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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 Valentin Dimitrov Rutgers University Vladimir Gatchev UCF February 5, 2010
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 • 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) • 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? • 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 • 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 • 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) • 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) • 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 • 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 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))
Future 12-month Hedge Returns Based on Total Turnover of Institutional Ownership
Future 12-month Hedge Returns Based on Turnover of Institutions with Individuals
Future 12-month Hedge Returns Based on Turnover Among Institutions
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) • 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) • 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