Why and how do foreign institutional investors outperform domestic investors in futures trading: Evidence from Taiwan

• DOI: http://doi.org/10.1002/fut.21975
• Date: 01 March 2019
• Published date: 01 March 2019

Received: 20 March 2017

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Revised: 23 September 2018

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Accepted: 23 September 2018

DOI: 10.1002/fut.21975

RESEARCH ARTICLE

Why and how do foreign institutional investors outperform

domestic investors in futures trading: Evidence from

Taiwan

Yi‐Wei Chuang

1

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Yu‐Fen Lin

2

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Pei‐Shih Weng

3

1

Department of Economics and Finance,

University of Dayton, Dayton, Ohio

2

Mercuries Life Insurance Co., Ltd,

Taipei, Taiwan

3

Department of Finance, National Dong

Hwa University, Hualien, Taiwan

Correspondence

Pei‐Shih Weng, Department of Finance,

National Dong Hwa University, No.1,

Sec. 2, Da‐Hsueh Road, Shoufeng,

Hualien 97401, Taiwan.

Email: psweng@gms.ndhu.edu.tw

Abstract

A unique data set containing all transactions from the Taiwan Futures Exchange

allows us to dissect the long‐lasting outperformance of foreign institutional

investors in this emerging market. We show that foreign institutional investors

comprehensively outperform domestic investors in trade directions, submission

types, trading counterparties, order sizes, and order aggressiveness. Although

submitting passive orders increases the trading profits of each investor group

significantly, particularly for foreign institutions, the most passive domestic

trades still lose to the mostaggressive foreign institutional trades. We suggest that

information advantage plays a more important role than order submission

strategy in foreign institutional investors’superior performance.

KEYWORDS

foreign institutional investors, futures market, information advantage, order aggressiveness,

trading performance

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INTRODUCTION

Although the research shows mixed findings on the performance of domestic investors and foreign investors, most

findings attribute the better trading performance of investors to an information advantage. For example, Grinblatt and

Keloharju (2000), Froot and Ramadorai (2001), Seasholes (2004), Chiang, Qian, and Sherman (2010), and Chen, Chen,

and Huang (2014) find that foreign institutional investors outperform domestic institutional investors and, thus, view

foreign institutions as informed traders.

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However, Agarwal, Faircloth, Liu, and Ghon Rhee (2009) analyze the trading performance of all traders on the

Indonesia stock market and find that the inferior trading performance of foreign investors in Indonesia is mainly due to

the over‐aggressiveness of foreign investors’trading behavior. It appears that appropriate trading or submission

strategies can, to some extent, also play a major role in explaining investor trading performance. Similarly, Barber, Lee,

Liu, and Odean (2009) show that in the Taiwan stock market, retail traders lose to institutional investors because of

their aggressive orders.

Coupled with the findings of previous studies, an important and unanswered question arises: Which is more relevant

to trading performance: order submission strategy or information advantage? Using a unique data set of the Taiwan

Futures Exchange (TAIFEX), this study examines the trading performance of each investor type in the futures market

in detail to answer this question.

J Futures Markets. 2019;39:279–301. wileyonlinelibrary.com/journal/fut © 2018 Wiley Periodicals, Inc.

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Similarly, Brennan and Cao (1997); Choe, Kho, and Stulz (2001); Hau (2001); and Dvořák (2005) find that foreign investors’performance falls behind that of domestic investors. These studies attribute

the better investment performance of domestic investors to their superior information about trading in the local market.

Ourparticularinterestisinforeigninstitutionaltraders. Foreign institutional investors are known for their

superior trading performance in Taiwan, particularly in the derivatives market. Previous studies show that foreign

institutional trades are the most profitable trades on the TAIFEX (Chang, Hsieh, & Lai, 2009; Chen et al., 2014; Hao,

Chou, Ho, & Weng, 2015; Liu, Tsai, Wang, & Zhu, 2010; Weng & Tsai, 2018). These studies, however, implicitly

attribute the superior performance in trading to a single factor: Either a better order submission strategy or an

information advantage over other traders. An analysis comparing order submission and information advantage has

not been seen in the literature. Moreover, although previous studies on spot markets abound, few examine futures

markets.

Our analysis explores two major questions. First, compared to the whole market, we identify which investor type is

more profitable. Second, we determine whether better trading performance is more related to information advantage or

order aggressiveness. If superior performance is more likely related to information advantage, it will be more valuable

to dissect the information content of foreign institutional trading. Otherwise, the order submission of foreign

institutional investors will be a more effective reference for other traders.

The findings in our study are as follows. Considering the profits in terms of trading prices on average, when

purchasing an index futures contract, on average, foreign institutional investors pay 27, 34, and 35 basis points less than

futures proprietary firms, domestic institutional investors, and domestic individuals, respectively. When selling an

index futures contract, foreign institutional investors receive 36, 28, and 26 basis points more than futures proprietary

firms, domestic institutional investors, and domestic individuals, respectively. These results are consistent with the

literature, indicating that, overall, foreign institutional investors outperform domestic investors. We further compare

the trading performance of foreign institutional traders according to their different counterparties when they trade. We

find that, on average, foreign institutional traders win in transactions regardless of trading counterparty.

Furthermore, we classify executed orders into limit orders and market orders and find that foreign institutional

investors outperform domestic investors in both limit and market orders. For limit buy orders, foreign institutional

investors pay 26 basis points less than futures proprietary firms and 32 basis points less than both domestic institutional

investors and domestic individuals. Meanwhile, for limit sell orders, foreign institutional investors receive 36, 27, and

26 basis points more than futures proprietary firms, domestic institutional investors, and domestic individuals,

respectively. Similarly, foreign institutional investors outperform all types of domestic investors in both market buy and

market sell orders. Although Agarwal et al. (2009) suggest that the dominance of investors in trading activities should

represent the information advantage for their trades, our findings also show that the trading performance of limit orders

is better than that of market orders for all investor groups. This finding implies that the aggressiveness of trading

behavior tends to reduce the trading profits.

We launched a follow‐on examination to analyze the impact of the order aggressiveness of each investor group on its

trading performance. We first consider an investor to be a more aggressive trader if he has a higher probability of having

his limit orders fully executed. Next, we calculate the length of execution time for limit orders. Since a more aggressive

trader is eager to have his orders executed efficiently, the execution time of his orders should be short. As in the

literature, we show that order aggressiveness is related to trading performance: The least aggressive limit orders

perform better than the most aggressive limit orders. We also find that the monotonic relationship is more distinct for

foreign institutional traders. However, the most aggressive limit orders of foreign institutional traders still perform

better than the least aggressive limit orders of all domestic traders.

In sum, the overall evidence shows that foreign institutional traders outperform local traders on the TAIFEX, while

order over‐aggressiveness reduces their trading performance. However, it is worth noting that the most aggressive

foreign institutional traders still perform better than the least aggressive domestic traders, indicating that information is

the primary reason foreign institutional investors usually make profits on the TAIFEX.

Given that some studies find that information advantage is the reason for the better performance of investors while

others find that the better performance of investors is affected by order aggressiveness, our study addresses the question

of whether information advantage or order aggressiveness is more relevant for traders. To the best of our knowledge,

this is the first paper to explore this issue. We believe that this study will verify existing findings and enhance our

understanding of traders’behavior, particularly for foreign institutional traders. Our analysis also presents a practical

implication. Given that local investors have less of an information advantage in the market and their aggressive orders

further reduce trading profits, our advice for domestic traders is to be patient when trading.

The remainder of this study is organized as follows: Section 2 briefly discusses the previous literature; Section 3

describes in detail the data, methodology, and sample construction; Section 4 examines the trading performance of four

investor groups based on various dimensions; Section 5 concludes this study.

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