THE PORTFOLIO FLOWS: Related Literature

There are two main areas of work on which this paper builds. The closest is the small literature focused on international portfolio flows: Tesar and Werner (1993, 1995); Bohn and Tesar (1996); and Brennan and Cao (1997). These papers document positive contemporaneous correlations between inflows and dollar stock returns. There is mixed evidence of correlation between inflows and developed country exchange rates in Brennan and Cao (1997). Because their papers use quarterly data, there is little consistent evidence of non-contemporaneous correlations.

Brennan and Cao (1997) argue that the contemporaneous correlation between inflows and returns may be attributable to international investors updating their forecasts by more than locals in response to public information about local markets. If international investors’ priors are more diffuse than those of locals, i.e., if they have a “cumulative informational disadvantage”, then positive information releases will cause asset holdings to be reallocated toward international investors. Brennan and Cao favor this hypothesis because it may also help explain home bias in investor portfolios around the world.

A second explanation for the correlation between inflows and local-market returns is that of shocks to international demand that are unrelated to information. For example, shocks to the risk tolerance of international investors (relative to the risk tolerance of local-market investors) will increase local-stock prices and result in a reallocation of local-market stocks toward international investors. Similarly, exogenous shocks to international investor wealth will generate re-balancing demands that can simultaneously affect ownership patterns and prices.

Shocks to international investor demand suggest that we should observe positive correlation across country inflows. The Brennan and Cao story does not suggest large common components in crosscountry flows. The regional component of individual-country flows is best thought of as a supranational or global shock. It seems unrealistic to assume that international investors are at an information disadvantage relative to local market investors with respect to such global shocks. Common shocks to investor demand would more naturally explain regional components in portfolio flows across countries.