Does Institutional Ownership Matter for International Stock Return Comovement?

Abstract

There has been a long dispute about the relative importance of country versus industry diversification. We test the hypothesis that institutional ownership affects the relative importance of country and industry effects in explaining stock returns worldwide. We find that industry effects become relatively more important than country effects as more institutions hold a larger share of a firm’s shares. Additionally, industry effects dominate country effects among stocks in the top quartile of ownership by institutions, especially by foreign-based ones. Our findings show that cross-border portfolio affect return variation across national stock markets and international diversification.We first use the traditional dummy model (HR) as in Heston and Rouwenhourst (1994). In this model, excess returns are explained by country and industry dummies. Country (industry) dummies take the value one when the stock belongs to the country (industry) and zero otherwise. This model has been criticized since it assumes unitary loadings on factors. As an alternative, we propose a factor model (FM) to overcome this issue. We also suggest a different way to construct the factors. For each month, we construct two factors, country and industry, where each entry corresponds to the respective stock country and industry return. Notice that for either model, we use the firm as the unit of measurement in accordance with Griffin et al.(1998) and Campbell et al. (2001) who show that firm return variation is the most relevant unit in opposition to country, region, or industry indexes. The next step involves the use of stock institutional ownership to contrast country and industry effects between firms with low institutional ownership and high institutional ownership. We form quartiles on institutional ownership and we discuss the differences between the first and fourth quartiles. We also form quartiles on domestic and foreign institutional ownership. This allows to understand the influence of cross-border shareholders in explaining which effect, country or industry, dominates. We also present a non-parametric visualization of this issue by studying the benefits of portfolio diversification distinguishing between geographical and industrial allocation. We show that institutional ownership allows for different levels of risk reduction and industrial allocation is more beneficial from the group of firms with more institutional ownership. In addition, if this group is constituted by proportionately more foreign institutions, then it is even more beneficial. Our paper contributes to the ongoing debate by providing new insights on the relative importance of country and industry effects in stock returns by analyzing more than 48,720 individual stocks from 48 countries and 77 industries over the period from 2001 to 2007. We propose a new explanation for the relative importance of country and industry portfolio allocation in explaining return variation. We find that as institutions hold proportionally more stock of a firm, more important are industry factors in determining stock return variation. Industry effects dominate country effects for the firms in the top quartile of institutional ownership. In particular, it is the holdings of foreign institutions that matter. We show that what conveys the domination of industry against country effects is the importance of foreign institutions as firm's shareholders. We also show that after controlling for size, these conclusions still hold.