The wisdom of strangers: local versus foreign flows as drivers of country-equity market returns
A recurring question fielded by EPFR’s quantitative team is, “Are local or foreign-domiciled flows the drivers of return in specific markets”?
Most of our clients have their own qualitative view. For instance, those in Japan tell us they view foreign flows as the ‘dumb’ money. But what does a quantitative approach tell us?
In this piece we compare foreign versus local fund flows in various markets to see which has more predictive power.
To do so we utilize flow percentage data, which we define as the sum of flows, in percentage of AUM terms, into or out of a given market by equity funds that report both daily flows and monthly country allocations to EPFR. For a given country, local and foreign flows are, respectively, flow percentages computed on funds having and not having that country as their domicile.
Following the approach outlined in Srimurthy et al. (2018), we compound these local and foreign flow over a trailing four-week period. Only the 38 countries that have at least two full years of four-week flow data are considered in the analysis.
To refine our analysis, we use flow percentage data to compute average flow and local advantage data points. Average flow is simply the average of local and foreign flow while local advantage is defined to be the difference between local and foreign flow.
With these two data points in hand, we proceed to regress one-week forward country-equity-market return on both. The methodology of Britten‐Jones et al. (2011) is applied to counteract the use of overlapping weekly periods. This methodology results in t-statistics that can be interpreted in the standard manner.
Where the locals are smarter
In the first table below, we list those countries that have t-statistics -- associated with local advantage -- greater than one. These are countries where the local flows should be taken more seriously, as drivers of forward return, than the foreign flows. In this sense, the locals are to be considered ‘smarter’.
As it happens, Japan is one of the six countries on this list. Quantitative analysis supports the prevailing qualitative view.
Outsiders seeing clearly
Next, we consider the countries where the foreign flows have the advantage. These are countries where the foreign flows are more important than the local ones as drivers of forward returns. There are eight such countries where outsiders have the advantage.
Interestingly, the United States appears at the top of this list.
In a few countries like Japan, local flows are clearly the ones to heed. Then there is another group of countries where foreign flows trump local flows as drivers of local equity-market returns.
Overall, however, our analysis suggests there is no universal formula. Whether local or foreign flows are more dominant drivers of return varies country-by-country and, for a majority of the 38 countries studied, it is difficult to discern which kind of flow has a clear advantage.
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