Emerging Stars and Developed Neighbors: The Effects of Development Imbalance and Political Shocks on Mutual Fund Investments in China

Article excerpt

This paper examines the influence of regional economic development on mutual funds investment decisions. Using find holdings from 2003 to 2008, we find that Chinese mutual funds that collectively reside in the developed coastal region have the ability to select "star "firms from neighboring inland areas and overweight them in their portfolios. However, they present a clear local bias within the coastal region. Such investment behavior is robust to political interventions. In particular, changes in political climate make mutual funds seek fundamentals like growth prospects and diversification benefits. Overall, economic and political factors significantly influence mutual funds investment decisions in emerging China.

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Despite the well-recognized benefits of investment diversification, investors are observed to allocate their portfolios in a biased manner. They tend to invest more in domestic rather than international capital markets (French and Poterba, 1991) or hold certain stocks rather than a well-diversified market portfolio when investing in a single financial market (Falkenstein, 1996; Coval and Moskowitz, 1999; Gompers and Metrick, 2001). In finance literature, these anomalies are known collectively as "investment biases."

The literature suggests that deadweight costs stemming from various explicit and implicit investment barriers lead to limited diversification in both international and domestic equity markets (Cooper and Kaplanis, 1986). Factors such as economic development, financial market development, capital controls, and withholding taxes serve as deadweight costs in cross-border investment leading home markets and certain foreign markets to be overweighted by global investors (Chan, Covrig, and Ng, 2005). Within individual equity markets, investors are also known to avoid firms with high deadweight costs (Falkenstein, 1996; Kang and Stulz, 1997; Coval and Moskowitz, 1999; Dahlquist and Robertsson, 2001; Gompers and Metrick, 2001; Grinblatt and Keloharju, 2001).

The extant investment literature frequently reports empirical evidence regarding how investors from more developed economies such as the United States, Japan, and European markets invest at home and abroad in international and emerging markets (Falkenstein, 1996; Kang and Stulz, 1997; Coval and Moskowitz, 1999; Grinblatt and Keloharju, 2000; Dahlquist and Robertsson, 2001; Gompers and Metrick, 2001; Kaminsky, Lyons, and Schmukler, 2001; Edison and Warnock, 2004; Parwada and Wang, 2009). As most developed economies are treated as fully developed and financially integrated markets, implicit investment barriers other than information asymmetry, such as domestic imbalances, have largely been ignored. (1) However, in addition to conventional firm-level attributes and informational frictions that have been found to limit the benefits of diversification, macroeconomic and political features of the domestic market are likely to also be influential when making investment decisions.

In this paper, we investigate the effects of disparate economic development on mutual fund investment behavior to bridge the market and firm-level studies in this area. By examining how mutual funds make investment choices within domestic markets facing typically staggered economic development, we add new knowledge to the literature by taking into consideration the effects of domestic macroeconomic and political conditions on institutional investors' investment decisions. In particular, we focus on China, a rapidly growing emerging market, as a natural experiment. Over the past two decades, China's economy has witnessed rapid development in transitioning from a planned economy to a market economy. However, this development has progressed in an unbalanced fashion. In particular, the coastal area (see Figure 1) has developed much faster than the inland areas of China. (2) Figure 2 shows that by 2009, the nine coastal provinces generated a gross domestic product (GDP) of 19. …