What Determines the Domestic Bias and Foreign Bias? Evidence from Equity Mutual Fund Allocations Worldwide

Abstract

This study analyzes the detailed equity holdings of over 20,000 mutual funds from 26 developed and developing countries. Of particular interest is that we examine how this huge number of funds allocates their investment between domestic and foreign equity markets and what factors determine the distribution of their asset allocations worldwide. We find robust evidence that mutual funds, in aggregate, allocate a disproportionately larger fraction of investment to domestic stocks. Results indicate that the stock-market development and familiarity variables have significant, but asymmetric, effects on the domestic bias (domestic investors over-weighting their local markets) and the foreign bias (foreign investors under- or over-weighting the overseas markets). When a country is more developed, or is closer to the rest of the world in terms of physical distance or common language, foreign investors are attracted to that country (less foreign bias) and, in turn, proportionately fewer domestic investors are found to hold local equities (less domestic bias). Furthermore, we find that variables such as economic development, capital control, and withholding taxes also have significant, but smaller, effects on the investment decisions of foreign investors and not of domestic investors.