Cross-border portfolio investments are increasingly important in global markets. Since 2001, the share of equity holdings by foreign investors grew from 19 percent of the world's stock market capitalization to more than 35 percent by the end of 2015 (IMF, 2016). Much of this recent growth has been in foreign index funds, that is, in funds that replicate the return of an index by buying and holding all (or almost all) index stocks in the official index proportions (Cremers et al., 2016). Notwithstanding their popularity among investors, little is known about how managers of these funds trade to accommodate flows, and how their performance compares to domestic funds with similar management style.
In a new working paper (Pedraza, Pulga, and Vasquez, 2017), we investigate the issue of style and performance using a unique transaction data set from the Colombian Stock Exchange. We find that passively-managed foreign funds pay higher prices for stock purchases, receive less when they sell, and display inferior risk-adjusted returns than domestic passive funds. In particular, worst are on days when they are trying to accommodate large flows in similar proportions to their benchmark index by (i) trading multiple stocks in the same direction, (ii) buying (selling) the same stock multiple times, and (iii) making large trades at the end of the trading session.
Figure 1: Proportion (%) of traded value in the interval relative to the trading value of the day for: foreign passive funds, domestic pension funds and domestic mutual funds.
In order to understand outstanding characteristics which may be driving performance, we analyze the timing of flows across funds. The key finding is that daily net flows to foreign passive funds are strongly correlated in the cross-section. Specifically, we show that managers of these funds trade more intensively on days when other passive funds are trading in the same direction, a behavior that cannot be explained by momentum strategies (buying and selling stocks in the direction of lag returns).
Importantly, both components — passive portfolio management and correlated flows — are necessary conditions to explain the magnitude of the under-performance of foreign investors. If flow imbalances by passive funds are large enough, in order to trade stocks in similar index proportions, managers pay higher transaction costs to cling to their benchmark before the end of the trading session, that is, they pay a price to increase the speed of their trades to comply with their investment style. Meanwhile, other investors with more discretion over their flows appear to time their transactions to take advantage of the common order flow by foreign passive funds. For example, foreign active funds display superior returns during our period of analysis.
We would expect for similar findings in other developing countries, or in small (illiquid) stocks in developed countries. Overall, our results challenge the conventional wisdom that passive funds are, unconditionally, the best alternative for investors. While this could be the case for households investing in their home country (French, 2008), it is possible that for global strategies, index investing might deliver disappointing results.
Cremers, Martijn, Miguel Ferreira, Pedro Matos, and Laura Starks, 2016. “Indexing and active fund management: International evidence,” Journal of Financial Economics, 120 (3), 539–560.
French, Kenneth R, 2008. “Presidential address: The cost of active investing,” Journal of Finance, 64 (4), 1537-1573.
IMF, 2016. “Coordinated portfolio investment survey.”
Pedraza, Alvaro, Fredy Pulga, and Jose Vasquez, 2017. “Do foreign investors underperform? An empirical decomposition into style and flows,” World Bank Policy Research Working Paper 8002.