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Playing the Market: Turnover of Institutional Ownership and Stock Returns Valentin Dimitrov Rutgers University Vladimir Gatchev UCF February 5, 2010 Institutional Investors Institutional investors play a dominant role in U.S. equity markets

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playing the market turnover of institutional ownership and stock returns

Playing the Market:Turnover of Institutional Ownership and Stock Returns

Valentin Dimitrov

Rutgers University

Vladimir Gatchev

UCF

February 5, 2010

institutional investors
Institutional Investors
  • Institutional investors play a dominant role in U.S. equity markets
    • According to the Conference Board, in 2006 the market value of total institutional equity holdings was $12.9 trillion, accounting for 66.3% of total equity
  • Institutions are active traders
    • Boehmer and Kelley (2009) report that institutional investors account for the majority of trading volume on NYSE
    • We find that institutional investors turn over 37% of their ownership per quarter
    • There is substantial variation in institutional turnover rates across stocks (0% to 100% per quarter)
motivation
Motivation
  • What are the implications of turnover rates by institutions for stock prices?
  • Share turnover rates and disagreement
    • Karpoff (1986)
    • Harris and Raviv (1993)
  • Disagreement and stock valuation
    • Miller (1977)
  • A more comprehensive theory
    • Harrison and Kreps (1978)
    • Scheinkman and Xiong (2003)
scheinkman and xiong 2003
Scheinkman and Xiong (2003)
  • Two classes of investors disagree about fundamentals
  • The relative valuations of the two classes fluctuate over time
  • When valuations cross, the optimists buy the shares from the pessimists, leading to share turnover
  • With short-sales constraints, share ownership comes with an option to sell to more optimistic investors
  • Share prices include a premium for the option to sell
    • Investors buying the shares pay that premium
    • Investors selling the shares require that premium
  • In equilibrium, higher turnover rates are accompanied by a higher premium in prices – investors “Pay to Play”
do institutions pay to play
Do Institutions Pay to Play?
  • Is high turnover of ownership by institutions associated with a premium in stock prices?
    • If, on average, institutions expect to profit from trading, a premium in prices may exist
  • Would institutions’ expectations of trading profits depend on who they trade with?
    • Individuals
      • Commonly held view is that individuals are less informed that institutions
      • If institutions hold that view, they will expect to make profits when trading with individuals
    • Other institutions
      • If institutions believe that other institutions are also well informed, then they may not expect to make profits from trading with other institutions
hypotheses
Hypotheses
  • Turnover of institutional ownership is negatively related to future stock returns
  • The negative relation between turnover of institutional ownership and future stock returns is:
    • More pronounced when turnover is due to trading of institutions and individuals than when turnover is due to trading among institutions
  • The negative relation between turnover of institutional ownership and future stock returns is more pronounced for firms in which differences of opinion are more likely to be high:
    • High return volatility stocks
    • High total trading activity stocks
    • High growth opportunities stocks
related literature
Related Literature
  • Institutional ownership
    • Gompers and Metrick (2001)
    • Yan and Zhang (2009)
  • Changes in institutional ownership
    • Nofsinger and Sias (1999)
    • Cohen, Gompers, Vuolteenaho (2002)
    • Cai and Zheng (2004)
    • Campbell, Ramadorai, Schwartz (2009)
  • Institutional herding
    • Wermers (1999)
    • Sias (2004)
    • Dasgupta, Prat, Verardo (2009)
  • Changes in breadth of ownership
    • Chen, Hong, Stein (2002)
snapshot of results 1
Snapshot of Results (1)
  • Turnover of institutional ownership is negatively related to future returns
  • Based on 10 portfolios, the hedge return for the two extreme portfolios is 8.6%
  • The relation is due to trading of institutions with individuals
  • Robust to controls for size, B/M, past returns, level and change of institutional ownership, return volatility, and overall trading activity
snapshot of results 2
Snapshot of Results (2)
  • Results are more pronounced for
    • stocks with high overall trading activity
      • 15.0% (vs 2.1%) hedge return
    • stocks with high stock return volatility
      • 10.2% (vs 0.3%) hedge return
    • stocks with low B/M
      • 13.6% (vs 2.5%) hedge return
  • Not subsumed by additional ownership-related variables
    • change in breadth of institutional ownership
    • persistence in institutional buying
sample and turnover measures
Sample and Turnover Measures
  • Main sample from CDA/Spectrum database
    • Common stocks between 1983:Q4 to 2007:Q4
    • A total of 416,384 observations for an average of 4,293 per quarter
    • A minimum of 3,263 and a maximum of 5,765 stocks per quarter
  • Turnover of institutional ownership
    • Due to total trading (1):

Absolute value of quarterly change in shares held by each institution, summed up over all institutions, divided by average shares held by all institutions, over the past 8 quarters

    • Due to trading of institutions with individuals (2):

Absolute value of quarterly change in shares held by all institutions, divided by average shares held by all institutions over the past 8 quarters

    • Due to trading among institutions: (1) minus (2)
additional variables
Additional Variables
  • Additional data sources
    • CRSP, Compustat
  • Additional variables
    • Stock returns for the past 24- and 12-months
    • Stock returns for the future 3-, 6-, and 12-months
    • Market capitalization of equity
    • Book-to-market of equity
    • Stock return volatility for the past 24 months
    • Total share turnover for the past 24 months
    • Level of institutional ownership
    • Average change in institutional ownership for the past 8 quarters
    • Change in breadth of ownership (Chen, Hong, and Stein (2002))
    • Persistence in institutional buying (Dasgupta, Prat, Verardo (2009))
robustness
Robustness
  • Measuring turnover rates
    • 6 quarters, 4 quarters
    • Dollars vs shares
  • Robust across different time periods
    • 1983-1997; 2000-2007
  • Other controls
    • 8 lags of change in institutional ownership
  • Data selection
    • Winsorizing future returns; truncating variables
    • Using stocks below $1/share
conclusions 1
Conclusions (1)
  • High turnover of institutional ownership is associated with a premium in stock prices
  • The premium is driven by trading of institutions with individuals
  • The premium is more pronounced for:
    • stocks with high stock return volatility
    • stocks with high overall trading activity
    • stocks with low B/M
conclusions 2
Conclusions (2)
  • Results consistent with disagreement-based models
    • Harrison and Kreps (1978)
    • Scheinkman and Xiong (2003)
  • Risk-based explanations?
    • Liquidity?
    • Adverse selection costs?
  • What differences between institutions and individuals drive our findings?
    • Predictable individual investor sentiment
    • Agency issues of institutional investors
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