Taming the Top 1%: The Surprising Role of Foreign Portfolio Flows

New research finds large swings of foreign capital flows through the mutual fund industry may reduce the income of the ultra-wealthy

By Profs. Si Cheng (Chinese University of Hong Kong), Massimo Massa (INSEAD), and Hong Zhang (Tsinghua University)

Financial globalisation related to foreign direct investment is widely seen as raising income inequality, but recent research documented a surprising finding: large swings of capital flows delegated through the global mutual fund industry could in fact reduce the income of the top 1 percent.

This finding emerged from an attempt to fill perceived gaps in existing literature on how financial globalisation influences income inequality: the question of whether foreign indirect investment’s impact might differ from foreign direct investment’s, and potential spurious correlation of financial globalisation measured at country-level with other country characteristics affecting income distribution.

By linking large waves of delegated portfolio flows – in particular those triggered by fire sales and fire purchases – to measures of inequality from the World Wealth and Income Database, the paper, entitled Financial Globalization vs. Income Inequality: The Surprising Role of Foreign Portfolio Flows in Taming the Top 1%, finds the two to be negatively related. Differentiating flow shocks by countries of origin shows that the mitigating effect comes mainly from capital flows of foreign funds. Since fire sales and fire purchases of a foreign fund tend to be independent to the economic conditions of the investing country, such a finding suggests that financial globalisation in terms of delegated portfolio flows might reduce inequality.

To investigate this finding, the authors constructed a dataset of worldwide ownership of both public and private firms for the 2001 to 2013 period, merging ownership information with detailed accounting data so as to be able to measure inequality as the fraction of sales revenues accrued to rich families in each country or industry. This measure focuses on income inequality as measured as wealth concentrated in a small group of rich persons being driven directly and indirectly by the sales revenues of companies they own, i.e., cash flow inequality.

“Unlike in the case of technology shocks or foreign direct investment, delegated portfolio investment in global financial markets could mitigate income inequality.” – Prof. Si Cheng

With this novel dataset and measure of income inequality, the paper’s empirical analysis first confirms that delegated portfolio shocks in general and foreign delegated portfolio shocks in particular are negatively related to this measure of inequality. In order to pin down the economic mechanism, the paper shows that large swings of portfolio flows and especially foreign portfolio flows significantly reduce allocation efficiency, suggesting that the industries sold by ultimate owners subsequently outperform their holding ones. In addition, lower allocation efficiency (induced by large inflow shocks) leads to lower measured inequality.

The authors found that a one-standard-deviation increase in foreign flow shocks transforms into an 11 per cent-standard-deviation reduction in inequality through this “asset misallocation” channel. The paper further shows that only strategic trades involving transfer of controlling ownership in a particular industry affected inequality but not marginal trades. In addition, ultimate owners tend to sell their core assets to foreign institutions, suggesting that diversification plays an important role in rich families’ strategic trades.

The paper then goes on to investigate alternative mechanisms such as corporate governance, taxation, labour market conditions, technology shocks, education, financial development and liquidity, but finds that these do not generate or explain the observed phenomenon.

These results have important normative implications. They suggest that, unlike in the case of technology shocks or foreign direct investment, delegated portfolio investment in global financial markets could mitigate income inequality. Foreign portfolio flows induce local ultimate owners to rebalance their assets and benefit from diversification, which could have some unintended consequences because rich families tend to sell industries that can subsequently outperform their holding ones.