AN EMPIRICAL ANALYSIS OF PORTFOLIO CONCENTRATION BEHAVIOR OF INSTITUTIONAL INVESTORS IN EMERGING MARKETS

Abstract

Incorporating international assets into a portfolio can mitigate risks and enhance returns more than depending exclusively on domestic diversification. However, diversifying across different countries may provide little benefits due to underlying factors that reduce independent variations. Empirical research shows that globalization has led to the integration of global stock markets, reducing diversification opportunities for investors. Notably, literature-related investment behavior shows that investors concentrate their portfolios on a few stocks, industries, and regions for better performance. Information advantage theory describes that investors choose to focus on a particular industry, market, or region due to possessing initial information advantages. However, researchers have observed that not all investors benefit from their portfolio concentration decisions. Research findings indicate that managers' learning capacity and skills also play a role in portfolio concentration and portfolio performance. Moreover, there have been periodic expressions of concern from researchers and news stories regarding the risk of index concentration for investors. Concentration and integration within the index reduce diversification and increase the index's volatility. Prior literature on investors' portfolio concentration behavior focuses on developed market mutual funds. Much attention has been given to examining portfolio concentration and performance relationships in literature. Only a few studies have worked to understand the direct relationship between concentration and managers' skills. Even studies that worked on managers skills and concentration use alpha (a performance measure) to identify managers' skills. Moreover, there is a scarcity of research that examines index concentration and its risk for investors.Therefore, this research takes emerging market institutional investors to investigate the behavior of portfolio concentration and its relationship with performance and skill. The study introduces a new proxy to identify skilled and less skilled investors. Further, the study examines index concentration in emerging markets and its possible risk for investors. It also explores new dimensions to investigate the effect of portfolio concentration and managers' skills on fund investors' fund allocation behavior. In the process, the study also underscores the potential of cumulative prospect theory to explain fund flow and provide evidence of how emerging market fund investors assess managers' skills. This thesis uses data spanning a minimum of ten years, holding different frequencies, obtained from several emerging markets to achieve the objectives of the study. For instance, The thesis explores index concentration risk for investors in emerging markets using BRICSU (BRICS plus US) nations' index data and Indian institutional investor portfolio data to examine manager skills, performance, and portfolio concentration. The study considers all emerging market funds data to examine the effect of portfolio concentration and skills on fund investors' fund allocation behavior. The thesis used various econometrics tools such as GARCH, ARIMA-MLP, panel regression, Fama Macbeth regression, and quantile regression for analysis. Additionally, the study uses the potential of cumulative prospect theory to understand fund investors' fund allocation behavior. The thesis provides various empirical insights from the investigation. First, the study observes that except for fluctuation in stock market concentration over time, there is no direct link between stock market concentration and index variance. The finding clarifies that index concentration does not contribute to index volatility, and it results in uneven growth of a few companies due to competitive and technological advancement. Second, Indian institutional investors concentrate on their portfolio compared to benchmarks but are not benefiting from it, as the study found a negative relationship between performance and portfolio concentration. However, some evidence shows that skilled Indian institutional investors who concentrate their portfolios have a positive relationship between performance and concentration. Third, The study shows evidence of CPTV's ability to explain fund flow and finds that high CPTV does lead to incremental fund flow in the subsequent month for emerging market funds. Moreover, the result opposes the findings of the overestimation of extreme stock returns. Our study reveals that investors who invest in emerging market funds measure skills from alpha and avoid giving distorted incentives for FFR. Notably, the managers' skills affect the efficacy of CPTV in explaining fund flow. The study suggests that CPTV explains less skilled fund flow more significantly than skilled funds. Furthermore, the thesis shows that fund investors who include the managers' skills in their investment decisions do not unnecessarily over-extrapolate extreme performance. On the other hand, those who cannot find skilled funds extrapolate recent performance and allocate more money to funds with extremely recent performance. The study finds that CPTV explains concentrated funds' fund flow better than their diversified counterparts. The study contributes to the literature on portfolio concentration by providing empirical evidence from emerging markets. Apart from these empirical findings, this thesis significantly advances theoretical development by introducing a new proxy to identify skilled and less skilled investors.