Institutional Investors: Arbitrageurs Or Rational Trend Chasers
ICMA Centre, Henley Business School
February 25, 2016
This paper studies the relationship between institutional investor holdings and stock misvaluation in the U.S. between 1980 and 2010. I find that institutional investors overweigh overvalued and underweigh undervalued stocks in their portfolio, taking the market portfolio as a benchmark. Cross-sectionally, institutional investors hold more overvalued stocks than undervalued stocks. The time-series studies also show that institutional ownership of overvalued portfolios increases as the portfolios’ degree of overvaluation. As an investment strategy, institutional investors’ ride of stock misvaluation is neither driven by the fund flows from individual investors into institutions, nor industry-specific. Consistent with the agency problem explanation, investment companies and independent investment advisors have a higher tendency to ride stock misvaluation than other institutions. There is weak evidence that institutional investors make positive profit by riding stock misvaluation. My findings challenge the models that view individual investors as noise traders and disregard the role of institutional investors in stock market misvaluation.
Institutional Investors: Arbitrageurs Or Rational Trend Chasers – Introduction
Stock market investors are classified as two broad types: arbitrageurs and noise traders.1 Noise traders trade for non-information-based reasons and are subject to systematic biases on their stock return expectations. In contrast, arbitrageurs form rational expectations based on the available information and correct any stock misvaluation caused by the trading of noise traders. The existence of noise traders subsidizes arbitrageurs’ information production cost (Grossman and Stiglitz, 1980). In reality, the participants in the stock market are composed of institutional investors and individual retail investors. The previous literature regarded sophisticated institutional investors as informed arbitrageurs and behavioral individual investors as noise traders, which leads to a question. Why does stock misvaluation still persist in a stock market which institutional investors dominate in terms of both market share and trading volume? To better understand the role of institutions in stock market misvaluation, I investigate the institutional holdings of mispriced stocks in the U.S. stock market.
Although the efficient market hypothesis precludes the existence of long-term stock misvaluation, the presence of mispriced stocks has been widely documented. For individual stocks, some famous examples are the mispricing of carve-outs when 3COM spun off its Palm unit in March 2000; the dual-listed stock price discrepancies for Infosys on March 7, 2000; and the price gaps between Royal Dutch and Shell from 1907 to 2005. Other examples of misvaluation on the stock market level are the Japanese stock market bubble in the late 1980s’, the Dot-com bubble in the late 1990s’, and the real estate bubble in 2007. Indeed, there has been a long debate on the existence of stock bubbles in the previous literature.2 But a common consensus that stock prices may deviate from their intrinsic value, at least in the short-run, has been reached.
Why do rational arbitrageurs fail to drive stock prices back to their intrinsic value? Among all the explanations for the failure of arbitrage, three are generally accepted by most researchers. Firstly, both fundamental risk and noise trader risk cause an unpredictability of future returns on mispriced stocks (Black, 1985; Mitchell et al., 2002; Lamont and Thaler, 2003). Secondly, stock misvaluation can only be corrected if arbitrageurs collectively trade against it. But the synchronization among arbitrageurs is hard to achieve in practice (Abreu and Brunnermeier, 2002, 2003). Thirdly, heterogenous investor opinions and short sale constraints limit the arbitrage, so that only good information is reflected in stock prices (Miller, 1977; Diether et al., 2002; Jones and Lamont, 2002). However these theories may not fully explain the persistence of stock misvaluation in the U.S. stock market.
In 1950, 90% of U.S. corporate equities were held by individual investors (Allen, 2001). At that time, even if institutions3 traded against stock misvaluation, they might not have sufficient capital to correct stock mispricing promptly. Gradually, the U.S. stock market has become more institutionalized. According to Gompers and Metrick (2001), the largest one hundred institutions controlled more than half of the market value of U.S. publicly traded equities in 1996. Ferreira and Matos (2008) also report that the institutional stock holdings accounted for 65.7% of the U.S. stock market value in 2005, 59:6% if held domestically. The previous empirical literature shows that institutions are better informed and less likely to be affected by irrationality than individual investors (Griffin et al., 2003; Barber et al., 2009; Boehmer and Kelley, 2009). If institutions trade as arbitrageurs, they should be able to correct the stock misvaluation caused by the trading of noise traders. Recent empirical evidence also documents institutional herding, which raises some doubts about the impossibility of the synchronization among institutions. Lastly, Battalio and Schultz (2006) argue that during the Dot-com bubble period, investors were able to synthetically short overpriced internet stocks using stock options but they chose not to do so. Short saleconstraints may not prevent institutional investors from trading against stock misvaluation because they are the major participants in the derivatives market.
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