Do Institutional Investors Amplify Or Dampen Noise Shocks To Stocks?
Securities and Exchange Commission (SEC)
November 12, 2015
We examine whether institutional investors amplify or dampen mispricing induced by noise trading. Stock recommendations in the Wall Street Journal’s Investment Dartboard Column (IDC) stimulate noise trading that generates mispricing. The mispricing decreases with institutional ownership, which is consistent with the model of Kyle, Ou-Yang, and Wei (2010) and indicates that institutions dampen noise trading-induced mispricing. Institutions dampen mispricing by selling stealthily when wealth-constrained noise traders buy on IDC recommendations. Furthermore, stealth selling increases with information asymmetry. Our findings are robust to controls for liquidity and clustering, and alternative measures for institutional ownership and mispricing.
Do Institutional Investors Amplify Or Dampen Noise Shocks To Stocks? – Introduction
Institutional investors now dominate the U.S. equity market in terms of both ownership and trading. Institutional ownership of U.S. equities increased from 16% in 1965 to 63% in 2014. Between January 2000 and April 2004, non-retail trading accounted for 96% of daily trading volume at the New York Stock Exchange (Boehmer and Kelly, 2009). The growing presence of institutional investors raises important questions about the impact of their trading on asset prices, particularly during periods of turbulence. Specifically, when stock prices are pushed away from fundamental values by, for example, noise trading, do institutional investors amplify or dampen such noise shock? We use the Wall Street Journal’s Investment Dartboard Column (IDC) as a natural experiment that exogenously induces noise trading to examine this question. We find that the stocks recommended in the IDC experience mispricing on average, but the magnitude of the mispricing decreases with the level of institutional ownership. We also find that buy recommendations in the IDC generate significant increases in small buys and medium sells, which is consistent with naïve buying by wealth-constrained noise traders and stealth selling by informed institutions. Furthermore, institutional stealth selling increases with information asymmetry as measured by firm size, analyst coverage, and research and development expenditure, suggesting that institutions trade more aggressively against the noise shock when they possess a larger informational edge. Taken together, these findings indicate that institutional investors dampen, rather than amplify noise shocks.
Noise shock refers to the divergence of stock price from fundamental value – mispricing – due to noise trading. A noise shock adds to a stock’s idiosyncratic risk and provides greater scope for the risk reduction benefits of portfolio diversification, holding total risk constant. To the extent that idiosyncratic risk is priced in the cross-section of stock returns, innovations in idiosyncratic risk due to noise shocks should affect expected returns and thus costs of capital (see, e.g., Merton, 1987; Ang, Hodrick, Xing, and Zhang, 2006; Fang, 2009). Furthermore, if stock prices convey useful signals about project attractiveness to managers, then mispricing induced by noise trading could degrade the quality of the price-based signals and reduce the efficiency of corporate investments (Leland, 1992; Chen, Goldstein, and Jiang, 2007; Foucault and Fresard, 2014). Given the growing influence of institutional investors in the stock market, the question arises as to whether this class of investors affects the severity of noise shocks. Drawing on the extant literature, we formulate and test two opposing hypotheses of the impact of institutional investors on noise shock.
Kyle, Ou-Yang, and Wei (2011) develop an integrated model of strategic trading and portfolio delegation to study the impact of institutional trading on stock prices. In their model, a risk-neutral investor hires a risk-averse informed trader as the portfolio manager and compensates the portfolio manager with a linear contract that combines a fixed component and a variable component that is increasing in the portfolio’s trading profits. In the absence of portfolio delegation (i.e., without the compensation contract), the risk-averse informed trader’s wealth is fully exposed to the risk of trading against noise traders and she scales back trading when noise trading increases. A key insight from Kyle, Ou-Yang, and Wei (2011) is that portfolio delegation makes the risk aversion of a portfolio a combination of the risk aversions of the portfolio manager and the portfolio’s investors. Thus, as long as the investors are less risk averse than the manager, the manager’s effective risk aversion is reduced, prompting her to trade more to correct mispricing generated by increased noise trading either by trading actively on new information or by passively providing liquidity to the noise traders. If institutional ownership reflects the presence of delegated portfolio managers, the model of Kyle, Ou-Yang, and Wei (2011) predicts that when noise trading increases, the resulting noise shock decreases with the level of institutional ownership. This is because a stock with higher institutional ownership implies that there are more delegated portfolio managers and thus more trading to correct mispricing than a stock with lower institutional ownership. We call this hypothesis the ‘shock reduction hypothesis’.
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