Why do foreign investors underperform domestic investors in trading activities? Evidence from Indonesia

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Abstract

Foreign investors generally underperform domestic investors in trading activities. This study shows that their inferior performance is attributable to non-initiated orders. Foreign investors actually perform better than domestic investors in initiated orders. In addition, their performance is also mixed when trades are classified depending on who the counterparties are. These mixed performances can be explained by neither the information disadvantage hypothesis proposed by [Dvořák, T., 2005. Do domestic investors have an information advantage? Evidence from Indonesia. Journal of Finance 60, 817–839.] nor the poor timing of trade hypothesis suggested by [Choe, H., Kho, B.C., Stulz, R., 2005. Do domestic investors have an edge? The trading experience of foreign investors in Korea. Review of Financial Studies 18, 795–829.]. We propose and confirm that their inferior performance is explained by their aggressive trading behavior. Three metrics we utilize to measure the aggressiveness of foreign investors’ trading provide overwhelmingly strong evidence that foreign investors are more aggressive than their domestic counterparts.

Introduction

The existing literature documents mixed findings on the relative performance of foreign and domestic investors. Grinblatt and Keloharju (2000) and Seasholes (2004) report that foreign investors are better traders, since they are better informed. They find evidence that foreign investors generally outperform domestic investors. Brennan and Cao (1997), Hau, 2001, Dvořák (2005), Choe, Kho, and Stulz (2005), however, report the opposite findings. Dvořák (2005) finds that domestic investors earn higher profits than foreign investors in the Indonesian market. Choe, Kho, and Stulz (2005) report that foreign investors pay more than domestic investors for purchases and receive less for sales in the Korean market. After investigating underlying reasons for foreign investors’ poor performance, they find that foreign investors trade at worse prices because prices tend to move against them before they trade, indicating the poor timing of their trades. Even though Dvořák (2005) and Choe, Kho, and Stulz (2005) agree that foreign investors’ trading performance is inferior to that of domestic investors, their explanations differ. Dvořák (2005) attributes it to information disadvantage, while Choe, Kho, and Stulz (2005) rely on the poor timing of trades by foreign investors.4

Based on a much longer study period and more comprehensive data, we find that foreign investors on the Jakarta Stock Exchange (JSX) pay 9 basis points more than domestic investors when they buy and that they receive 14 basis points less than domestic investors when they sell. These results confirm the findings by Choe, Kho, and Stulz (2005) and Dvořák (2005). However, this consistency in empirical findings ends when: (i) we classify executed orders into initiated and non-initiated orders and (ii) we identify the counterparties in the two types of executed orders.

By definition, initiated orders are those that initiate trades, while non-initiated orders are those matched by incoming initiated orders. Initiated and non-initiated orders have different cost implications. Buyer-initiated purchases cost buyers more because buyers have to pay full bid–ask spreads for their purchases, while seller-initiated purchases cost buyers less because sellers incur full bid–ask spreads. Likewise, sellers receive less in seller-initiated sales and receive more in buyer-initiated sales. In the Indonesian market, foreign investors underperform domestic investors in non-initiated orders. To buy with non-initiated orders, they pay 33 basis points more than domestic investors. Meanwhile, they receive 40 basis points less than domestic investors with non-initiated sell orders. However, foreign investors outperform their domestic counterparts when they place initiated buy and sell orders. For example, foreign investors pay 20 basis points less than domestic investors when they initiate purchases; and foreign investors receive 18 basis points more than domestic investors when they initiate sales. These results suggest that overall underperformance by foreign investors is totally attributable to their non-initiated orders.

We further categorize buy and sell trades into four different types depending on counterparty classification to gain insight into the seemingly puzzling findings that foreign investors underperform domestic investors in non-initiated orders but outperform them in initiated orders. We find that the performance of both foreign and domestic investors is mixed when trades are classified depending on who the counterparties are. In the trades of foreign investors vis-à-vis domestic investors, foreign investors always underperform domestic investors in both initiated and non-initiated orders. However, foreign investors perform the best (worst) in both buy and sell initiated (non-initiated) orders when trading among themselves, while domestic investors exhibit the worst (best) trading performance in initiated (non-initiated) trading with their fellow domestic investors. As a result, better performance by foreign investors in initiated orders is largely attributable to the trades between foreign investors themselves, even though they do poorly when trading with domestic investors. On the other hand, foreign investors exhibit poor performance in all four types of non-initiated trades. We find that the counterparties to initiated and non-initiated orders do matter.

These findings raise a critical question about the robustness of the information disadvantage in explaining foreign investors’ trading performance. The findings are inconsistent with the information disadvantage hypothesis because if foreign investors have worse information, then their profits should be consistently lower regardless of what type of orders they place. A difference in performance between foreign and domestic investors that depends on who the counterparties are also raises a question about the effect of poor timing of orders on their trading performance. If foreign investors are ineffective in timing their trades, then their performance should be consistently worse regardless of whom they trade with. It is difficult to reconcile superior performance by foreign investors when initiating trading among themselves with inferior performance when trading against domestic investors on the basis of poor timing of trades.

In this study, we identify the aggressiveness of foreign investors as the underlying reason to explain the differences in trading performance between domestic and foreign investors. Three metrics we utilize to measure the aggressiveness of foreign investors’ trading provide overwhelmingly strong evidence that foreign investors are more aggressive than their domestic counterparts: (i) foreign investors are more likely to submit orders to initiate trades; (ii) it takes much less time for the non-initiated orders from foreign investors to be filled; and (iii) foreign investors have a higher probability of having their orders executed. These results are robust regardless of firm size and stock volatility level. The aggressiveness of foreigners’ trading does indeed affect their trading performance, particularly in the short term, even though they do not necessarily have any information disadvantage relative to domestic investors.

The remainder of our paper is organized as follows. In Section 2, we discuss our data and sample construction. In Section 3, we compare trading performance of domestic and foreign investors. In Section 4, we assess the trading aggressiveness of foreign and domestic investors to ascertain if trading aggressiveness by foreign investors explains why they underperform their domestic counterparts. In Section 5, we present our concluding remarks.

Section snippets

Data and sample construction

The trading system of the JSX is built on a centralized electric limit order book. Unlike other well-known limit order markets, such as the Tokyo Stock Exchange and Paris Bourse, no market orders are allowed on the JSX to enter the system. Because of this feature, a large order will not walk up or walk down the order book, which can lead to higher trading costs in this market. It will also not bypass those orders with uncommitted liquidity. Investors submit a buy (sell) order that matches the

Overall trading performance

A number of studies indicate that foreign investors are better traders, since they have an information advantage over domestic investors (Grinblatt and Keloharju, 2000; Seasholes, 2004). Other studies, however, report that domestic investors earn higher profits than foreign investors (Brennan and Cao, 1997; Dvořák, 2005; Choe, Kho, and, Stulz 2005). Dvořák (2005) argues that domestic investors on the JSX have a short-lived information advantage over foreign investors. Choe, Kho, and Stulz (2005)

The aggressiveness of trading by foreign investors

Empirical findings documented in the previous section indicate that the performance of foreign investors relative to that of their domestic counterparts is affected by the type of executed orders and the counterparties to the executed orders. Neither the information disadvantage hypothesis nor the poor timing of trade hypothesis can explain these findings. Consequently, we search for a better explanation of why foreign investors underperform their domestic counterparts. As is implicit in the

Conclusion

With executed orders classified into initiated and non-initiated orders and with the counterparties to trades identified, new findings emerge that raise questions about the validity of the information advantage hypothesis proposed by Dvořák (2005), as well as the validity of the poor timing of trade hypothesis suggested by Choe, Kho, and Stulz (2005). The performance of foreign investors depends on whether they place initiated or non-initiated orders, as well as who the counterparties are. If

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    FII's investment in equity markets is considered to be volatile, highly reversible and driven by cyclical factors (Hattari and Rajan, 2011).2 Although Seasholes (2000) and Bailey et al. (2007) show that foreign investors have superior information processing ability, there is a much larger body of literature that argues that relative to their domestic counterparts, FII are at an information disadvantage in emerging markets, i.e., FII possess lower levels of relevant information (Choe et al., 2005; Dvořák, 2005; Agarwal et al., 2009; Leuz et al., 2009; Kang and Kim, 2010; Bell et al., 2012; Baik et al., 2013). Such information asymmetry stems from physical, linguistic, or cultural barriers resulting in suboptimal investments (Chan et al., 2005; Bell et al., 2012).

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We would like to thank Avanidhar Subrahmanyam (the editor), the referee, and seminar participants at the Shenzhen Stock Exchange, Renmin University of China, as well as the 2005 and 2007 annual meetings of the Financial Management Association International. The views expressed are those of the authors alone and do not necessarily represent those of the Federal Reserve Bank of Chicago.

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