Foreign Investor Heterogeneity and Stock Liquidity around the World

February 7, 2019

Foreign Investor Heterogeneity and Stock Liquidity around the World
Lilian Ng; Fei Wu; Jing Yu; Bohui Zhang
Review of Finance, Volume 20, Issue 5, 1 August 2016, Pages 1867–1910,https://doi.org/10.1093/rof/rfv048

This article examines whether foreign investor heterogeneity plays a role in stock liquidity in a sample of 27,828 firms from 39 countries worldwide. Foreign direct ownership is negatively associated with stock liquidity, while foreign portfolio ownership is positively associated with stock liquidity. Consistent with theoretical predictions, foreign ownership explains stock liquidity through both trading activity and information channels. We further exploit the 2008 global credit crunch to examine how foreign investor heterogeneity is related to changes in liquidity. We observe a persistent sharp fall in liquidity across all countries during this large market downturn. Foreign direct ownership aggravates changes in stock illiquidity during the crisis period, while foreign portfolio ownership reduces it. The final analysis links the effects of foreign investor heterogeneity on stock liquidity to firm valuation. The results reveal that the value-enhancing benefits of foreign direct investors’ monitoring efforts outweigh their liquidity costs and high adverse selection premium. However, the positive impact of foreign portfolio ownership on firm performance becomes negative and is not robustly significant after controlling for liquidity.

Our study makes three deliberate departures from the existing literature. First, instead of combining foreign investors as one investment group, we distinguish the types of foreign investment using a comprehensive firm-level international sample. Second, our work adds new evidence to the long-standing discussion of the role of foreign investors and their effects on the cost of capital, firm valuation, and the growth of domestic capital markets. Existing evidence finds value-enhancing benefits of foreign institutional investors and suggests that these benefits are likely to arise from foreign investors’ specialties in business intervention and management expertise. Our results show that these benefits are derived at the expense of high liquidity costs and a high cost of capital, which reflects the adverse selection premium demanded by uninformed investors.

Finally, our study extends our understanding of the effects of ownership structure on stock liquidity in an international setting. Prior substantial evidence that ties ownership concentration to stock illiquidity focuses mainly on US markets. We extend this strand of the literature with a focus on one pivotal group of shareholders—foreign investors, and more importantly, their heterogeneity. We show that the size of foreign ownership stakes matters for stock liquidity and that trading activity and asymmetric information are two channels through which foreign ownership explains stock liquidity.