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The Effects of Market Comovements on International Mutual Fund Managers’ Portfolio Holdings

The Effects of Market Comovements on International Mutual Fund Managers’ Portfolio Holdings. Jerry T. Parwada University of New South Wales Eliza Wu University of New South Wales. Research aims. Design a robust method of identifying significant structural changes in market comovements.

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The Effects of Market Comovements on International Mutual Fund Managers’ Portfolio Holdings

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  1. The Effects of Market Comovements on International Mutual Fund Managers’ Portfolio Holdings Jerry T. Parwada University of New South Wales Eliza Wu University of New South Wales

  2. Research aims • Design a robust method of identifying significant structural changes in market comovements. • Examine whether fund managers from 41 countries systematically change their holdings of U.S. equities around major structural breaks in equity market comovements between their home countries and the U.S.

  3. Predictions (1) • Decreased investment opportunities hypothesis • Portfolio diversification theory (Markowitz, 1952). • Diversifying internationally should earn higher returns for each unit of risk and deliver superior portfolio performance if returns in investors’ home or source markets are not significantly correlated with destination markets (Frankel, 1982). • Expect decreased international diversification.

  4. Predictions (2) • Increased investment opportunities hypothesis • Increasing bilateral trade leads to higher bilateral holdings of banking assets (Aviat & Coeurdacier, 2006). • “Weak evidence of the diversification motive” in cross-border portfolio flows (Portes & Rey (2005). • Diversification benefits in emerging and high risk markets (Driessen & Laeven, 2006/Goetzmann et al., 2005). • International diversification opportunities are scarce, but increased correlations increase investment (Goetzmann et al., 2005). • Investors may ‘correct’ underdiversification by increasing holdings of countries they become more familiar with.

  5. Sample construction and data • 41 countries with equity mutual funds that invest in U.S. equities • MSCI national stock market indices (daily) • Elkins-McSherry LLC aggregate U.S. equity trading costs data (implicit and explicit) • Thomson Financial CDA/Spectrum Mutual Fund Holdings data (quarterly aggregates by country of fund manager’s origin) • Macro-economic data (IMF and Datastream)

  6. Comovement breakpoints • Endogenously determined using daily stock market returns in the spirit of Bekaert et al., 2002, Longin & Solnik, 1995, and Kim et al., 2005). • Two-step empirical estimation • ARMA-exponential GARCH in mean conditional correlations between the U.S. and other countries (eq 1-4). • Bai & Perron (2003) algorithm applied to estimated time varying conditional correlations to test for multiple structural breaks.

  7. Determinants of portfolio holdings • Empirical approach closely follows Gelos and Wei (2005). • Quasi-event study of changes in quarterly portfolio holdings around structural breaks in market comovements. • We first determine each fund/country’s benchmark allocation to the U.S. using ICAPM (Frankel, 1982). • With GDP-weighted MSCI World Index as the proxy for the world market portfolio, the benchmark allocation must be a proportion of a country’s GDP equal to the fraction of the U.S. market in the world index.

  8. Determinants of portfolio holdings (contd.) • Base specification

  9. Determinants of portfolio holdings (contd.) • Controls and robustness checks • Regional fixed effects • Business cycles dummies • Information asymmetry proxies • Distance • U.S. equity transaction costs • Trade dependence with the U.S. • Shared language dummy • Lagged portfolio allocations to the U.S.

  10. Results • Structural breaks spread across 1996-2005 period (see Table 1) • Descriptive statistics (Means) U.S. allocation by country (%) 3.26 U.S. share in the world index (%) 37.72 Distance (kilometres) 8833 U.S. trading commissions (basis points) 12.50 U.S. market impact costs (basis points) 19.89 U.S. total transaction costs (basis points) 32.70 Trade dependence 0.27 English language dummy 0.31

  11. Results – Univariate regressions (Table 4)

  12. Results – Multivariate analysis (Table 5)

  13. Conclusions • U.S. bound mutual fund flows react positively to increased comovements between U.S. equity markets and the fund managers’ home markets. • The results are robust to the inclusion of information asymmetry proxies. • More work is called for on: • Theories on investors’ decision making in the face of strengthening market interdependencies. • Determination of the economic value of the fund managers’ “comovement timing” activities.

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