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Thoughts on the Recent Surge in Cross-border Foreign Equity Investment by Retail Investors of Korea
2022 Jan/04
Thoughts on the Recent Surge in Cross-border Foreign Equity Investment by Retail Investors of Korea Jan. 04, 2022 PDF
Summary
Korean investors’ outward equity investment has recently been growing rapidly, in particular, driven by retail investors through direct cross-border transactions. Direct investing in foreign equities issued and traded in foreign countries goes through complex routes via multiple financial institutions, due to its cross-border transaction nature. It entails additional risks arising from higher transaction costs and greater currency risk, compared to domestic trading. In general, these constraints serve as an obstacle to retail investors’ direct foreign equity investment in major economies. However, Korea has seen growing interest of retail investors in direct investing in foreign equity since the Covid-19 pandemic outbreak, mainly thanks to its relative advantages in terms of transaction convenience. In the Korean market, convenience in trading foreign equity brings about economic benefits such as low transaction costs but, at the same time, it poses additional risks especially in terms of investor protection. In particular, given the recent rise in foreign equity holdings through direct investment, retail investors seem to perceive outward equity investment as a high-risk, high-return investment strategy. This calls for a paradigm shift among investors to ensure that they recognize outbound equity investment as part of portfolio diversification to improve the risk-adjusted returns.
In the wake of the Covid-19 pandemic, the participation of retail investors in capital markets is increasing around the world. Korea has also witnessed the rising attention of retail investors to direct investing in foreign equity. According to recent statistics, foreign equity holdings by Korean investors including individuals and corporate entities have surged dramatically, a more than five-fold increase from the pre-pandemic levels. In this respect, this article intends to explore the structure and characteristics of Korean investors’ direct foreign equity investment to understand the recent trend, and to present relevant implications.

 
Changes in Korea’s outward equity investment
 
Korean investors’ portfolio investment in foreign equity has continued rapid growth since the early 2000s. As of the third quarter of 2021, Koreans’ portfolio investment in foreign equity outstanding stands at $552.7 billion, a whopping 160-fold increase from the 2003-end level of $3.4 billion. In particular, the foreign equity holdings of Korea’s pension funds and other public sector investors have jumped up since the global financial crisis. The National Pension Service (NPS), Korea’s largest outbound equity investor, holds foreign equities that take up one quarter of its gross asset value. The outstanding amount of foreign equities held by the general government including the NPS has surpassed a majority of Korean investors’ foreign equity holdings. In addition, the outbound equity investment outstanding recorded by the private sector including major financial institutions and individuals has recently shown an upward trend.1)
 
Recently, the most prominent aspect in Korea’s outward equity investment is the rapid growth of retail investors’ direct investing in foreign equity, which could be indirectly estimated through the Korea Securities Depository (KSD)’s data on foreign equity holdings in custody.2) As of the end of October 2021, Korean investors’ foreign equity holdings deposited with the KSD roughly amount to $68 billion, more than five times larger than the pre-pandemic levels as of 2019-end. This statistical data has been compiled regarding the foreign equity holdings of retail investors and other investors including a corporate entity, which are placed in a foreign currency securities deposit account with the KSD. But the recent growth seems to result from the increase in retail investors’ direct investing in foreign equity.3) Given the latest decline in indirect foreign equity investment through overseas funds, this trend indicates that retail investors are shifting towards outbound direct investment.4)
        


 
Structure and characteristics of outward direct investing in equities

Outbound direct investment in equities issued and traded in foreign countries is a cross-border transaction that allows investors to directly purchase and sell stocks, which goes through complex routes via multiple financial institutions. As illustrated in Figure 2, a domestic investor who intends to trade foreign equities through a domestic investment broker should engage with an investment broker based in the target country and a foreign securities depository institution. More specifically, a domestic investment broker opens an account with an investment broker located in the target country for foreign equity trading, and the trading and payment process regarding the foreign equities is implemented in the local capital market via a global securities depository institution. This complex trading structure serves as a constraint on transaction costs, compared to domestic trading. The cost borne by domestic investors includes brokerage fees charged by a domestic broker as well as mediation and custody fees incurred in foreign markets.       
 

 
Aside from a constraint on transaction costs, outward equity investment entails a wide range of other constraints that stem from the characteristics of cross-border transactions. In particular, the time difference between Korea and investment destinations and the different pace of the local settlement process mean that outward equity investment requires more time than domestic trading. Furthermore, its trading structure requires investors to undergo multiple institutions to obtain information on the trading process, thereby limiting investors’ ability to acquire and use relevant information, compared to domestic trading. An additional factor worth considering is currency risk accompanied by international transactions, and information asymmetries arising from language and time difference produce an array of barriers to entry. For this reason, direct equity investing by retail investors is primarily conducted to a limited extent in most countries, compared to indirect investment through overseas funds. What is also notable is that ETFs composed of foreign equities are being traded on stock exchanges in major advanced economies. Thus, retail investors are able to engage in trades of foreign equity with the same approach as with domestic trading. In light of this, the recent boom in direct investing in foreign equity among Korean investors is viewed as an unusual phenomenon.

   
The surge in direct investing in foreign equity: causes and implications

The recent increase in Korea’s direct investing in foreign equity can be interpreted as a result of retail investors’ growing interest in outbound portfolio investment after the Covid-19 pandemic and the Korean market-specific convenience for direct investing in foreign equity. Korea has a central foreign currency securities depository system where the KSD acts as an agent for settlement and custody of foreign equities on behalf of domestic securities firms.5) This system helps achieve economies of scale and enables service providers to establish business arrangements with ease, contributing to enhancing the convenience of domestic investors for direct foreign equity investing. The high level of convenience is primarily attributable to economies of scale stemming from the central depository system that applies differential fees depending on the size of assets in custody. In practice, settlement and custody fees of foreign equity charged by the KSD on domestic securities firms have lowered as the size of deposited assets is increasing. In addition, the system allows domestic securities firms to easily build business arrangements required to support retail investors’ outward equity investment, despite the complex structure intrinsic in cross-border transactions. This also contributes to reducing relevant transaction costs. In particular, small-scale brokerage firms that find difficulties in establishing overseas networks can open accounts and establish foreign equity services through the central depository system. Currently, 23 domestic securities firms are found to offer services for foreign equity direct investing to retail investors, and the competition among multiple service providers has delivered benefits to financial consumers, such as lower transaction fees.6)
 
Amid the recent rise in foreign equity holdings through direct investment, however, retail investors hardly seem to fully benefit from outward equity investment in terms of international diversification of portfolios. Many studies have already confirmed that individuals’ direct investment behavior usually leads to inefficient results compared to the investment of institutional investors or other investors.7) As suggested by Kim (2017) and Kim (2020), investment behavior shown by Korea’s retail investors rarely aims for international portfolio diversification8) and their foreign investment bias by region9) remains quite higher than that of other investors. This implies that retail investors tend to make outward equity investment to achieve high returns by investing in high-risk products, rather than to create a diversified global portfolio.
 
Furthermore, retail investors are exposed to investor protection-related risks arising from regulatory divergence in outbound equity investment between Korea and other countries as well as risks posed by aggressive investment behavior, which requires caution. Although retail investors can purchase a wide range of leveraged foreign equity products from domestic securities firms, limited access and investor protection requirements prescribed in domestic laws are not applicable to the foreign equity products created under foreign laws.10) For instance, when investing in a domestic leveraged ETF, domestic investors are required to complete a preliminary lecture regarding payment of deposit money, etc., which, however, is not applicable to those buying foreign equity products subject to foreign laws.
    
In theory, the largest benefit derived from outward equity investment is improvement in risk-adjusted returns through international portfolio diversification.11) Many studies have empirically evidenced the effects of the global diversification approach on maximizing portfolio returns. Given that Korea’s home bias remains quite higher than that of major economies, it is beneficial to facilitate outward equity investment by giving wider access in that investors can have a chance to achieve additional economic gains.12) However, it is noteworthy that excessive direct investment by retail investors could pose an additional risk to investor protection efforts and retail investors’ growing attention to outward equity investment well reflect their preference for a high-risk, high-yield investment strategy. This calls for a paradigm shift among investors to ensure that they recognize outbound equity investment as part of international portfolio diversification.
 
1) As of the third quarter of 2021, the portfolio investment in foreign equity outstanding recorded by private institutional investors and ordinary investors (individuals and corporate entities) stands at $254.1 billion, a more than four-fold increase from the end of 2016 (the BOK International Investment Position). 
2) The foreign equity holdings outstanding in the KSD’s Seibro (Securities Information Broadway) represent the gross holdings outstanding centrally deposited with the KSD, including proprietary assets held by corporate entities and securities firms as well as retail investors.
3) With reference to the outbound investment trend of retail investors released occasionally by the Financial Supervisory Service (press release), it can be indirectly estimated that as of the end of August 2020, around 80% of the foreign equity holdings outstanding, placed with Korean Securities Depository, are retail investors’ holdings.
4) As of 2020-end, the outstanding amount of foreign investment funds sold to individuals amounts to about KRW 24 trillion, a 35% decline from the 2011-end level. 
5) The Financial Investment Services and Capital Markets Act obliges domestic investment brokers to have their foreign currency securities centrally deposited with the KSD, as is the case with domestic securities (see Article 61 of the said Act). 
6) Foreign equity transaction fees charged by domestic securities firms roughly range from 7 to 25bp, which are lower than the fees charged in major economies given the trading volume of retail investors (Fidelity, the US financial services company, charges transaction fees of $20 to $50 per deal).
7) An analysis of retail investors’ behavior in the domestic stock market by Kim & Kim (2021) reveals that retail investors have a propensity for aggressive investment and underperform against their institutional counterparts. 
8) The studies suggest that as for institutional investors, risk distribution may act as a statistically significant determinant of outward equity, but it has little statistical significance to retail investors.  
9) Foreign investment bias is measured using divergence between the theoretically optimal asset allocation and the actual regional asset allocation by domestic investors (ranged between the maximum overinvestment bias ‘-1’ and the maximum underinvestment bias ‘+1’).
10) ‘PROSHARES ULTRAPRO QQQ ETF’, which ranked first in terms of the net purchase value for the past six months, is a 3x leveraged inverse ETF that is not permitted in Korea.
11) Markowitz (1952) presents the theoretical foundation for improving risk-adjusted returns through portfolio diversification, and Sonlik (1974) and other studies provide empirical evidence regarding the effects of international portfolio diversification on improving risk-adjusted returns.
12) Home bias measures the tendency of domestic investors to slant toward domestic equity, compared to the theoretically optimal foreign equity portfolio (ranged between 0 (no home bias) and 1 (maximum home bias)). As of end-2018, Korea’s home bias is 0.79, higher than that of the UK (0.33), Germany (0.38), and other major economies.


References

Coeurdacier, N., Rey, H., 2012, Home bias in open economy financial macroeconomics, Journal of Economic Literature 51(1), 63-115.
Markowitz, H., 1952, Portfolio selection, Journal of Finance 7(1), pp.77-91.
Portes, R., Rey, H., 2000, The determinants of cross-border equity flows: The geography of information, CEPR. 
Solnik, B., 1974, An equilibrium model of the international capital market, Journal of Economic Theory 8(4), 500-524.
(Korean)
Kim, M.K. & KIM, J.S., 2021, Retail Investors’ Investment Behavior and Performance in the Face of the Covid-19 Pandemic, Korea Capital Market Institute Issue Paper 21-11.
Kim, H.S., 2017, Research of Foreign Portfolio Investment: Global Status and Determinants, Korea Capital Market Institute Research Paper 17-08.
Kim, H.S., 2020, Domestic Investors’ Outward Equity Investment by Region: Status and Characteristics, Korea Capital Market Institute Issue Paper 20-02.
Kim, H.S., 2021, Analysis of Domestic Investors’ Access to Direct Investing in Foreign Equity and its Implications, Korea Capital Market Institute Issue Paper 21-30.