International fund investment and local market returns Yothin Jinjarak a, * , Jon Wongswan b , Huanhuan Zheng a a Division of Economics, Nanyang Technological University, 14 Nanyang Avenue 637332, Singapore b Phatra Securities Public Company Limited, 252/6 Ratchadapisek Road, Bangkok 10310, Thailand article info Article history: Received 5 November 2009 Accepted 2 April 2010 Available online 13 April 2010 JEL classification: E44 F37 G15 Keywords: Asset returns Bonds and equities Capital flows Institutional investors Global integration abstract International fund investment in bonds and equities is characterized by a positive association between current net inflows and contemporaneous and past market returns: positive-feedback trading, while being possibly profitable for international fund investors, could be destabilizing for the underlying mar- kets. Allowing for interactions between equity investment and bond investment, our panel vector auto- regression shows that past equity returns contain useful information in forecasting equity and bond flows and that bond flows impact future equity returns positively. Ó 2010 Elsevier B.V. All rights reserved. 1. Introduction The financial globalization of the past three decades has led to large two-way capital flows that have brought with them the ben- efits of global risk-sharing and real productivity improvement but have periodically ended in financial calamities and crises. Conse- quently, a frequent concern of academics and policy makers fo- cuses on the dynamics of portfolio flows, which can amplify the boom-bust cycles of local asset prices and spread financial trouble across countries and regional markets. 1 By and large, previous studies investigating the relationship be- tween cross-border flows and returns have devoted substantial ef- fort toward equity investment and tend to find a positive association between contemporaneous net inflows and local market returns. 2 Their primary focus is to understand a strategic portfolio investment by institutional investors in the equity market across countries. There are now dozens of studies on institutional investment and market returns, led, for example, by the early works on the US markets of Lakonishok et al. (1992) and Warther (1995). The former has provided much of our understanding on two aspects of trading by institutional investors: herding, which refers to simul- taneously buying (selling) the same stocks that other managers are buying (selling), and positive-feedback trading, which refers to buy- ing past winners and selling past losers. Using monthly and weekly data, Warther (1995) examines aggregated mutual fund flows and returns (the cash flows into or out of all mutual funds and market- wide returns), and finds evidence of a positive relation between flows and subsequent returns as well as evidence of a negative rela- tion between returns and subsequent flows. Later studies including Froot et al. (2001) and Kaminsky et al. (2004) have gone beyond na- tional boundaries, extending the literature by studying institutional equity investment across a larger set of countries at various stages of financial development. 0378-4266/$ - see front matter Ó 2010 Elsevier B.V. All rights reserved. doi:10.1016/j.jbankfin.2010.04.002 * Corresponding author. Tel.: +65 6790 6798; fax: +65 6794 6303. E-mail addresses: YJinjarak@ntu.edu.sg (Y. Jinjarak), Jon@phatrasecurities.com (J. Wongswan), H070010@ntu.edu.sg (H. Zheng). 1 See for example Claessens et al. (1995), Levchenko and Mauro (2007), Broner et al. (2006), Ferreira and Laux (2009), and Smith and Valderrama (2009). Using monthly US capital flows to Latin American and Asian countries, Chuhan et al. (1998) find that global factors (the drop in US interest rates and the slowdown in US industrial production) and country-specific developments are important in explaining capital inflows. De Santis and Lührmann (2009) find that population aging, institutions, money and deviations from the Uncovered Interest Parity (UIP) influence developments in net capital flows. 2 A related strand of the literature studies the determinants of cross-border portfolio flows and holdings. For aggregate flow data, see Aviat and Coeurdacier (2007), Portes and Rey (2005), and Gelos and Wei (2005). For fund-level flow data, see also Griffin et al. (2004) for daily data or Froot and Ramadorai (2008b) for weekly data. Journal of Banking & Finance 35 (2011) 572–587 Contents lists available at ScienceDirect Journal of Banking & Finance journal homepage: www.elsevier.com/locate/jbf