Their new paper makes a dent
subject to newer data that they would welcome. The paper,
entitled U.S. International Equity Investment, disputes two
favored and long-held assumptions about disproportionate
investment in foreign companies that cross-list their
depository shares in the U.S. The first is that lower
transaction costs did not explain the imbalance.
If the reduction in transaction costs motivated investors
who wanted to trade stocks on the NYSE, most cross-listings
would have been ADRs. Instead, underlying foreign securities
received the bulk of attention from U.S. investors. This
evidence rules out transaction costs as a primary impediment to
foreign investments.
Institutions wait for firms to list in the U.S. before they
invest, says David Smith, who directs the Center for Financial
Innovation at the University of Virginia’s McIntire School
of Commerce. When firms satisfy reporting requirements for
cross-listing, investors instruct traders to buy shares where
they are cheapest. More often than not, traders bypass ADRs for
direct investments.
Common wisdom fails inspection again in the second of the
favored explanations when it assigns a cross-listing effect to
differences in legal systems. That was not a main draw, it
turned out. “We didn’t find any evidence that
‘bonding’ to U.S. laws led to a larger
‘cross-listing effect,’” says Frank Warnock, the
Paul M. Hammaker Associate Professor of Business Administration
at The University of Virginia’s Darden School of
Business.
Most U.S. investment nowadays resides in the ordinary shares
of companies with depository receipt programs, if the companies
hail from the developed world. “Depository receipts
probably represent between an eighth and a quarter of total
U.S. ownership,” says Dave Stueber, managing director and
head of sales for the Depositary Receipts business at BNY
Mellon. Most U.S. investment in GlaxoSmithKline, for instance,
resides in ordinary shares, not in its depository receipts.
Stray into Russia, Brazil or emerging regions unlike the known
world 15 years ago, Steuber says, and depository receipts
command a much larger share of U.S. and global investment.
Accounting implications furnish the authors with the most
plausible of three explanations to the question that launched
their research into why U.S. investors buy foreign
stocks. Periodic fillings in English reconciled to
generally accepted accounting principles (GAAP) confer
confidence. “It really seems to be an information
story rather than about costs or legal systems,” says
Warnock. Listing here appears to boost confidence most in the
reported financial performance by companies from countries with
sub-par accounting standards.
“Companies that got the biggest pop come from countries
with strong legal structures but poor accounting systems,”
Warnock says. In other words, investors seem keenest to gamble
on foreign companies once they satisfy the SEC. But if they go
wrong, sound legal systems in home countries can put things
right. New markets notwithstanding, that’s human
nature.