Asian Review of Financial Research Vol.36 No.4 pp.1-35 https://www.doi.org/10.37197/ARFR.2023.36.4.1
Crowded Trading of Foreign Investors in the Korean Stock Market
Key Words : Crowded trading,Asset pricing anomaly,Stock returns,Korean stock market,Foreign investors
In this paper, we examine the crowded equity positions fomented by foreign investors in the Korean stock market. As the participation of foreign investors accelerates globally, understanding the impact of foreign investors on the stock market has become central. Specifically, as groups with shared common interests or information often engage in similar actions, it is widely recognized that foreign investors "flock together" or "herd" in the stock markets. This influence of foreign investors can have dual effects. On the one hand, their participation can facilitate price discovery by quickly reflecting information in the stock market. On the other hand, it can lead to liquidity shortages, potentially causing a trigger for fire sales. Consequently, there has been a long-standing discussion about the participation of foreign investors and its potential to cause destabilization in the stock markets. However, studies on the impact of foreign investors in the Korean stock market are still limited, with a focus on their trading volume or ownership. This paper aims to bridge the gap by examining the crowded equity positions by foreign investors. Crowdedness is a situation where the ownership proportion of a specific group of stocks is excessively high compared to their liquidity. We focus on the crowdedness of foreign investors by calculating the shareholdings of the foreign investor group as a percentage of average daily trading volume, which is called Days-ADV. Days-ADV shows the time it takes for the foreign investor group toliquidate their holdings of the respective stock. Therefore, even if the ownership is low, Days-ADV can be high if the turnover rate of the stock is low, while even if the ownership is high, Days-ADV can be low if the turnover rate of the stock is also high. As evident from the definition, this proxy enables a more direct examination of the impact of foreign investors'herding behavior on stock prices by incorporating their ownership and stock liquidity. Our research investigates the impact of foreign investors on the Korean stock market, with Days-ADV as our key variable of interest. The results of our study are as follows. First, portfolio-level analyses and firm-level cross-sectional regressions indicate a significant positive relation between the Days-ADV and stock returns in the subsequent month. For example, the high-minus-low (H-L) Days-ADV portfolio, which buys the top 20% of stocks and sells the bottom 20% of stocks based on the rank of the Days-ADV at the end of the month, yields a return of 1.32% (t-statistic = 2.97) in the following month. Furthermore, this positive premium of the Days-ADV is not driven by foreign ownership or illiquidity. It implies that the Days-ADV, a composite measure of foreign ownership and illiquidity, provides additional information on future stock returns. Second, we find no evidence that the crowdedness of foreign investors leads to relatively larger drawdowns during distress periods. During the crisis period, the high Days-ADV portfolio exhibits a significantly negative return of -1.82% (t-statistic = -2.20). However, in comparison, the H-L portfolio still shows positive return of 1.29% (t-statistic = 1.19). Lastly, we find that the Days-ADV predicts future earnings surprises significantly in a positive direction. The predictive power is most pronounced for the upcoming earnings announcement and gradually diminishes over time; the predictive power remains significant for up to the following three quarters' earnings announcements. We also find that the abnormal return of the H-L portfolio based on the crowdedness of foreign investors is intensified in stocks with higher sensitivity to export growth, the S&P 500 index, and won-dollar exchange rates. These findings support the argument that the return predictability of the crowdedness of foreign investors could occur as they flock to specific stocks through information superiority. This study contributes to the understanding of the impact of foreign investors' behaviors in several ways. First, this is the first study to examine the impact of the crowdedness of foreign investors on stock returns in the Korean stock market. In contrast to previous studies that primarily focus on the effects of foreign investor ownership or herding behaviors, this study introduces a new anomaly based on the crowdedness of foreign investors. Second, our study aids in understanding whether the crowdedness of foreign investors triggers fire sales during the exogenous shock period. Lastly, our paper helps to understand the factors underlying the abnormal returns generated by the crowdedness of foreign investors. We expect that these results shed light on the role of foreign investors in the Korean stock market and the impact of crowdedness by investor groups on stock prices.