The Impact of International Institutional Investors on Local Equity Prices: Reversal of the Size Premium

Using comprehensive company-level ownership data from Japan, the authors found that the equity size premium correlates strongly with the investment flows of international institutional investors. When investment flows intensified and shifted into larger stocks in the mid-1990s, the equity size premium was reversed. Their findings suggest that a large fraction of the time variation in the size premium is driven by price pressures, regardless of any shift in the fundamentals of small and large companies. We investigated the behavior of international institutional investors and its impact on the size premium (or small-stock premium) of the Japanese equity market. In many equity markets around the world, the size premium has disappeared or even been reversed in the past decades. We argue that the growing presence of global institutional investors contributed to this reversal of the size effect. We found that international institutional investors prefer holding large-cap stocks; when they expand their investments in the local equity market, their demand shocks exert price pressures on large stocks, which increases the stocks’ valuation and contributes to a reversal of the size premium. Our results suggest that a large fraction of the time variation in the size premium reflects mispricing driven by price pressures. The Japanese equity market offers a unique opportunity to explore the impact of international institutional investors on local equity prices. After the mid-1990s, international investors significantly increased their holdings of Japanese equities, particularly large-cap stocks. From the mid-1990s to around 2001, the Japanese government introduced various liberalization measures under the so-called Financial Big Bang Program. These liberalization measures, together with the institutionalization of the global financial markets, contributed to the expansion of international institutional investors into Japan. In particular, the value-weighted average ownership of foreign investors in Japan increased almost threefold, from 9.1 percent in 1995 to 27.1 percent in 2008. Not only did the level of international institutional ownership increase over this period, but also preferences for large-cap stocks intensified dramatically. Concurrent with the expansion of international institutional investors, we have seen a reversal of the size premium in the Japanese market since the mid-1990s. We examined the net demand of international institutional investors for small stocks as compared with large stocks and found that it positively correlates with the size premium. This correlation cannot be explained by the momentum trading pattern of international institutional investors. We also examined the fundamentals of Japanese companies in various size groups and found no compelling evidence that fundamentals explain the reversal of the size premium in the Japanese market. We also studied the association between international institutional investments and future stock returns at the individual company level. We found that the level of international institutional ownership positively predicts future returns after the mid-1990s but not before, which suggests the existence of price pressures from international institutional investors after the mid-1990s. We also found that the return forecasting power of international institutional ownership is strong for non-keiretsu companies but is nonexistent for keiretsu companies. This finding is consistent with international institutions investing more aggressively in non-keiretsu companies, whereas the stable cross-holdings of keiretsu companies and the substantial business ties within their corporate groups may deter outside investments in those companies.