Chan - Covrig - NG 2005

THE JOURNAL OF FINANCE • VOL. LX, NO.
3 • JUNE 2005
What Determines the Domestic Bias and Foreign

Bias? Evidence from Mutual Fund Equity
Allocations Worldwide
KALOK CHAN, VICENTIU COVRIG, and LILIAN NG∗
ABSTRACT
We examine how mutual funds from 26 developed and developing countries allocate
their investment between domestic and foreign equity markets and what factors de-
termine their asset allocations worldwide. We find robust evidence that these funds,
in aggregate, allocate a disproportionately larger fraction of investment to domestic
stocks. Results indicate that the stock market development and familiarity variables
have significant, but asymmetric, effects on the domestic bias (domestic investors
overweighting the local markets) and foreign bias (foreign investors under or over-
weighting the overseas markets), and that economic development, capital controls,
and withholding tax variables have significant effects only on the foreign bias.
INCREASED ACCESS TO FINANCIAL MARKETS ACROSS the globe has provided expand-
ing opportunities for investors to diversify their investments across many
markets. It is widely recognized that cross-border diversification of equity
portfolios offers potential gains to investors (Grubel (1968), Levy and Sar-
nat (1970), Solnik (1974), Grauer and Hakansson (1987), Eldor, Pines, and
Schwartz (1988), DeSantis and Gerard (1997), among others). Substantial re-
search has shown, however, that investors do not exploit such diversification
opportunities, as they allocate a relatively large fraction of their wealth to do-
mestic equities, a phenomenon commonly called the “home bias”— representing
one of the unresolved puzzles in the international finance literature.1 Earlier
studies in the literature mainly provide theoretical explanations for the ex-
istence of this home bias in the equity markets. Examples of these explana-
tions include that there are barriers to international investment (Errunza and
∗ Chan is from the Department of Finance, Hong Kong University of Science and Technology;
Covrig is from the Department of Finance, Real Estate and Insurance, California State University
at Northridge; and Ng is from the School of Business Administration, University of Wisconsin-
Milwaukee. We thank Susan Christoffersen, Gunter Dufey, Wayne Ferson, Gaston Gelos, Jack Glen,
Takato Hiraki, Michael Phillips, Sergei Sarkissian, Alice Xie, an anonymous referee, the editor
Rob Stambaugh, and participants at Chapman University, Korea University, the 2003 Financial
Management Meetings in Denver, the “Challenges and Opportunities in Global Asset Management”
conference, and the 2004 Western Finance Association Meetings in Vancouver for their helpful
comments and suggestions. Chan acknowledges the Earmarked Grants from the Research Grants
of Hong Kong (HKUST6010/00H) for financial support, and Covrig acknowledges financial support
from the Nanyang Business School of the Nanyang Technological University, Singapore.
1
See Lewis (1999) and Karolyi and Stulz (2003) for excellent surveys of the home bias literature.
1495
1496 The Journal of Finance
Losq (1985)), there are departures from purchasing power parity (Cooper and
Kaplanis (1994)), and there is hedging of human capital or other nontraded
assets (Baxter and Jermann (1997), Stockman and Dellas (1989), Obstfeld and
Rogoff (1998), Wheatley (2001)). Recent empirical studies show that the home
bias in the equity market is not only international, but also regional (Coval and
Moskowitz (1999), Grinblatt and Keloharju (2001)).
A major obstacle to research on the home bias has been the lack of cross-
border holdings data. In many studies, foreign holdings are estimated using
accumulated capital f lows and valuation adjustments (e.g., see Cooper and
Kaplanis (1994), Tesar and Werner (1995), Bekaert and Harvey (2000)). How-
ever, Warnock and Cleaver (2001) show that estimates of country-level holdings
from f low data can be wildly off the mark because the underlying f low data are
not designed to estimate holdings. Some other studies use the comprehensive
surveys of U.S. residents’ holdings of foreign securities conducted by the U.S.
government (Ahearne, Griever, and Warnock (2004)), or data on foreign own-
ership in Japanese firms (Kang and Stulz (1997)). Nevertheless, most of these
studies are from the perspective of U.S. investors, and they leave open the ques-
tion of whether investors in other countries exhibit the same degree of home
bias. A common explanation for the home bias is that U.S. investors are infor-
mationally disadvantaged in markets with poor information disclosure. Since
the United States and other developed markets have higher standards of infor-
mation disclosure, the informational asymmetry between domestic and foreign
investors in these markets is less severe, so that foreign investors might not
underweight their holdings in these developed markets. It is therefore impor-
tant to examine if investors in other markets, especially developing markets,
exhibit a smaller degree of home bias.
This paper makes two important contributions to the existing literature.
First, we study the cross-border investment behavior of investors from vari-
ous countries that include both developed and developing countries. We em-
ploy a rich and interesting data set from Thomson Financial Securities (TFS)
that contains detailed mutual fund equity holdings from 26 developed and de-
veloping countries, with a breakdown of the market value of equity holdings
across 48 countries for the years 1999 and 2000. The data also provide valuable
information on how mutual funds in different countries allocate their portfo-
lios between domestic and nondomestic stocks. This includes the allocations of
stocks held by more than 20,000 mutual funds in 26 countries across 48 equity
markets worldwide. Our extensive analysis of these data allows us to provide
more robust evidence on whether the equity home bias is specific to only the
few developed countries documented in the existing studies, or is widespread
across developed and developing countries.
It is imperative to recognize that our data set contains only stockholdings of
mutual funds from each country for a period of 2 years. Ideally, our analysis
would be more precise if we were to analyze stockholdings of both individual
investors and many different types of institutional investors, including mutual
fund investors. Several studies have provided much evidence that mutual funds
What Determines the Domestic Bias and Foreign Bias? 1497
engage in similar trading strategies as those of other institutional investors.2

Furthermore, mutual fund managers play a relatively significant role as finan-
cial intermediaries in capital markets. Their main responsibility is to manage
assets on behalf of their clients, who primarily are individual investors. Hence,
their portfolio holdings ought to reveal the fund manager’s preferences for do-
mestic versus foreign equities as well as preferences of individual investors,
whose money they manage. It is therefore reasonable to assume that mutual
funds are representative institutional investors of a country. Notwithstanding
this assumption, prior to our work, no study has such similar information avail-
able that allows them to conduct a comprehensive and thorough analysis of the
home-bias issue.
Second, we are able to distinguish the domestic and foreign components of
home bias. The domestic bias ref lects the extent to which mutual fund in-
vestors overweight home markets in their mutual fund holdings, while the
foreign bias ref lects the extent to which investors underweight or overweight
foreign markets. For the purpose of illustration, we use a hypothetical three-
country example, with each country’s market capitalization forming a third of
the world’s market capitalization. Country A’s local investors, in aggregate, put
50% of their wealth in the domestic market and the remaining 50% equally in
countries B and C. A’s domestic investors display a domestic bias, but have an
equal foreign bias toward the equity markets in countries B and C. Country
B’s domestic investors, on the other hand, invest 50% of their aggregate wealth
in their own market, 8.3% in A, and 41.7% in C. Like A’s domestic investors,
B’s local investors exhibit a domestic bias. Unlike A’s, B’s local investors un-
derweight country A (more foreign bias) but overweight country C (less foreign
bias). Finally, C’s domestic investors invest 33.3% of their wealth in the domes-
tic market, 41.7% in country A, and 25.0% in country B. C’s domestic investors
exhibit no domestic bias but only foreign bias, overweighting A, and under-
weighting B.
The domestic and foreign biases, as implied by an international equilibrium
setting, arise from various barriers to cross-border investments. Effects of such
barriers to cross-border investments form deadweight costs for foreign investors
investing in local equities and for domestic investors investing in foreign eq-
uities. If foreign investors face a greater deadweight cost in entering the local
market than domestic investors face, foreign investors will hold less of the local
equities than will domestic investors. As a result, a higher degree of foreign
bias (less investment by foreigners) will be accompanied by a higher degree of
domestic bias (more investment by domestic investors). Thus, our distinction
between the two types of biases permits us not only to analyze how each bias
2
For example, Gompers and Metrick (2001) find that U.S. institutional investors, in general,
show similar preferences for stocks that are larger and more liquid, and He, Ng, and Wang (2004)
find that banks, life insurance companies, mutual funds, and investment advisors are inclined to
engage in similar trading strategies. Dahlquist and Robertsson (2003) find similar evidence using
Swedish data. Using data from 11 developed countries, Covrig, Lau, and Ng (2004) show that
foreign and domestic institutional managers exhibit similar stock preferences as well.
varies across countries, but also to examine whether the investment barriers
have similar or different impacts on the two biases.
We propose a set of predetermined variables, drawn from the existing litera-
ture, as sources of domestic and foreign biases. Given the numerous variables
that are associated with the explanations of the home bias offered in the lit-
erature, we classify them into: (i) economic development, (ii) capital control,
(iii) stock market development, (iv) familiarity, (v) investor protection, and
(vi) other variables. We expect some of these predetermined variables to exhibit
symmetric, while others asymmetric, effects on the domestic and foreign biases.
We therefore investigate how each category of variables affects the weightings
of a particular market’s equities in the mutual fund holdings of domestic and
foreign investors.
Our analysis, based on the 2-year data on the equity holdings of mutual
funds from 26 different countries, shows that equity home bias is ubiquitous.
All 26 countries exhibit domestic bias: the share of mutual fund holdings in the
mutual fund’s domestic market is much larger than the world-market capital-
ization weight of the country. Interestingly, the domestic bias varies substan-
tially across the countries. Greece, for example, has the highest percentage of
average mutual fund holdings in its domestic market (93.5%), as compared to
its mean world market capitalization weight of 0.46%, whereas Ireland has the
lowest with 6.14%, as opposed to its mean world market capitalization weight
of 0.19%. It should be noted that Ireland is a major center for offshore mutual
funds, and this explains why its percentage allocation to the local market is ex-
tremely low. If we exclude Ireland, Austria has the lowest percentage of mutual
fund holdings in its domestic market (6.77%), as opposed to its world market
capitalization weight of 0.09%.
Our results show that the six different categories of predetermined variables
have varying significant effects on the domestic and foreign biases. Only the
stock market development and familiarity variables play an important role
in the domestic bias. These two factors also have significant but asymmetric
effects on the foreign bias. When a host country is more remote from the rest
of the world and has a different language, domestic investors will invest more
in that country’s market, while foreign investors will invest less. Furthermore,
when a host market is more developed, larger in market capitalization, and
has lower transaction costs, foreign investors will invest more and domestic
investors will invest less in the market. These findings suggest that when a
country is more developed or less remote from the rest of the world, this reduces
deadweight costs for foreign investors investing in local equities, resulting in
smaller domestic and foreign biases. The results further indicate that factors
such as economic development, capital control, and withholding taxes also have
significant, albeit smaller, inf luences on the investment decisions of foreign
investors and not on those of domestic investors. The overall results are robust
to countries with closely held firms and to the place of incorporation of funds.
The remainder of this paper is organized as follows. Section I provides a the-
oretical framework that forms the basis of our empirical analysis. Section II
describes the mutual fund holdings data and measures of domestic and foreign
biases. This section also offers some preliminary statistics on the two mea-
sures of biases. Section III discusses the variables that are likely to inf luence
such biases. Section IV presents the empirical analyses and results. Section V
concludes the paper.
I. Theoretical Framework
Cooper and Kaplanis (1986) offer a theoretical framework that is excellent
for our analysis of domestic and foreign biases. Their model assumes that a
representative investor in country i maximizes the expected return of his or
her wealth for a given level of variance:
Max(wi R − wi ci ), (1)
subject to
wi V wi = v
wi I = 1,
where wi is a column vector containing the portfolio weights, the jth element
of which is wij , wij is the proportion of individual i’s total wealth invested in
risky securities of country j, R is a column vector of pre-tax expected returns,
ci is a column vector, the jth element of which is cij , cij is the deadweight cost to
investor i of holding securities in country j, V is the variance/covariance matrix
of the gross (pre-cost, pre-tax) returns of the risky securities, v is the given
constant variance, and I is a unity column vector.
The Lagrangean of the above maximization problem is
L = (wi R − wi ci ) − (h/2)(wi V wi − v) − ki (wi I − 1), (2)
where h and ki are Lagrange multipliers. Setting the derivative of the objective
function with respect to wi to zero, we get
R − ci − hV wi − ki I = 0. (3)
Therefore, the optimal portfolio for investor i is
wi = (V −1 /h)(R − ci − ki I ), (4)
where

ki = I V −1 R − I V −1 ci − h I V −1 I .
Given the individual portfolio holdings, we can now aggregate to get the world
capital market equilibrium. The market clearing condition is
Pi wi = w∗ , (5)
where Pi is the proportion of world wealth owned by country i, w∗ is a column
vector, the ith element of which is wi∗ , and wi∗ is the proportion of the world
market capitalization in country i’s market.
Using equations (4) and (5) and defining z as the global minimum-variance
portfolio (=V −1 I/(I V −1 I)), we can obtain
hV (wi − w∗ ) = ( Pi ci − ci ) − z ( Pi ci − ci )I . (6)
If there is no barrier for any investor to access both the domestic and the foreign
markets such that the deadweight costs (cij ) are equal to zero for all i and j,
then the right-hand side of (6) is zero and each investor holds the world market
portfolio.
If deadweight costs are not equal to zero, then the portfolio holdings of each
investor will deviate from the world market portfolio. To examine the deviation,
we consider a simple case when the covariance matrix, V, is diagonal with all
variances equal to s2 . The deviations of the portfolio weight of investor i in
country j from the world market portfolio are given by

hs2 wii − wi∗ = −cii + bi + ai − d , i= j (7)

hs2 wij − w∗j = −cij + b j + ai − d , i = j (8)
where
ai = z ci ,
b j = Pk ck j ,
d = z Pi ci .
The value ai can be interpreted as the weighted average marginal deadweight

cost for investor i, bj as the weighted average marginal deadweight cost for
investors investing in country j, and d as the world-weighted average marginal
deadweight cost. Equation (7) measures the extent to which the mutual fund
holdings of investor i in the domestic market deviate from those of the world
market portfolio, whereas equation (8) measures the extent to which the mu-
tual fund holdings of investor i in foreign market j deviate from those of the
world-market portfolio. For convenience, we refer to the former as domestic bias
(DBIASi ) and the latter as foreign bias (FBIASij ).
From equation (7), if the deadweight cost for investor i investing in her own
country i (cii ) is substantially less than the weighted average deadweight cost
for world investors (bi ), she will overweight domestic country (DBIASi > 0).
Investor i will also overweight her domestic country if the weighted average
deadweight cost she faces (ai ) is large enough that she is discouraged from in-
vesting in foreign countries. Equation (7) further shows that a country would
not experience domestic bias if the deadweight costs for domestic (cii ) and for-
eign investors (bi ) investing in country i were symmetric. In other words, if
the transaction cost in country i is higher than that in country j, and if the
transaction cost applies symmetrically to domestic and foreign investors in
both markets, then we would not expect the degree of domestic bias to differ
between the two countries.
Equation (8) indicates that the difference between the deadweight cost for
investor i investing in country j (cij ) and the weighted average deadweight cost
for world investors (bj ) affects how much investor i invests in country j. If cij
is significantly larger than bj , investor i underweights country j (FBIASij < 0).
Furthermore, the higher the deadweight cost, cij , the larger is the foreign bias
for investor i investing in country j (a more negative FBIASij ).
II. Data and Preliminary Statistics

A. Data
The key data set for the current study consists of mutual fund holdings data
from 26 countries in 1999 and 2000, with a breakdown of the market value of
equity holdings across 48 countries. The data are obtained from TFS, which
was created by the merger of The Investext Group, Securities Data Company,
and CDA/Spectrum. According to TFS, the mutual fund holdings information
around the world is gathered from agents of the local authorities,3 and directly
from mutual funds. All the information is available at the fund level.
The TFS database contains information on the equity holdings of 21,711
mutual funds from 37 countries in 1999 and of 26,145 funds from 39 coun-
tries in 2000. In our study, we use only 20,821 and 24,589 mutual funds from
26 countries in 1999 and 2000, respectively. To simplify our further discussion,
we refer to the 26 countries as “host” countries. These 26 host countries account
for about 93% of the total market capitalization in our sample. The remaining
countries are all emerging markets, and their funds are invested entirely in
local markets. When we include the emerging markets as host countries, our
results on the domestic bias are much stronger than those reported here. This
is because the predetermined variables that we employ play a more vital role
in these emerging markets than in the 26 developed markets. To make our re-
sults consistent with the foreign-bias results, we focus only on the mutual fund
holdings of the 26 host countries.
The database contains three data files: (i) the Fund Master File, containing
the fund number, fund name, management company name, country code, and
report date; (ii) the Security Master File, containing the security number, se-
curity name, country code, security price, and shares outstanding; and (iii) the
Portfolio Holdings File, reporting the fund number, security number, number
of shares held by the fund, and net changes in shares held since prior report
dates. The country code of a fund is based on the country of incorporation. Thus,
some of the funds might in fact be feeder funds, and this could pose a problem
when we need to classify them into domestic versus foreign funds, in order to
determine the degree of domestic bias that a mutual fund displays. We address
this issue later in this study. We note that the report dates vary across differ-
ent funds. About one-third of the mutual funds report holdings at least twice a
3
For example, CDA/Spectrum, acting on behalf of the U.S. Securities Exchange Commission,
collects quarterly 13f institutional holdings and semi-annually mutual funds holdings information.
year, and about half only twice a year. To compute equity holdings, we use the
holdings that are reported on various dates between July and December of 1999
and 2000, because more than 75% of the funds report holdings in December. Fi-
nally, the funds are both closed-end and open-end mutual funds or unit trusts.
For the purpose of this study, we include funds of all types, but only the equity
portion of those that are not 100% invested in stocks. The reason for the latter
is that TFS does not provide any information on the cash and bond holdings
of a fund. According to company representatives, TFS gathers information on
the equity holdings of almost all of the various funds from each of the countries
in their database, but might exclude some of the newly established funds. The
“missing” new funds that were established in 1999 are subsequently included
in their 2000 database.
We therefore checked the coverage of funds by TFS with the summary statis-
tics on mutual funds provided by the Investment Company Institute (ICI). The
TFS information includes only funds that own at least one equity share, while
ICI reports all types of mutual funds, including equity funds, money market
funds, and fixed income funds but excluding closed-end funds. As a result, there
is a large variation in the number of funds and the size of the mutual fund mar-
ket between the two sets of data. For example, in 1999, the number of funds
reported by TFS and ICI data are, respectively, 1,369 and 6,511 for France;
1935 and 1,618 for the United Kingdom; and 4,095 and 895 for Germany. The
larger number of funds in the TFS sample versus that in ICI is due to the fact
that the TFS sample includes both open- and closed-end funds, while the ICI
data set covers only open-end funds. We further checked that the United King-
dom has more than 500 closed-end funds, so this could potentially explain the
differences between the two data sources. We also verified with S&P Micropal
fund data and found that the number of German funds contained in their data
set is consistent with the number contained in the TFS database.
The TFS data set certainly affords us an excellent opportunity to study mu-
tual fund equity allocations worldwide, but unfortunately it does not give in-
formation on the investment style of each fund. One way to determine the
investment style is to look at the name of the fund. On average, however, of
less than 1% of the funds from each country (though 14% of the U.S. funds), the
name reveals the investment styles. We therefore propose a simple approach
to determine each fund’s investment style. While our approach is not perfect,
it ought to give us some idea on the distribution of the investment styles of all
the funds in our sample. To begin, we classify funds into domestic and interna-
tional funds. Domestic funds are those with more than 80% of their total net
asset value invested in domestic stocks. Otherwise, the funds are classified as
international funds. Next, we determine the investment style of each fund as
follows.
For each market, we sort all the stocks based on their market capitaliza-
tion (firm size) and book-to-market equity, separately, to determine the median
value of each characteristic. Data on firm size and book-to-market equity are
obtained from either Worldscope or Global Vantage. We then assign a dummy
variable of one to all stocks whose firm size or book-to-market equity is greater
than the median value and zero otherwise. For each fund, we calculate its
value-weighted average dummy firm size or its value-weighted average dummy
book-to-market equity of its stockholdings. Based on the value-weighted aver-
age dummy firm size, we sort funds into three groups: large, mid-cap, and small
funds. Similarly, based on the value-weighted average dummy book-to-market
equity, we sort funds into two groups: value and growth funds. Table I shows
the distribution of the fund investment styles across the 26 host countries. Not
surprisingly, the majority of both the domestic and international funds are large
or growth funds. Consistent with earlier studies in the literature, mutual funds
tend to invest more in larger firms. After comparing the domestic and inter-
national funds, we notice that, in almost all of the 26 countries, the majority
of the international funds focus on growth, whereas in only 14 countries the
majority of domestic funds are growth funds. All these patterns suggest that
international funds generally prefer to invest in large firms.
B. Statistics on Mutual Fund Holdings

For each of the 26 host countries, we calculate the percentage allocation of
mutual fund holdings in 48 countries as follows:
MV ij
wij = , (9)

48
MV ij
j =1
where wij is the share of country j in mutual fund holdings for host country i and
MVij is the market value of mutual fund holdings of country j for host country
i. We also compute the weight of country j in the world market portfolio, which
is defined as the portfolio of the 48 countries included in the sample
MV ∗j
w∗j = , (10)

48
MV i∗
i=1
where wj∗ is the share of country j in the world market portfolio and MV ∗j is the
market capitalization of country j. We compute wij in 1999 and 2000 separately
and then take a simple average of the two values.
Table II presents the distribution of 26 host countries’ average equity mutual
fund allocations (in percentage) across 48 national markets in the world. It
also contains the average number of mutual funds in each of the 26 countries
(second row) and the mean total market value of fund holdings (third row)
for the 2 years in the sample. On average, the United States has the largest
number of mutual funds (6,144), followed by Germany (4,493) and the United
Kingdom (2,021). Correspondingly, the overall market capitalization of each
of their countries’ funds is about US$ 3 trillion, US$ 380 million, and US$
605 million, respectively. Even though the number of funds in the United States
Table I
Distribution of Fund Investment Styles across 26 Host Countries
This table contains the distribution of investment styles of funds across the following 26 countries
in 1999: the United States (US), the United Kingdom (UK), Canada (CA), Germany (GM), Italy (IT),
Sweden (SW), France (FR), Switzerland (SZ), Austria (AU), Belgium (BE), Denmark (DA), Ireland
(EL), Finland (FI), Greece (GR), Luxembourg (LU), Norway (NO), Portugal (PO), Spain (SP), the
Netherlands (NL), Japan (JA), Australia (AS), Singapore (SN), Hong Kong (HK), New Zealand (NZ),
Taiwan (TW), and South Africa (SF). Domestic funds are those with more than 80% of their total
net asset value invested in domestic stocks. Otherwise, the funds are classified as international
funds. The investment styles of funds are determined as follows. For each market, we sort all the
stocks based on their market capitalization (firm size) and book-to-market equity (BM), separately,
to determine the median value of each characteristic. We then assign a dummy variable of one to all
stocks whose firm size or BM is greater than the median value and zero otherwise. For each fund,
we calculate its value-weighted average dummy firm size or its value-weighted average dummy BM
of its stockholdings. Based on the value-weighted average dummy firm size, we sort funds into three
groups: large, mid-cap, and small funds. Similarly, based on the value-weighted average dummy
BM, we sort funds into two groups: value and growth funds.
Domestic Funds International Funds

Number of
Country Funds Large/Mid Small Value Growth Large/Mid Small Value Growth
US 6,444 4,205 935 1,693 3,447 1,145 159 376 928

UK 1,935 432 179 336 275 1,153 171 482 842
CA 1,264 771 274 552 493 197 22 72 147
GM 4,095 453 49 240 262 3,543 50 1,557 2,036
IT 320 71 24 59 36 211 14 103 122
SW 308 19 10 9 20 247 32 73 206
FR 1,369 467 170 264 373 645 87 241 491
SZ 321 24 26 31 19 254 17 116 155
AU 117 17 4 8 13 89 7 40 56
BE 314 47 14 25 36 225 28 122 131
DA 119 14 10 11 13 83 12 40 55
EL 142 14 5 10 9 107 16 46 77
FI 58 21 6 12 15 23 8 13 18
GR 34 16 4 12 8 13 1 5 9
LU 777 0 0 0 0 671 106 402 375
NO 148 33 5 17 21 102 8 35 75
PO 168 85 14 47 52 67 2 31 38
SP 1,547 575 61 347 289 894 17 405 506
NL 157 22 14 20 16 107 14 36 85
JA 203 61 29 65 25 111 2 32 81
AS 120 64 22 38 48 29 5 8 22
SN 166 16 3 8 11 140 7 40 107
HK 289 52 4 25 31 208 25 54 179
NZ 44 16 8 13 11 18 2 9 11
TW 181 144 4 62 86 33 0 14 19
SF 181 68 18 55 31 93 2 40 55
is about three times larger than that in the United Kingdom and 1.4 times
larger than that in Germany, the size of the U.S. funds is at least five and eight
times, respectively, larger than the funds in the United Kingdom and Germany.
The size of U.S. mutual funds ref lects both the rising stock market value and
the tremendous growth in its mutual funds industry in the later part of the
1990s.
To highlight the extent of the domestic bias, we shade all cells in the table that
contain the share of mutual fund holdings in the domestic market of the 26 coun-
tries and also present the average world market capitalization weight of each
country (Column 2). It is immediately obvious that the domestic bias exists in
every country. Across all 26 countries, the share of mutual fund holdings in the
domestic market is much larger than the world market capitalization weight
of the country. Greece, for example, has the highest percentage of mutual fund
holdings in the domestic market (93.5%), compared to its world market capital-
ization weight of 0.46%. The United States has the second highest percentage
in the domestic market (85.7%), although its deviation from the world market
capitalization weight (46.9%) is much smaller than that of Greece. Ireland has
the lowest percentage of mutual fund holdings in the domestic market (6.14%),
but it is still above its world market capitalization weight (0.19%). The low
percentage of domestic investments for the latter is consistent with the fact
that Ireland is a major center for offshore mutual funds, providing important
incentives to fund operators in the form of reduced taxes. Therefore, many mu-
tual funds domiciled in Ireland are bought by investors outside Ireland. If we
exclude Ireland, Austria has the lowest percentage of mutual fund holdings
in its domestic market (6.77%), as opposed to its world market capitalization
weight of 0.09%.
There is also prevalent evidence that investors do underweight foreign mar-
kets in their mutual fund portfolios. The figures in the nonshaded cells in the
table represent the percentage allocations of mutual fund holdings in different
foreign markets; they are generally much smaller than the world market cap-
italization weights of the corresponding foreign markets. There are, however,
some exceptions. Interestingly, the exceptions appear to occur among coun-
tries on the same continent or in the same region. For example, Canadian in-
vestors overweight the U.S. market in their mutual fund portfolios (i.e., 61.9%
vs. 46.9%), Taiwanese investors overweight the Japanese market (i.e., 22.3% vs.
11.3%), New Zealand investors overweight the Australian market (i.e., 14.4%
vs. 1.2%), and Hong Kong investors overweight the Singapore market (i.e., 7.7%
vs. 0.5%). This table provides preliminary evidence that geographical proxim-
ity plays a vital role in determining the extent to which investors overweight
foreign markets.
C. Statistics on Domestic Bias and Foreign Bias

In this study, we compute measures of the domestic and foreign biases for
every country, based on the country’s equity mutual fund allocations. As de-
fined earlier, the domestic bias for a specific host country j (DBIASj ) is the
extent to which the mutual fund holdings in the domestic market of country j
deviate from the holdings of country j in the world market portfolio. The value
DBIASj is therefore defined as the log ratio of the share of country j’s mutual
fund holdings in the domestic market (wjj ) to the world market capitalization
Table III
Domestic Bias of Domestic Investors and Average Foreign Bias
of Foreign Investors
The table shows the distribution of the domestic bias of domestic investors and the average foreign
bias of foreign investors in a host country, across the 26 host countries. The home bias for country
j ref lects the deviation of the share of country j in its mutual fund holdings (wjj ) from the world
market capitalization weight of country j (wj∗ ), and is measured by log(wjj /wj∗ ), while the foreign
bias ref lects that of country j in mutual fund holdings for each host country i (i = j) (wij ) from the
world market capitalization weight of country j (wj∗ ), which is given by log(wij /wj∗ ). We calculate
the average foreign bias of foreign investors in a host country j by averaging FBIASj across all
remaining countries. The table shows the average values for the sample period of 1999 and 2000.
Domestic Bias Average Foreign Bias
US 0.61 −1.43
UK 1.67 −0.41
CA 2.41 −2.53
GM 2.12 −0.65
IT 2.77 −1.20
SW 3.81 −0.41
FR 2.55 −0.44
SZ 2.26 −0.60
AU 4.28 −1.79
BE 3.77 −2.26
DA 4.07 −1.30
EL 3.06 −0.97
FI 3.86 0.06
GR 5.35 −3.40
LU 4.87 −1.61
NO 5.55 −1.71
PO 5.48 −1.56
SP 3.22 −0.72
NL 2.27 −0.35
JA 1.86 −0.97
AS 3.94 −1.23
SN 3.55 −0.85
HK 2.66 −1.54
NZ 7.00 −2.38
TW 4.21 −3.07
SF 4.57 −3.54
weight of country j (wj∗ ). If country j exhibits a domestic bias, then it has a

positive DBIASj . On the other hand, the foreign bias shows the extent to which
domestic investors underweight or overweight foreign markets in their mutual
fund holdings. Similar to the domestic-bias measure, a foreign-bias measure
(FBIASij ) is defined as the log ratio of wij to wj∗ .
In the preceding subsection, we established that the home bias is prevalent
across all countries. Intuitively, when domestic investors overinvest in their
local market, foreign investors must on average underinvest in the market.
As a matter of interest, we show in Table III how the average foreign bias is
distributed across the 26 host countries. The average foreign bias of foreign
investors in a host country j is calculated by averaging FBIASij across all

countries.
In general, we observe a significant cross-sectional variation in both the
domestic-bias measure and average foreign-bias measure. The former varies
from 0.62 (the United States) to 6.93 (New Zealand), and the latter ranges be-
tween −0.13 (Finland) and −3.32 (Greece). While this result confirms the well-
documented evidence that the home bias is robust, how this bias varies across
countries and the factors that explain this cross-sectional variation are, unfor-
tunately, lacking. We address this issue in subsequent sections of the paper.
III. Plausible Sources of Domestic Bias and Foreign Bias

In this section, we introduce some explanatory variables and discuss how
they affect international portfolio holdings. Drawn mainly from the existing
literature, the explanatory variables are categorized into the following groups:
(i) economic development; (ii) capital control; (iii) stock market development;
(iv) familiarity; (v) investor protection; and (vi) others. We calculate the de-
scriptive statistics of all these explanatory variables for the period 1999 and
2000. We find the cross-sectional variation of these measures across our sam-
ple of countries to be generally stable over the 2 years. Thus, for the purpose
of reporting and discussion, we focus only on the 1999 data, as presented in
Table IV.
A. Economic Development
We conjecture that the percentage of mutual fund holdings in a particular
country is related to the economic development of that country. We construct
several measures of economic development. The first four measures are gross
domestic product (GDP) per capita in U.S. dollars (GDPC); the real growth rate
in the gross domestic product (RGDP); the average of exports and imports scaled
by GDP (TRADE); and foreign direct stock investment inward, scaled by GDP
(DI). Data on these four variables are obtained from the World Competitiveness
Report 2000 produced by the World Economic Forum. The last variable is the
country credit rating (CREDIT), which is based on a scale of 0–100 as assessed
by the Institutional Investor Magazine.
Table IV shows a significant cross-sectional variation in the five measures
of economic development across countries, implying that the different mea-
sures capture different aspects of economic development in each country. While
the top countries in terms of GDPC are all developed markets (Luxembourg
(US$ 44,424), Switzerland (US$ 36,071), Japan (US$ 34,459), and the United
States (US$ 33,846)), the top countries in terms of RGDP are all emerging
markets (China (7.1%), Korea (6.9%), India (5.8%), and Poland (5.7%)). The
countries with the highest foreign direct stock investment inward scaled by
GDP are Singapore (1.01), Belgium (0.67), and New Zealand (0.64), while the
countries with the largest trade volume as a percentage of GDP (TRADE) are
Singapore (149.6%), Hong Kong (129.0%), and Malaysia (106.7%).
1512
Table IV
Summary Statistics for the Explanatory Variables in 1999
For each country, the six sets of explanatory variables employed are (i) Economic development variables, including gross domestic product (GDP) per capita,
real GDP growth, trade volume as a percentage of GDP, foreign direct investment as a percentage of GDP, and country credit rating; (ii) Capital control
variables, including capital f low restrictions; (iii) Stock market development variables, including stock market capitalization as a percentage of GDP, market
turnover, transaction costs, and emerging market dummy variables; (iv) Familiarity variables, including average common language dummy variable, and
average distance in kilometers; (v) Investor protection variables, including rule of law index, accounting standard index, minority investor protection index,
risk of expropriation index, efficiency of judicial system index, and legal system dummy variable; (vi) Other variables, including past 1- and 5-year return
performances, average return correlation, and average withholding tax.
Panel A
The Journal of Finance

Economic Development Capital Stock Market Development Familiarity
Control
GDP Real Foreign Stock Common
Per GDP Trade Direct Country Capital Market Emerging Language
Capita Growth Volume Investment Credit Flow Capitalization Transaction Market Dummy
($) (%) (% of GDP) (% of GDP) Rating Restrictions (% of GDP) Turnover Costs Dummy (Average)
US 33,846 3.8 11.9 0.09 90.9 10 1.80 113.4 29.2 0 0.21

UK 24,168 1.9 27.5 0.23 90.2 10 2.07 48.2 34.1 0 0.21
CA 20,890 3.7 40.9 0.22 83.5 10 1.25 60.9 46.8 0 0.25
GM 25,508 1.0 28.1 0.11 92.0 10 0.68 122.6 30.6 0 0.04
IT 20,014 1.3 24.8 0.09 81.3 10 0.63 74.3 41.0 0 0.00
SW 26,630 3.9 40.5 0.23 81.2 10 1.58 70.5 33.0 0 0.00
FR 24,058 2.7 25.5 0.12 91.4 5 1.04 63.3 35.7 0 0.06
SZ 36,071 1.7 38.6 0.23 93.0 10 2.70 89.7 38.6 0 0.11
AU 25,452 2.0 45.7 0.12 89.4 8 0.16 54.3 53.2 0 0.04
BE 23,871 2.2 73.9 0.67 84.9 10 0.76 25.3 27.1 0 0.06
DA 32,675 1.3 35.5 0.18 85.1 10 0.61 58.4 40.8 0 0.00
EL 24,353 8.6 92.7 0.26 83.4 8 0.47 87.2 93.7 0 0.21
FI 24,430 3.7 35.5 0.12 83.6 8 2.77 48.8 45.2 0 0.00
GR 11,407 3.3 15.2 0.18 59.1 8 1.70 102.7 105.1 1 0.00
ISRAEL 16,167 2.3 36.6 0.09 55.8 2 0.65 28.2 N.A. 1 0.00
LU 44,424 5.1 86.7 N.A. 90.3 N.A. 1.92 N.A. 43.2 0 0.06
NO 34,269 0.6 35.8 0.16 87.7 8 0.42 82.6 41.5 0 0.00
PO 10,322 3.1 37.0 0.21 78.4 8 0.66 64.5 35.7 1 0.02
SP 15,124 3.7 27.3 0.20 81.7 8 0.72 174.2 39.2 0 0.15
NL 24,299 3.4 61.5 0.44 91.2 10 1.81 106.2 24.5 0 0.00
JA 34,459 0.6 11.0 0.01 86.5 8 1.04 49.9 19.4 0 0.00
AS 20,441 4.3 21.0 0.27 75.8 8 1.10 40.1 54.7 0 0.21
SN 21,814 5.3 149.6 1.01 81.9 10 2.34 58.5 51.5 0 0.28
What Determines the Domestic Bias and Foreign Bias?

HK 23,019 2.9 129.0 0.61 61.3 10 3.84 82.4 47.3 0 0.26
NZ 13,944 2.7 31.0 0.64 74.0 8 0.53 41.5 36.9 0 0.21
INDIA 446 5.7 14.5 0.03 44.2 0 0.42 63.7 113.3 1 0.21
KOREA 8,682 6.6 45.4 0.05 56.8 5 0.76 267.2 73.2 1 0.00
MALAYSIA 3,596 5.4 106.7 0.52 51.7 5 1.84 56.6 91.7 1 0.02
THAILAND 2,027 4.1 54.1 0.16 48.3 5 0.47 63.4 65.0 1 0.00
TW 13,111 5.6 47.5 0.07 75.3 5 1.30 374.1 55.1 1 0.06
INDONESIA 741 0.0 49.0 0.40 27.1 0 0.42 57.8 107.3 1 0.00
PHILIPPINES 996 2.4 60.2 0.13 45.9 5 0.63 41.3 126.2 1 0.21
MEXICO 4,964 3.1 32.2 0.13 48.2 5 0.32 33.7 51.5 1 0.15
BRAZIL 3,697 0.8 8.9 0.26 36.5 0 0.38 65.5 50.6 1 0.02
ARGENTNA 7,816 −4.1 10.4 0.16 42.4 10 0.29 30.8 58.0 1 0.15
CHILE 4,346 −1.5 28.5 0.47 61.0 5 1.05 11.1 107.4 1 0.15
COLOMBIA 2,233 −3.5 17.1 0.15 44.1 5 0.12 8.0 195.1 1 0.15
PERU 2,097 −2.4 18.3 N.A. 37.3 8 N.A. 22.2 71.6 1 0.15
VENEZUELA 4,238 −4.5 20.4 0.18 33.8 5 0.07 20.8 239.5 1 0.15
RUSSIA 1,245 3.2 30.1 0.07 19.3 N.A. 0.40 N.A. N.A. 1 0.00
HUNGARY 4,915 4.1 60.3 0.37 57.3 N.A. 0.33 N.A. 66.3 1 0.00
CZECH 5,167 0.8 60.8 0.25 59.1 N.A. 0.22 N.A. 69.7 1 0.00
POLAND 3,759 5.7 28.9 0.15 57.5 N.A. 0.20 N.A. N.A. 1 0.00
PAKISTAN 489 N.A. N.A. N.A. N.A. 2 N.A. 223.1 N.A. 1 0.00
SF 3,046 2.1 25.6 0.14 45.6 2 2.00 26.4 55.8 1 0.21
TURKEY 2,867 −4.8 25.9 0.04 38.9 2 0.61 120.4 47.0 1 0.00
EGYPT 1,392 1.1 N.A. N.A. 44.2 5 N.A. 52.1 N.A. 1 0.00
CHINA 782 7.1 19.6 0.26 56.4 N.A. 0.33 N.A. N.A. 1 0.06
(continued)
1513
1514
Table IV—Continued
Panel B
Familiarity Investor Protection Other Variables
The Journal of Finance

Distance Legal Lag Lag Return Withholding
(Kilometers) Rule of System 1-Year 5-Year Correlation Tax (%)
(Average) Law Accounting Minority Expropriation Efficiency Dummy Return Return (Average) (Average)
US 8,535 10.0 71 5 9.98 10.0 1 18.3 21.5 0.51 11.4

UK 5,727 8.57 78 4 9.71 10.0 1 21.9 14.8 0.53 10.6
CA 8,562 10.0 74 4 9.67 9.25 1 35.5 15.6 0.55 12.1
GM 5,547 9.23 62 1 9.90 9.00 0 12.8 14.5 0.51 11.6
IT 5,636 8.33 62 0 9.35 6.75 0 2.4 19.3 0.42 12.4
SW 5,650 10.0 83 2 9.40 10.0 0 51.2 23.9 0.50 11.8
FR 5,688 8.98 69 2 9.65 8.00 0 26.9 20.6 0.48 10.5
SZ 5,591 10.0 68 1 9.98 10.0 0 −4.3 10.0 0.42 11.2
AU 5,528 10.0 54 2 9.69 9.50 0 −8.3 −3.1 0.42 10.4
BE 5,614 10.0 61 0 9.63 9.50 0 −24.9 10.5 0.31 12.1
DA 5,563 10.0 62 3 9.67 10.0 0 7.7 14.3 0.45 11.7
EL 5,910 7.80 74 3 9.67 8.75 1 −13.8 14.3 0.43 13.5
FI 5,712 10.0 77 2 9.67 10.0 0 64.7 52.8 0.39 11.5
GR 5,848 6.18 55 1 7.12 7.00 0 50.5 33.8 0.31 15.8
ISRAEL 5,456 4.82 64 3 8.25 10.0 1 62.8 24.7 0.27 19.3
LU 5,586 N.A. N.A. N.A. N.A. N.A. N.A. 28.1 22.3 0.39 14.1
NO 5,688 10.0 74 3 9.88 10.0 0 34.0 7.0 0.50 13.1
PO 6,386 7.80 36 2 8.90 5.50 0 −8.8 15.6 0.38 15.9
SP 6,129 7.80 64 2 9.52 6.25 0 −1.2 17.8 0.47 12.9
NL 5,610 10.0 64 2 9.98 10.0 0 24.4 24.2 0.50 11.8
JA 8,574 8.98 65 3 9.67 10.0 0 62.3 2.9 0.33 12.6
AS 13,102 10.0 75 4 9.27 10.0 1 20.3 7.2 0.48 13.4
SN 9,498 8.57 78 3 9.30 10.0 1 64.1 −1.2 0.44 14.3
HK 8,812 8.22 69 4 8.29 10.0 1 51.6 5.6 0.46 19.2
NZ 14,300 10.0 70 4 9.69 10.0 1 9.7 −5.0 0.47 14.2
What Determines the Domestic Bias and Foreign Bias?

INDIA 7,236 4.17 57 2 7.75 8.00 1 67.8 17.1 0.27 18.5
KOREA 8,020 5.35 62 2 8.31 6.00 0 113.3 3.5 0.39 17.2
MALAYSIA 9,083 6.78 76 3 7.95 9.00 1 73.4 −28.3 0.17 18.5
THAILAND 8,405 6.25 64 3 7.42 3.25 1 25.5 −44.3 0.37 16.2
TW 8,780 8.52 65 3 9.12 6.75 0 44.7 10.2 0.36 18.6
INDONESIA 9,917 3.98 65 2 7.16 2.50 0 52.7 −39.2 0.35 21.4
PHILIPPINES 9,102 2.73 65 4 5.22 4.75 0 12.9 −19.2 0.43 22.1
MEXICO 10,100 5.35 60 0 6.07 6.00 0 54.1 8.5 0.52 16.9
BRAZIL 10,489 6.32 54 3 7.62 5.75 0 48.8 −3.2 0.49 17.4
ARGENTNA 12,059 5.35 45 4 5.91 6.00 0 23.8 3.4 0.49 17.8
CHILE 12,405 7.02 52 3 7.5 7.25 0 28.4 −9.0 0.41 22.6
COLOMBIA 10,267 2.08 50 1 6.95 7.25 0 −6.9 −7.6 0.11 21.9
PERU 11,462 2.50 38 2 5.54 6.75 0 24.9 1.0 0.23 18.8
VENEZUELA 9,527 6.37 40 1 6.89 6.50 0 6.4 3.2 0.28 17.3
RUSSIA 4,993 N.A. N.A. N.A. N.A. N.A. N.A. 89.2 −38.8 0.22 13.2
HUNGARY 4,332 N.A. N.A. N.A. N.A. N.A. N.A. 24.5 34.1 0.48 15.5
CZECH 4,187 N.A. N.A. N.A. N.A. N.A. N.A. 25.5 5.8 0.32 18.3
POLAND 4,289 N.A. N.A. N.A. N.A. N.A. N.A. 25.5 3.3 0.47 11.3
PAKISTAN 6,495 3.03 61 4 5.62 5.00 1 49.1 5.6 0.24 16.3
SF 9,610 4.42 70 4 6.88 6.00 1 45.1 −7.1 0.53 13.5
TURKEY 4,966 5.18 51 2 7 4.00 0 121.6 20.4 0.41 18.7
EGYPT 5,452 4.17 24 2 6.3 6.50 0 43.7 13.6 0.16 24.4
CHINA 8,130 N.A. N.A. N.A. N.A. N.A. N.A. 14.2 22.2 0.07 13.2
1515
A country’s level of advancement in economic development ought to affect

its ability to draw foreign investment to the country. Whether such advance-
ments have similar or different effects on domestic and foreign biases depends
on how domestic and foreign investors evaluate this factor for investment pur-
poses. If a country’s advancement in economic development could help lower the
deadweight cost for foreign investors much more than for domestic investors,
more foreign investors would be attracted to invest in the country and, as a
result, fewer domestic investors would hold local equities. On the other hand,
if a country’s advancement in economic development could lower the dead-
weight cost for both domestic and foreign investors symmetrically, none of the
economic-development measures would have any different impacts on foreign
and domestic biases.
B. Capital Control
Although capital control has been greatly reduced in many countries, some
countries still place restrictions on foreign equity investment and international
capital f low. Conceivably, capital control can still affect cross-border invest-
ment. The Economic Freedom Network constructs an index that measures the
restrictions countries impose on capital f lows (RFLOW) by assigning lower
ratings to countries with more restrictions on foreign capital transactions.
When domestic investments by foreigners and foreign investments by local
residents are unrestricted, a rating of 10 is assigned to such countries. When
these investments are restricted only in a few industries (e.g., banking, de-
fense, and telecommunications), countries are assigned a rating of 8. When
these investments are permitted but regulatory restrictions slow the mobility
of capital, countries are rated 5. When either domestic investments by foreign-
ers or foreign investments by local residents require approval from government
authorities, such countries receive a rating of 2. A 0 rating is assigned when
both domestic investments by foreigners and foreign investments by locals re-
quire government approval. The RFLOW data are downloaded from the website
http://www.freetheworld.com. In Table IV, RFLOW ranges from 0 for Indonesia
and Brazil to 10 for 13 countries, including two from Asia (Hong Kong and
Singapore).
When a country imposes capital control, this will either prohibit or discour-
age foreign investors from holding stocks in companies in that country. There-
fore, the degree of foreign bias for a country will be higher (more negative
FBIAS) when the country has higher capital control measures. We also expect
a strong inf luence of capital control measures, especially RFLOW, on the do-
mestic bias. When a country has a low score on RFLOW, domestic investors find
it more difficult to invest overseas as it requires government approval. Conse-
quently, they are forced to have a disproportionate amount of their investments
in the domestic market, resulting in an even larger domestic bias (more positive
DBIAS).
We have also considered two alternative measures of capital control: one con-
structed by Edison and Warnock (2003) and Ahearne et al. (2004), and another
by Kaminsky and Schmukler (2000). The first is a measure of the intensity of

foreign ownership restrictions, constructed based on the International Finance
Corporation’s (IFC) emerging market indices, and equals one minus the ratio
of the total market capitalization of a country’s IFC investible and global in-
dex stocks. The investible index comprises all stocks in the global index that
are deemed by the IFC to be available to foreign investors. Since the IFC only
constructs emerging market indices, we do not have observations on developed
markets. Therefore, we decided not to use this measure in our analysis. The
second measure was constructed by Kaminsky and Schmukler (2000).4 We find
that all countries except Malaysia and Indonesia are considered fully liberal-
ized and have a value of 1 for the period of our study. As there is virtually no
cross-sectional variation in this measure across countries, our analysis does not
employ alternative measures either.
C. Stock Market Development

Other things being equal, investors tend to invest in more developed stock
markets because of higher liquidity and lower transaction costs in these mar-
kets. We construct several measures of stock market development.
The first variable is the relative size of the stock market of each country,
measured by the stock market capitalization as a percentage of the country’s
GDP (SIZE). The value of SIZE ranges from 0.07% in Venezuela to 3.84%
in Hong Kong. The next variable is the turnover ratio (TURN), defined as
the ratio of the total value of stocks traded to the average market capital-
ization in a given country. To reduce any short-term f luctuation in turnover,
we use the average turnover during the period 1997 through 1999 in our
analysis. During this 3-year period, the average turnover ranges from 8%
for Colombia to 374.1% for Taiwan. Data on SIZE and TURN of each coun-
try are collected from Standard and Poor’s Emerging Stock Markets Factbook
2000.
The third variable is the transaction cost associated with trading foreign se-
curities (COST). Our transaction cost estimates are from Elkins-Sherry Co.,
whose data are also studied by Domowitz, Glen, and Madhavan (2000). Elkins-
McSherry provides trading cost analysis for pension funds, investment man-
agers, and brokerage houses. Their estimates are based on commissions, fees,
and market impact costs for the period September 1996 to December 1998. Al-
though our sample period is 1999–2000, it is reasonable to assume that these
transaction cost estimates typically do not change substantially and are still
applicable to our analysis. We have transaction cost estimates for 42 out of
48 markets, ranging from 19.4 basis points for Japan to 239.5 basis points for
Venezuela.
Finally, we also include a dummy variable (DUMEMG) that equals 1 for an
emerging market and 0 otherwise.
4
We thank Sergio Schmukler from the World Bank for providing us with the capital control
series.
Similar to the discussion on economic-development measures, whether ad-

vancements of a country’s stock market development have symmetric or asym-
metric effects on domestic and foreign biases depend on how domestic and for-
eign investors view this factor for investment purposes. If such advancements
help lower the deadweight cost for foreign investors much more than for do-
mestic investors, foreign investors will have greater desires to invest more in
the local equity market, resulting in domestic investors holding proportionately
less local equities. On the other hand, if the advancements lower the deadweight
cost for both domestic and foreign investors symmetrically, we expect none of
the stock market development measures to have any different impact on the
foreign and domestic biases.
D. Familiarity
One explanation for the home bias in investor holdings is that investors are
less familiar with foreign markets. With less familiarity, investors face a greater
information cost that discourages them from investing abroad. Kang and Stulz
(1997) observe that U.S. investors tend to invest in larger and more interna-
tionally known manufacturing firms in Japan. The observation is consistent
with the notion that investors are reluctant to hold securities of firms that they
are not familiar with. Coval and Moskowitz (1999) find that, within the United
States, mutual fund managers prefer investing in firms headquartered close
to their home city. Grinblatt and Keloharju (2001) show that, in Finland, in-
vestors are more likely to trade stocks of firms that share the investor’s same
language and cultural background. For example, Finnish investors whose na-
tive language is Swedish are more likely to own stocks of companies in Finland
that have annual reports in Swedish and Swedish-speaking CEOs than are
investors whose native language is Finnish. There is also evidence that famil-
iarity affects overseas listing decisions as well. Sarkissian and Schill (2004)
find that geographic proximity of the foreign market, along with some other
proxies for the degree of familiarity, play a dominant role in selecting overseas
listing destinations.
We construct several familiarity variables for each pair of countries, i and j.
For each country j, we calculate the average of each familiarity variable across
all pairs. The first familiarity variable is common language. We hypothesize
that mutual fund investors prefer to invest in foreign countries that share a
common language with the home country. Data on language are obtained from
the World Factbook 1999, which contains the major or official languages of
countries from all over the world. The Factbook also reports the nonofficial
language(s) that a significant proportion of the population also speaks. In our
regression analysis of foreign bias of country i for country j, we construct a
language dummy variable (DUMLANG) that equals 1 if countries i and j share
a major language and 0 otherwise. As indicated in Table IV, countries such as
the United States, the United Kingdom, Canada, India, and Australia share a
common language (i.e., English), while countries such as Italy, Japan, Korea,
and Indonesia have their own languages.
The second variable is geographical proximity. Data on geographical dis-

tances (DISTANCE) are obtained from www.nber.org/∼wei, which calculates
the bilateral distance between capital cities of countries.5 Not surprisingly,
European countries enjoy the closest proximity compared with the other coun-
tries, as almost a half of the number of countries in our sample are from Europe,
and the average geographical distance ranges from 4,187 km for the Czech Re-
public to 5,910 km for Ireland. The most remote countries are Australia and
New Zealand, with an average geographical distance of 13,000 km and 14,300
km from the other countries.
The third variable is the amount of bilateral trades (TRADEB), with values
ranging from 0 to 1. A value of 0.1 for TRADEB between the United States
(host) and United Kingdom means that 10% of the total U.S. trade (imports and
exports) is with the United Kingdom. By chasing goods and services produced by
foreign firms, the domestic investors obtain information about these companies.
At a minimum, investors have more confidence in holding the stocks of foreign
companies whose products are known to them.
Common language, geographic distance, and the amount of bilateral trades
predict the likelihood of information f low between countries, measure the bar-
riers that foreign investors face when accessing information overseas, and in-
dicate the extent of informational asymmetry between foreign and domestic in-
vestors.6 These variables obviously suggest that domestic and foreign investors
face different deadweight costs. We hypothesize that mutual fund investors in
country i, who are more familiar with country j, through sharing a common
language, closer proximity, or having larger bilateral trades, will display less
foreign bias toward mutual fund holdings in country j (FBIASij ). We also ex-
pect the familiarity variables to affect the degree of domestic bias (DBIAS). If
a country is more isolated from the rest of the world, high information costs
will discourage home investors from investing overseas. In such a case, local
investors would have to forego diversification benefits and invest an exception-
ally higher fraction of their wealth in the home market instead.
E. Investor Protection
Existing literature has established that financial markets are more developed
in countries where investors’ rights are more protected (see La Porta et al. (1997,
1998, 2000)). The implication is that investors are more reluctant to invest in
countries with poorer investor rights. Table IV reports six measures of investor
protection for 42 out of 48 countries, which are based on literatures of La Porta
et al.
The first measure is the rule of law index (LAW), which assesses the law
and order tradition in the country, as produced by the risk-rating agency,
5
The data are used in Frankel and Wei (1998).
6
We employ average values of DUMLANG and DIST in the regression analysis of domestic bias.
The average value of TRADEB is not used as an explanatory variable in the regression analysis of
home bias, because it is equal to 1/47 for each observation.
International Country Risk. The index has a scale of 0–10, with lower scores for
countries without tradition for law and order. It ranges from 2.08 for Colombia
to 10 for 12 countries, with 10 of these countries in North America and Europe.
The second measure is the accounting standard index (ACC), which defines
the amount and transparency of the information available to investors. The
index is created based on the examination and rating of companies’ 1990 annual
reports on the basis of their inclusion or omission of 90 items. These items fall
into seven categories (general information, income statements, balance sheets,
fund f lows statements, accounting standards, stock data, and special items).
For each country, at least three companies are included for constructing the
index. Table IV shows that Sweden has the highest score (83), followed by the
United Kingdom (78), and Singapore (78), and the countries such as Venezuela
(40), Peru (38), and Egypt (24) have the lowest.
The third measure is the antidirector rights (MINORITY) measure; it indi-
cates the degree of minority investor protection. The value varies from 0 to 5,
with 0 indicating the lowest degree of protection and 5 the highest. Table IV
shows that the United States has the highest score (5), while Italy, Belgium,
and Mexico have the lowest (0).
The fourth measure includes the risk of expropriation index (EXPROP),
which is constructed by the International Country Risk agency. This mea-
sure provides an assessment of the risk of “outright confiscation” or “forced na-
tionalization.” The index has a scale from 0 to 10, with lower scores for greater
risks. This index varies from 5.22 for the Philippines to 9.98 for the United
States, Switzerland, and the Netherlands.
The fifth measure is the efficiency of the judicial system (EFFICIENCY),
which is constructed by Business International Corporation. It provides an
assessment of the “efficiency and integrity of the legal environment as it affects
business, particularly foreign firms.” It ranges from 3.25 for Thailand to 10
for 14 countries, which are primarily developed countries. EFFICIENCY is
highly correlated with LAW—countries with high LAW scores also obtain high
EFFICIENCY scores. But there are some exceptions. For example, Israel has
10 for EFFICIENCY, but only 4.82 for LAW.
The sixth measure is a dummy variable that captures the type of legal sys-
tem. Among all of the legal systems, the English common law system provides
the best legal protection to shareholders, while the German and French civil
law system afford the worst legal protections. We therefore create one dummy
variable (DUMLEGAL) that equals 1 for common-law countries and 0 other-
wise. As seen in Table IV, 14 countries in our sample are based on the English
common law.
Overall, developed countries generally score better on different investor pro-
tection measures, while developing countries score worse. However, not all de-
veloped countries receive favorable investor-protection rules. Italy and France,
for example, have mediocre scores in most of the investor-protection measures.
We expect an increase in informational asymmetries between domestic and for-
eign investors in countries with less favorable investor-protection mechanisms.
In such a case, the deadweight cost for foreign investors investing in these
countries becomes greater relative to that for domestic investors. Consequently,

foreign investors will hold less of local equities, while domestic investors will
hold more in markets with lower investor-protection measures.
F. Other Variables
In addition to the above variables, we include several other variables that
have the potential of explaining either the domestic or foreign bias. The first
two variables are the past 1-year return (RET1) and the past 5-year return
(RET5). Previous studies (Froot, Scharfstein, and Stein (1992)) document that
institutional investors are positive feedback traders, buying when the mar-
ket rises and selling when the market falls. Bohn and Tesar (1996) also find
that U.S. investors exhibit “return-chasing” behavior, with a tendency to un-
derweight countries whose stock markets have performed poorly. On the other
hand, as shown by Grinblatt and Keloharju (2001), while foreign investors in
Finland are positive feedback traders, domestic investors in Finland tend to
be contrarian traders. If mutual fund managers pursue such a strategy, we
expect investors to reduce the investment weight in the domestic market and
increase the investment weight in the foreign market, when the past returns
of the respective stock market increase.
The third variable is the correlation between returns of two countries
(CORR)). For each pair of countries, i and j, where i is the home country of
mutual fund investors and j is the country in the mutual fund holdings, we
compute the correlation coefficient using country returns in U.S. dollars from
Datastream from 1995 to 1999. The correlation coefficient is a proxy for the
diversification potential between the two countries. When the correlation be-
tween countries i and j is small, investors in country i enjoy a larger diversifica-
tion gain from investing in country j; they have greater desire to increase their
equity holdings in country j. Therefore, the degree of foreign bias of country i
for j will be smaller (less negative FBIASij ). For each host country i, we also
compute the average correlation coefficient with the other 47 countries. The
smaller the average correlation between country i and the rest of the world,
the larger the percentage of funds that investors in country i invest overseas
and the smaller the percentage they invest in the domestic market. Hence, the
degree of domestic bias is lower (smaller DBIASi ).
It is apparent from Table IV that CORR and distance, DIST, are negatively
correlated. This relationship might imply a potential impact of CORR/DIST on
the domestic or foreign bias. As we have discussed earlier, a closer proximity
between two countries helps reduce the information costs of foreign investors
and hence attracts more foreign investment in the country. However, if the
return correlation between the two countries is sufficiently high, it might deter
foreign investors from investing in the country.
The fourth variable is withholding tax (TAX); the data are obtained from
Corporate Taxes: Price Waterhouse, 1996. Although previous studies, such as
the one by French and Poterba (1991), do not find a significant relationship be-
tween taxes on foreign investment and capital f low, we include the tax variable
to capture the potential inf luence of TAX on the foreign bias. We expect foreign
investors to reduce their stock holdings in countries with higher withholding
taxes. Thus, the foreign bias will be larger (more negative FBIAS). As Table IV
shows, the average bilateral withholding tax rate is between 0% for several of
tax haven countries and 35% for Chile.
IV. Empirical Analysis

In this section, we test the empirical implications of Cooper and Kaplanis’
(1986) model by examining the role of predetermined economic factors in the
domestic and foreign biases. Specifically, we determine which factors inf luence
each type of bias.
In all our tests, we stack up all the observations on the domestic-bias mea-
sure (DBIASj ) and regress them against each set of the previously described
explanatory variables. We do the same for the foreign-bias measure (FBIASij ).
We perform the regression analyses for the sample observations in 1999 and
2000 separately. The two different years of samples produce almost identical
qualitative results. The reasons are twofold. One, the weight of each country’s
mutual fund holdings in the local market relative to the country’s weight of the
world market capitalization is fairly stable across the 2 years. Two, many of the
predetermined variables do not change between 1999 and 2000. Consequently,
to conserve space, in all subsequent sections, we report results from regress-
ing average values of the dependent variables (DBIAS or FBIAS) against the
predetermined variables of 1999.
A. Results for Domestic Bias

Table V presents regression results of the domestic-bias measure on each of
the six groups of variables.7 The second column shows the predicted signs of
the coefficients, while the third through eighth columns contain estimates of
the explanatory variables from the six categories separately. The table reveals
several interesting observations.
It is apparent that some categories of predetermined variables play more
significant roles than others in explaining the cross-sectional variation of
DBIAS. The results show that the stock market development variables have the
maximum, while investor-protection variables have the minimum, explanatory
power for DBIAS. Judging from the adjusted R2 values, the former explain 28%
of the cross-sectional variation of DBIAS, whereas the latter explain only 6%.
All the variables that are proxies for stock market development are significant,
at least at the 10% level. We find that DBIAS is negatively related to the
size of the market (SIZE) and positively related to the dummy variable for
emerging markets (DUMEMG). The domestic investors in an emerging market
7
We also performed the same analysis using the average foreign-bias measure as the dependent
variable. Interestingly but not surprisingly, the results mirrored the ones using the domestic-bias
measure.
or a market with small market capitalization seem to enjoy smaller deadweight

costs when investing in local equities relative to foreign investors and therefore
are induced to put more investment in the local market. On the other hand,
larger stock markets are more visible, more recognized, and more developed
globally, and hence they are able to attract more foreign investments. Moreover,
domestic investors in these markets ought to be more investment-savvy than
those in emerging markets. These factors possibly contribute to the smaller
domestic and foreign biases in these markets.
Conversely, only two of the investor-protection variables, LAW and EXPROP,
are statistically significant at the 5% level. While the coefficient on LAW is pos-
itive, the coefficient on EXPROP is negative. When a country strongly enforces
its law, the confidence of domestic investors in the regulatory system is boosted
and hence they are willing to invest more locally than overseas. Similarly, the
greater expropriation risk should have less impact on the decisions of local in-
vestors than on those of foreign investors to invest in the local market. As a
result, when the expropriation risk is small (larger EXPROP), relatively more
foreign investments are attracted to the local market and hence we observe a
lower DBIAS.
Furthermore, restrictions on capital f lows (RFLOW) have a significant neg-
ative impact on DBIAS; the coefficient is −0.25 with a t-ratio of −2.45. As we
have explained in Section III, the lower the RFLOW, the greater the restric-
tions on foreign investors investing in local markets and on domestic investors
investing in foreign markets. This finding provides two implications. First, be-
cause of greater restrictions imposed on domestic investors investing abroad,
they turn to local markets. Second, the fewer restrictions imposed on the mo-
bility of capital into and out of the country encourage greater f lows of both the
foreign capital into the domestic market and, at the same time, local capital
into foreign markets. Overall, the evidence is consistent with the hypothesis
that the higher deadweight costs for domestic investors investing overseas and
foreign investors investing in local markets increase the measure for domestic
bias.
Common language (DUMLANG) and geographical proximity (DIST), which
are proxies for familiarity, are both shown to have a statistically significant
impact on domestic mutual funds’ preference for local equities. DUMLANG is
negatively, while DIST is positively, related to DBIAS. Therefore, countries
that share a common language have a smaller domestic bias, while those that
are farther away from the rest of the world are inclined to have a larger do-
mestic bias. Thus, it is evident that investors tend to weight domestic rather
than foreign equities more heavily when they are less familiar with foreign
markets. This is consistent with the hypothesis that the domestic bias in-
creases when the deadweight cost for domestic investors investing overseas
increases.
In contrast, however, none of the other variables that measure a country’s
economic development is statistically significant at the 5% level. This finding
suggests that the economic performance of a country plays virtually no role in
the domestic investors’ asset allocation of funds to the local market.
At this juncture, it is interesting to evaluate the incremental predictive power

of each group of explanatory variables when all the variables are estimated
jointly. However, as there are only 26 countries, it is not feasible to include all
explanatory variables in a single regression. Instead, we employ an alternative
approach. In this approach, we first obtain the fitted values of the above six
different regressions and next regress the domestic-bias measure against all
the fitted values jointly. The regression results, as indicated in the last row of
Table V, show that only the coefficients associated with the fitted stock market
development and familiarity variables remain statistically significant. Thus,
these results reinforce the above evidence that stock market development and
familiarity are the two important factors that explain the cross-sectional vari-
ation of the domestic bias.
It is important to emphasize that our regression results are not driven by the
large United States’ market-capitalization weight in the world market portfolio.
We have re-estimated all the regression results of Table V by removing the
United States from the sample, and the qualitative results remain materially
unchanged. We have also verified the results in the remaining tables of this
study under these conditions and found that our results are robust.8
B. Results for Foreign Bias

Table VI presents regression results for the foreign-bias measure, FBIASij .
In contrast to Table V, we now include an additional independent variable,
INV DBIASi , defined as (1 − DBIASi ), in all regressions. The additional vari-
able controls for the automatic impact of the domestic bias on the foreign bias;
if investors hold a disproportionate share of the mutual fund portfolio in their
local market, then the remaining portion that they could invest in the other
countries must be disproportionately low. As Table VI indicates, this effect is
strongly evident: an increase in INV DBIASi leads to a significant decrease in
FBIASij in almost all specification models. The coefficients for INV DBIASi are
mainly negative and statistically significant at conventional levels.
The regression results for FBIAS are not only strikingly different from those
of DBIAS, but also more pronounced. In contrast to those for DBIAS, many
of the explanatory variables for FBIAS are statistically significant. The ad-
justed R2 values from the FBIAS regressions are substantially larger than their
counterparts reported in Table V. While the corresponding 2–24% increases in
the adjusted R2 values are partly attributed to the strong correlation between
FBIAS and INV DBIAS, they are also due to the predictive power of the vari-
ables for FBIAS. Therefore, we look at the order of its magnitude across the six
regression specifications as an indication of the relative explanatory powers of
the different groups of explanatory variables.
Among the six different categories of explanatory variables, both the stock
market development and investor-protection variables exert the largest in-
fluence on the foreign bias, whereas the capital-control variables exert the least.
8
These additional results can be easily obtained from the authors upon request.
All of the stock market development variables are statistically significant and
bear the correct signs. Intuitively, foreign investors would have greater desires
to invest more (less negative FBIAS) in countries with large stock market cap-
italization (SIZE), with high stock market turnover (TURN), with lower trans-
action costs (COST), and in nonemerging markets (DUMEMG = 0). In other
words, mutual funds tend to invest in large, highly visible developed markets,
which are more liquid and have lower trading costs. This result is also consis-
tent with our earlier finding of a smaller domestic bias associated with larger
stock market capitalization. Similarly, mutual funds also are more inclined to
invest in countries that offer strong investor-protection rights. As indicated in
Table VI, variables that are proxies for investor protection mainly have a sig-
nificant effect on the allocation of foreign mutual fund holdings in a country.
Except for those on MINORITY and DUMLEGAL, the coefficients on LAW,
ACC, EFFICIENCY, and EXPROP are all statistically significant at conven-
tional levels. It is a little puzzling that the efficiency of the judicial system has
a significantly negative, as opposed to a positive, impact on FBIAS. In contrast,
LAW, ACC, and EXPROP explain FBIAS in the direction consistent with our
predictions. When making decisions whether or not to invest in a particular
country, foreign investors factor in the country’s laws, accounting standards,
and the level of expropriation risk. Comparing the results of Tables V and VI,
we see that foreign investors are more concerned about a country’s ability to
offer better investor-protection rights than are domestic investors. The greater
the country’s protection of investors’ rights, the smaller its foreign bias.
Economic-development and familiarity variables also exhibit significant ef-
fects on FBIAS, but they are not as strong as those of stock market develop-
ment and investor-protection variables. All three of the familiarity variables,
while four of five economic-development variables, are statistically significant
and have the predicted signs. As predicted, foreign investors tend to allocate
more of their equity investment in a country with a higher GDP per capita
(GDPC), a higher real growth rate of GDP (RGDP), a larger foreign direct-
stock investment inward per capita (DI), and a higher country credit rating
(CREDIT). Furthermore, they also tend to invest more of their money in coun-
tries that share a common language and are closer in geographical proximity;
and mutual fund holdings in a foreign country are higher when there is a
larger bilateral trade volume. The results therefore suggest that while famil-
iarity inf luences the distribution of foreign and local mutual fund holdings, the
advancement of a country’s economic development only affects the foreign fund
holdings.
As expected, capital control has a strong impact on the investment behav-
ior of foreign investors. The coefficient on RFLOW is 0.33 with a t-ratio of
12.2, suggesting that countries with fewer restrictions on capital f low (higher
RFLOW) experience greater foreign investments (higher FBIAS). Similarly,
countries with lower withholding taxes promote more foreign investments.
When all the explanatory variables are estimated jointly, some of the
coefficients are no longer statistically significant. While the stock market de-
velopment and familiarity variables remain statistically significant, most of the
economic-development and investor-protection variables are either insignifi-

cant or bear the wrong sign. In an alternative approach in which we regress
the foreign-bias measure on all of the fitted explanatory variables from the first
stage regressions, the stock market development and familiarity variables are
again the most statistically significant. Conversely, the coefficient of the fitted
value of capital control has the wrong sign, and that of investor protection is
insignificant. These results are broadly consistent with those in Table V, which
shows that only the stock market development and familiarity contribute to
the investment decisions of domestic investors. Here, we find that these two
categories of variables have the most significant inf luence on the investment
decisions of foreign investors as well.
Our results are closely related to those of Portes and Rey (2000). Portes and
Rey (2000) find that the market size (equity market capitalization), openness
(population or the ratio of total trade to GDP), efficiency of transactions (an
index of sophistication of the financial market), and distance play a critical
role in equity transaction f lows between 14 developed countries for the period
1989 to 1996. While our study and theirs address a different issue, we both
reach similar conclusions. The implication is that the market size, openness,
and distance not only determine the home bias, but also the bilateral equity
flows between countries. More importantly, Portes and Rey’s evidence helps
to support our earlier claim that our results are not necessarily restricted to
mutual funds, but can be generalized to include other institutional investors as
well.
C. Additional Tests
C.1. Domestic Bias Calculated Based on a World Float Portfolio
According to Dahlquist, Pinkowitz, Stulz, and Williomson (2003), the preva-
lence of closely held firms in countries with poor investor protection explains
part of the home bias of U.S. investors. Based on their estimates of the percent-
age of closely held market capitalization, we construct a world f loat portfolio
with country weights based on the amount of free-f loating shares available to
investors. Next, we calculate the f loat-adjusted foreign bias (FBIAS FLOAT)
and domestic bias (DBIAS FLOAT), which are used as dependent variables in
the regression analysis. The results are reported in Table VII. The second to
the seventh columns of the table show regression estimates of DBIAS FLOAT
against the respective six groups of explanatory variables, and the final col-
umn shows those of FBIAS FLOAT on all variables jointly, while conditioning
on INV DBIAS (=1 – DBIAS FLOAT).
The results for the f loat-adjusted domestic bias, while more pronounced, are
qualitatively the same as those for the unadjusted domestic bias, DBIAS. Ex-
planatory variables that have a significant effect on DBIAS also exhibit a signif-
icant effect on DBIAS FLOAT, but the predictive power of the latter is generally
slightly greater than that of the former. Consistent with the results of Table V,
the stock market development and familiarity variables play a significant role
Table VIII
Regression Analysis of the Foreign Bias for Financial
and Nonfinancial Centers
The dependent variable is the foreign bias (FBIASij ), as measured by the log ratio of the share
of country j in mutual fund holdings of host country i to the world market capitalization weight
of country j. The explanatory variables are INV DBIAS (one minus domestic bias for country i);
log GDP per capita (GDPC); real GDP growth (RGDP): trade volume scaled by GDP (TRADE);
foreign direct investment scaled by GDP (DI); country credit rating (CREDIT); capital f lows re-
strictions (RFLOW); stock market capitalization scaled by GDP (SIZE); log turnover ratio (TURN);
log transaction costs (COST); emerging market dummy variable (DUMEMG); common language
dummy variable (DUMLANG) for two countries; log geographical distance between two countries
(DIST); and bilateral trade volume between two countries (TRADEB); rule of law index (LAW);
accounting standard index (ACC); risk of expropriation index (EXPROP); efficiency of judicial
system index (EFFICIENCY); past 1-year return (RET1); past 5-year return (RET5); correlation
between returns of two countries (CORR); and withholding tax percentage (TAX). The table sum-
marizes estimates of seemingly unrelated regressions corresponding to financial and nonfinancial
centers. The financial centers are: the United States, the United Kingdom, Luxembourg, Switzer-
land, Ireland, Japan, Hong Kong, and Singapore. The t-statistics are based on standard errors
adjusted for heteroskedasticity using the White (1980) method. The F-stat tests the hypothesis
that the coefficients of the respective variable are the same between financial and nonfinancial
centers.
Financial Centers Nonfinancial Centers

Predicted F-stat.
Sign Coeff. t-stat. Coeff. t-stat. ( p-value)
CONSTANT 13.82 4.75 13.98 4.47 0.02 (0.96)

INV DBIAS − −3.14 −3.09 −2.11 −2.01 0.42 (0.51)
GDPC + −0.41 −1.59 −1.04 −3.70 2.68 (0.10)
RGDP + 0.24 4.62 0.37 6.59 2.93 (0.08)
TRADE + −0.65 −3.23 −0.89 −3.93 0.61 (0.44)
DI + −0.03 −0.66 0.02 0.32 0.46 (0.49)
CREDIT + 0.01 0.66 0.03 1.63 0.56 (0.45)
RFLOW + 0.01 0.19 0.28 3.42 5.79 (0.01)
SIZE + 0.17 1.16 0.49 3.13 3.04 (0.08)
TURN + 0.47 2.71 −0.03 −0.18 3.79 (0.05)
COST − −0.82 −2.86 −0.34 −2.11 1.27 (0.26)
DUMEMG − −1.42 −2.60 −2.09 −3.56 2.19 (0.13)
DUMLANG + 0.33 1.36 1.03 3.30 2.89 (0.08)
DIST − −0.84 −8.65 −0.94 −8.70 0.43 (0.51)
TRADEB + −5.32 −2.43 −3.17 −1.98 0.80 (0.39)
LAW + −0.10 −0.90 0.25 2.15 3.09 (0.06)
ACC + 0.00 −0.20 −0.01 −0.45 0.51 (0.48)
MINORITY + 0.02 0.18 0.14 1.35 0.52 (0.47)
EXPROP + −0.09 −0.39 0.31 1.19 1.31 (0.26)
EFFICIENCY + −0.08 −0.87 −0.43 −4.30 6.92 (0.01)
DUMLEGAL + 0.25 0.73 −1.13 −3.24 8.03 (0.01)
RET1 + 1.21 2.66 2.19 4.38 2.11 (0.14)
RET5 + −2.42 −3.11 −2.67 −3.12 0.22 (0.63)
CORR − 1.33 1.99 1.10 1.62 0.05 (0.82)
TAX − −1.32 −1.17 −6.82 −5.34 10.46 (0.01)
Adjusted R2 0.56 0.53
in explaining DBIAS FLOAT, with the former having the largest adjusted R2
value of 31%. Similarly, the results for the f loat-adjusted foreign bias are also
generally consistent with those for the unadjusted foreign bias, FBIAS. We find
that all the variables that previously had an effect on FBIAS still possess a sig-
nificant explanatory power for FBIAS FLOAT. In particular, the stock market
development and familiarity variables maintain their statistically significant
explanatory power for the foreign bias.
Overall, the results corroborate our evidence that several predetermined vari-
ables not only are significant, but also exhibit varying effects on the domestic
bias and foreign bias, even after controlling for closely held firms.
C.2. Financial versus Nonfinancial Centers

Here we consider the possibility that the results we have so far established
may be due to the approach we use to classify funds. As discussed earlier, we
group funds into domestic and foreign funds strictly based on the country of in-
corporation of the funds. This might create a problem, as it is quite common to
incorporate mutual funds in some financial centers that will receive subscrip-
tions from investors all around the world. For example, Asian investors might
subscribe to a mutual fund incorporated in Luxembourg or the U.K., or U.S.
investors might subscribe to a fund incorporated in Hong Kong or Singapore.
As a result, the funds incorporated in financial centers might serve investors
from other countries as well.
To examine this possibility, we divide the funds into two groups: financial cen-
ters and nonfinancial centers. The financial centers include the United States,
the United Kingdom, Switzerland, Luxembourg, Ireland, Japan, Hong Kong,
and Singapore, with the remaining host countries classified as nonfinancial
centers. We re-estimate all the regressions for both samples using the foreign
bias as the dependent variable and the same set of explanatory variables. We
use a seemingly unrelated regression method to allow for any possible correla-
tion in the residuals of the two regressions. Results are presented in Table VIII.
The overall results indicate that our earlier results are robust. The coefficients
that are significant in the whole sample remain significant in the nonfinancial
center subsample. In fact, the level of significance for some of the coefficients
in the nonfinancial center subsample appears to be higher than those in the
financial centers subsample.
V. Conclusion
This study presents a comprehensive and thorough analysis of the mutual
fund holdings of 26 countries, with a breakdown of their allocations across
48 countries, for the years 1999 and 2000. It is the first to seek evidence of how
the home bias is distributed across different countries from all over the world,
including developed and emerging markets. In contrast to earlier studies in
the literature, we distinguish between the domestic bias (overweighting of the

domestic market) and the foreign bias (under- or overweighting of the foreign
markets) and examine what economic factors can possibly capture their cross-
sectional variation across countries.
Our analysis provides robust evidence of the home bias for every developed
and developing market. More interestingly, different countries exhibit differ-
ent degrees of the domestic bias (domestic residents overweighting the country)
and of the foreign bias (foreign investors under- or overweighting the country).
The evidence motivates us to investigate whether the cross-sectional variation
in the foreign bias and domestic bias can be explained by some common fac-
tors. The results show that six categories of predetermined variables drawn
from the literature have varying significant effects on the two types of biases.
Only the stock market development and familiarity variables play an impor-
tant role in the domestic bias. These two variables also exhibit significant, but
asymmetric, effects on the foreign bias. When a host country is more remote
from the rest of the world and has a different language, domestic investors
will invest more in the market, while foreign investors will invest less. In con-
trast, the remaining factors such as economic development, capital control, and
investor protection have a less-pervasive impact on the foreign and domestic
biases.
Finally, we draw a connection between our results and those on international
cross listings. Recent studies such as those by Sarkissian and Schill (2004)
and Pogano, Röell, and Zechner (2002) have examined the market preference
of firms listing their stocks abroad. Interestingly, the factors that inf luence
overseas-listing decisions are those related to geographical proximity of the
foreign market along with other variables that proxy for the degree of famil-
iarity, variables that are shown in this paper to affect the foreign bias as well.
Therefore, our results suggest that the overseas-listing decisions are not driven
purely by the supply of foreign stock, but also by the demand for such stock. The
reason that the U.S. market lists so many American Depositary Receipts from
other developed countries like Canada and European countries is in part due
to the lower informational asymmetry associated with companies from these
countries, hence creating a demand for the stock in the U.S. market.
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THE JOURNAL OF FINANCE • VOL. LX, NO.

What Determines the Domestic Bias and Foreign

KALOK CHAN, VICENTIU COVRIG, and LILIAN NG∗

engage in similar trading strategies as those of other institutional investors.2

The value ai can be interpreted as the weighted average marginal deadweight

II. Data and Preliminary Statistics

B. Statistics on Mutual Fund Holdings

Domestic Funds International Funds

US 6,444 4,205 935 1,693 3,447 1,145 159 376 928

C. Statistics on Domestic Bias and Foreign Bias

Domestic Bias Average Foreign Bias

weight of country j (wj∗ ). If country j exhibits a domestic bias, then it has a

investors in a host country j is calculated by averaging FBIASij across all

III. Plausible Sources of Domestic Bias and Foreign Bias

The Journal of Finance

US 33,846 3.8 11.9 0.09 90.9 10 1.80 113.4 29.2 0 0.21

What Determines the Domestic Bias and Foreign Bias?

The Journal of Finance

US 8,535 10.0 71 5 9.98 10.0 1 18.3 21.5 0.51 11.4

What Determines the Domestic Bias and Foreign Bias?

A country’s level of advancement in economic development ought to affect

by Kaminsky and Schmukler (2000). The first is a measure of the intensity of

C. Stock Market Development

Similar to the discussion on economic-development measures, whether ad-

The second variable is geographical proximity. Data on geographical dis-

countries becomes greater relative to that for domestic investors. Consequently,

IV. Empirical Analysis

A. Results for Domestic Bias

or a market with small market capitalization seem to enjoy smaller deadweight

At this juncture, it is interesting to evaluate the incremental predictive power

B. Results for Foreign Bias

economic-development and investor-protection variables are either insignifi-

Financial Centers Nonfinancial Centers

CONSTANT 13.82 4.75 13.98 4.47 0.02 (0.96)

C.2. Financial versus Nonfinancial Centers

the literature, we distinguish between the domestic bias (overweighting of the

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