The Influence of Foreign Portfolio Investment on Domestic Stock Returns: Evidence from Taiwan

Foreign investors have played an increasingly important role in the stock markets of emerging host countries. Although foreign investors bring large amounts of capital, due to asymmetric information and home bias, they tend to invest only in certain stocks, rather than in the market as a whole. Therefore, the benefits of foreign investment may be limited and stock price dispersion may exist between foreign favored stocks and foreign un-favored stocks. We analyze how foreign investment portfolios affect the domestic stock market of host countries by comparing the performance of favored and un-favored stocks of foreign investors. Specifically, we empirically tested whether investors herded into each group and whether the favored group outperforms the un-favored group during both expansion and recession periods. The findings show that market participants did herd in the foreign investor favored stock group, but herded in the un-favored group only in bear markets. The foreign investor favored group outperformed the other only during economic expansion. During recession, the foreign investor unfavored group performed better.