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

• Author: Shu Lin,Shu Tian,Eliza Wu
• DOI: http://doi.org/10.1111/j.1755-053X.2012.01206.x
• Published date: 01 June 2013
• Date: 01 June 2013

Emerging Stars and Developed

Neighbors: The Effects of Development

Imbalance and Political Shocks on

Mutual Fund Investments in China

Shu Lin, Shu Tian, and Eliza Wu∗

This paper examines the influence of regional economic development on mutual funds investment

decisions. Using fund 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 growthprospects

and diversification benefits. Overall, economic and political factors significantly influence mutual

funds investment decisions in emerging China.

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 f inance 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).

∗Shu Lin is an Associate Professor of Accounting in the School of Business at Nanjing University in Nanjing,P.R. China.

Shu Tian (Corresponding Author)is an Assistant Professor of Finance at the School of Management at Fudan University

in Shanghai, P.R. China. Eliza Wu is an Associate Professor of Finance at the UTS Business School at the University of

Technologyin Sydney, NSW,Australia.

The authors thank Bill Christie (Editor), an anonymous referee,Lu Zheng, Qiao Yu, Qian Sun, Longzhen Fan,and seminar

participants at the University of Technology, Sydney for insightful comments and helpful suggestions.Ms. Wendy Jennings

helped with excellent proofreading. We would like to acknowledge financial support from the National Natural Science

Foundationof China (Grants No. NSFC-71002025, NSFC-70932003, and NSFC-70971025), the National Social Science

Foundation of China (Grant No. 08&ZD050), the Shanghai Foundation for Development of Science and Technology

(Grant No.11692102200), and Fundamental Research Funds for the Central Universities, China. All errors areour own.

Financial Management •Summer 2013 •pages 339 - 371

340 Financial Management rSummer 2013

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.1However, 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.2Figure 2 showsthat by 2009, the nine coastal provinces

generated a gross domestic product (GDP) of 19.30 billion Renminbi (RMB), accounting for 57%

of China’s GDP. Moreover, of the 1,605 stocks listed in China’s A-share market, 880 are from firms

located in these coastal provinces. Furthermore, Chinese mutual funds are located exclusively

in Beijing, Shanghai, and Guangdong province due to rapid economic development, developed

infrastructure, the concentration of public firms, and good human resources in these areas. Hence,

China offers a natural setting to assess whether the imbalance in regional development within a

single financial market may affect domestic institutional investments in public firms locating in

relatively more developed or emerging areas of a country.

One closely related study is Hong, Kubik, and Stein (2008). They find that regional population

density has a significant impact on stock performance via an “only-game-in-town” effect. This

paper differs from Hong et al. (2008) in that they focus on individual investors and analyze the

role of regional features like book value per capita and population density,while our study sheds

new light on mutual fund investment behavior in financial markets with staggered development

across geographic regions. We believe that disparities in regional development may influence

the attractiveness and quality of public firms as investment targets which affects institutional

investors’ behavior. Mutual funds investment decisions in China are important to understand

given the growing pool of assets under management in China and the growing share of the world

mutual funds industry to which China contributes.

Using mutual fund holdings data from June 2003 to December 2008, we find that at

the firm level, Chinese mutual funds tend to hold fir ms that carry lower deadweight costs.

1One exception is Christoffersen and Sarkissian (2009) whoreveal that city size and productivity affect fund performance

due to greater learning opportunities. In terms of stock return predictive ability, Korniotis and Kumar (2011) reveal that

local stock returns vary with local economic variables.

2The coastal area consists of Beijing, Tianjin, Shandong Province,Hebei Province, Shanghai, Jiangsu Province, Zhejiang

Province, Guangdong Province, and Fujian Province. The eight inland neighbor provinces include Liaoning Province,

Inner Mongolia, Shanxi Province, Henan Province, Anhui Province, Jiangxi Province, Hunan Province, and Guangxi

Province. The remaining inland regions are classified as the nonneighbor inland regions.

Lin, Tian, & Wu rEmerging Stars and Developed Neighbors 341

Figure 1. The Coastal Region of China

This figure depicts the geographical coverage of the nine coastal provinces in China. The coastal area

consists of Beijing, Tianjin, Hebei Province, Shandong Province, Jiangsu Province, Shanghai, Zhejiang

Province, Fujian Province, and Guangdong Province.In a later section of this paper, we define eight inland

provinces that are directly connected to the coastal region as the inland neighborhood region that covers

Liaoning, Inner Mongolia, Shanxi, Henan, Anhui, Jiangxi, Hunan, and Guangxi. The remaining provinces

are classified as the far inland region.

Specifically, Chinese mutual funds significantly overweight large, growth, and profitable stocks

with less concentrated ownership, good historical performance, and Shanghai-Shenzhen 300 In-

dex membership. This finding is consistent with evidence from US, Japanese, and European

markets.

At the macroeconomic level, Chinese mutual funds significantly overweight stocks from the

inland region with better growth prospects rather than the more developed local coastal region. If

a stock resides in the inland region, mutual funds will typically overweight it by 15% of its market

portfolio weight despite the implications of an inefficient investment portfolio. This evidence

suggests that the degree of regional economic development (and hence, growth opportunities)

fundamentally influences mutual fund investment behavior in China. However, while Chinese