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Behavioral Finance and the Foreign Bias:Implications for EM and FM Investing

by Erik L van Dijk, LMG Emerge

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Table of contents

Behavioral Finance and the Foreign Bias

Introduction: The World Has Changed

Home versus Foreign Bias

Country Level Analysis

Firm Level Analysis

1

2

3

4

5

Evaluation6

Cultural / Behavioral Factors

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1.1 Introduction -The World Has Changed I

Up until the 1990s Emerging Markets as a group did not really outperform developed markets in a structural manner- True, there were great periods and individual countries with strong

developments, but sooner or later negative surprises in combination with excess volatility / risk would cause disappointments

But since the beginning of this century things seem to be different, with the BRIC nations developing into a true global growth catalyst.

This has also positively affected growth in other Emerging and Frontier Nations (compare for instance GSAM‘s Next-11 concept)

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1.2 The ‘Old World’ of the Large Institutional Investors

Based on market values of investable assets

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1.3 The New ‘Three Bloc World’

Distribution of Global Wealth based on GDP

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1.4 Introduction -The World Has Changed II

But what about risks?

- Debt and Currency Crises? (so common in the past)- 12 of the 20 richest countries in the world when looking at their Gold and Foreign

Currency Reserves are now Emerging!- And when looking at debt levels, it is actually the richer/developed nations that are

struggling!- Currency risks have gone down too: some of the strongest currencies in the world are

now to be found in Emerging Markets

- But excess volatility, high betas, political, governance and accounting risks remain.....

Use the right manager and apply a well-thought-of approach (= diversification) that is closely linked to your overall portfolio

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2.1 Home versus Foreign Bias – How do we actually invest abroad?

We often talk in detail about differences between Developed Markets, but then proceed talking about EM/FM as if it is a homogeneous bloc.

This is wrong!

1. Enormous wealth differences

2. Commodity-rich versus commodity-poor countries

3. Huge differences in legal, tax and political systems

4. Diversified in terms of level of integration with world economy

5. Average growth level of GDP high, but large differences exist

6. Differences in quality of infrastructure (including financial!) are large

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2.2 Home vs Foreign Bias – The Home Bias

But How Do We Actually Invest Abroad?

HOME BIAS- Restrictions on International Capital Flows (e.g. Taxes)- Non-tradability of Goods- Inflation-hedging Motives- Exchange Rate Risk- Institutional Barriers- Transaction Costs- Information Costs / Quality

- Familiarity Arguments

- Behavioral Factors

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2.3 Home vs Foreign Bias – Rational vs Non-Rational Factors

What about that Behavioral Component?

- Investors tend to think that foreign markets are more risky than they actually are (compare Huberman (2001), Solnik (2008))

- Level of Patriottism in a Country (Morse & Shiva, 2008)

But when we overweight the home country by X percent,

We will automatically also underweight n foreign countries by X percent (combined)

But will we do so in a proportional manner?

The answer is NO (= FOREIGN BIAS)

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3.1 Country Level Analysis

A study by Aggarwal & Klapper (2003) sheds some light on the how and why of country over- and underweightings using data of mutual funds investing in Emerging Markets

Key Conclusions

1. Preference for larger, more developed and faster growing countries (but this is also simply the result of benchmarking to MSCI Indices)

2. We seem to love ‘neat price charts’ (from bottom left to upper right) more than at home (i.e. large focus on ‘momentum’ and ‘buying high’)

3. ‘Liquidity’ is an asset (more so than at home)

4. Accounting Quality, Shareholder Rights and Legality provide bonus points over an above regular risk indicators

5. We like to feel (over?)’informed’

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3.2 Country Level Analysis – Aggarwal & Klapper (2003)

Regression Analysis

Colored cells indicate significance levels, with orange and green 5% significance (positive and negative respectively); and yellow represents a 10% siignificance.

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3.3 Country Level Analysis – Developed Markets

Within Developed Markets Foreign Allocations seem to be more rational but Dahlquist & Robertsson (2001) and especially Beugelsdijk & B. Frijns (2008) indicate that rationality is not the whole story.

Additional Conclusions:

1. Bounded Rationality and sometimes even Irrationality is the Story

2. Relative weight of Return and Risk in investor’s utility functions more tilted toward risk abroad; as if there are two utility functions(!)

3. Information Asymmetry plays an important role in explaining this

4. But notwithstanding the fact that the bulk of foreign portfolio investments is done by institutional, professional investors:

- Excess focus on SIZE, MOMENTUM, GROWTH, RESEARCH COVERAGE

Separate Research into Cultural / Behavioral Effects Necessary (see ch 5)

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4.1 Firm Level Analysis

Analysis at the Firm Level reveals that ‘Growth’ is far more popular than ‘Value’ when going abroad; and to an extent not warranted by performance

Key Conclusions

1. When going abroad investors want ‘good’, ‘robust’ and ‘safe’ growth stories

2. And they want to have ‘all’ (or even ‘too much’) information to support that story

3. Have they forgotten that at home ‘Value’ managers were actually often the long-term outperformers?

4. They even translate their preference into a ‘strange’ asset manager preference (USUAL SUSPECTS instead of LOCAL, REGIONAL SPECIALISTS)

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4.2 Firm Level Analysis – Aggarwal & Klapper (2003)

Regression Analysis

Colored cells indicate significance levels, with orange and green 5% significance (positive and negative respectively); and yellow represents a 10% siignificance.

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4.3 Firm Level Analysis – Similar Patterns in Developed Markets Study

Dahlquist & Robertsson (2001):- Study of Foreign Investor Behavior in Sweden, pointing out that institutional

investors make similar ‘mistakes’ as private investors- with their focus when going abroad

Large Firm BiasGrowth BiasMomentumFear of Volatility‘Known’ instead of ‘Neglected’

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4.4 Firm Level Analysis – Linking Things with Country Level Analysis

Bounded Rationality instead of Full Rationality: Adding the Cultural/Behavioral Factor will add value

Additional Conclusions:

1. Behavioral Factors do definitely play a role

2. Institutional Investors are sensitive to them, almost as much as individual investors but full-fledge comparison is difficult

3. ‘Perception’ plays an important role next to ‘facts’

4. Integration of rational and non-rational / cultural factors in one framework might shed more light

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5.1 Cultural and Behavioral Factors

Beugelsdijk (Groningen University) and B. Frijns (Auckland University of Technology), 2008:

Incorporation of ‘Culture’ into the framework described in ch 3 and 4

1. Using indicators based on Hofstede’s seminal work on ‘Culture’ **

2. 3 of the 4 original Hofstede indicators are relevant in explaining international allocations (Uncertainty Avoidance, Individualism, Cultural Distance)

3. Uncertainty Avoidance dominates, explaining the excess / biased risk and growth focus; and maybe even the choice for ‘Usual Suspects’ as asset manager

4. The Home Bias is definitely not translated into a proportional underweighting of other countries / firms from other countries.

** G. Hofstede, ‘’Culture’s Consequences: International Differences in Work-related Values’’, Sage Publications, 2nd edition, 2001

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5.2 Cultural Bias – General Data (Foreign Investors by Home Country)

• Strong linkage between Foreign Bias and Cultural Factors

• Uncertainty Avoidance is most

important factor

• Cultural Difference ranges from 5.65 (SWE-JAP) to 0.26 (AUS-USA)

• Is it a coincidence that ‘take and not give’ style countries seem to be struggling?

• Investment Myopia US - taking into account their professionalism and cultural scores - really a big disappointment

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5.3 Cultural Bias – General Data (By Host Country)

• Foreign Bias hits EM/FM most

• Within BRIC Russia

and China most affected

• Based on CULTDIF remarkable mistrust of Argentina , Pakistan, South Africa

• Korea, Thailand and Netherlands encounter the opposite reaction

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5.4 Cultural Bias – Regression Analysis

When incorporating the cultural /behavioral factors in a regression framework, we reach the following conclusions:

Incorporation of ‘Culture’ into the framework described in ch 3 and 4

1. Countries that are characterized by a bigger home bias, have a bigger foreign bias as well (non-proportional deviations)

2. Cultural factors – especially Uncertainty Avoidance – have strong effect

3. The strong ‘Momentum’ bias remains

4. Diversification? Markowitz? Never heard of that free lunch!

5. Familiarity Breeds Investment; Especially Abroad

6. Asia Bias / Excess Preference might be next big risk in EM Investing

7. Opportunities in the ‘always’ disliked markets in Emerging Europe and Africa/MENA?

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5.5 Cultural Bias – Regression Beugelsdijk & Frijns (2008)

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6.1 Evaluation

Main Conclusions:1. Big Investors Do Need to Adjust their Investment Style Abroad, Especially in

EM and FM- Opportunities in Value and Mid- and Small Cap- Dare to incorporate LT Overreaction and Dividend Yield based strategies- More top-down / almost private equity like; less bottom-up / fundamental

- UNLESS

2. We (should) start using local and regional specialists more

3. Proper Diversification and Risk Management can add value (see Kritzman (2006) about the Markowitz-van Dijk heuristic); then use it!

4. Incorporate the fact that international money flows will start to change:- Larger flow into EM and FM- Growing role of SWF’s from EM and FM- With Investors from Different Countries showing differential sensitivity to Home and

Foreign Bias

5. Growing role for ‘Global Theme’ plays

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6.2 Evaluation - EM/FM : How to incorporate Style

How ‘Style’ can be incorporated ‘the local investment specialist’ way:

Key: Don’t follow the main crowd.

The more inefficient a market, the less valuable the information content of what the main crowd is doing.

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6.3 Evaluation - Allocation: How to Integrate Top-Down and Bottom-Up?

EM and FM: Now large enough to be a separate component within asset class mandates. Not just in allocation of mandates, but also ALM.

Bottom-up financial information often less reliable (information scarcity): Integrate top-down and bottom-up with top-down being an important constraint. No excitement about bottom-up stories when they are not more than corroborated by top-down outlook

EM and FM more important in the world? Pay special attention to EM-FM sensitivity of Western Firms:- Indirect way of investing in EM-FM wasn’t a good way of capturing the EM-FM

component so far, but things are rapidly changing- Theme plays (E.g. ‘’Water’’, ‘’Energy’’, ‘’Food/Agriculture’’, ‘Rising Middle

Classes in EM-FM’’

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6.4 Evaluation - Allocation: Risk

EM – FM: Take care of Risk factor- Beta and Volatility normally higher- More sensitive to changes or surprises in earnings, risk and other fundamental

variables- Some compensation in lower correlations but globalization and behavior of

Foreign investors in large caps have led to diminished value of the correlation factor

- Non-normal distributions: Kurtosis and Skewness are far more important than in developed markets

- Create a robust, diversified portfolio: transaction costs are often higher and liquidity lower. When you are wrong, there is not much to do but sit and wait.

But know that the real GM’s do often make their biggest profits during that sitting and waiting period when panic of others provides them with buying opportunities

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Contact:LMG Emerge

ZeistTel: +31 30 695 3828

erik.vandijk@lmg-emerge.comhttp://www.lmg-emerge.comhttp://www.facebook.com/NewEconomies

Any Questions?