There is a common belief that markets become more efficient as they mature – that informational inefficiencies in the US large cap space, for example, have been arbitraged into oblivion by legions of institutional investors and securities analysts. Many also believe that hedge fund strategies (particularly arbitrage strategies) will eventually all suffer the same fate. This pushes investors toward frontier (and less efficient) geographic markets, toward new (and less efficient) markets from securities and toward new (quantitative) technologies to exploit shrinking – but enduring – market inefficiencies. As we once mused, this search for alpha is not unlike the search for new energy sources.
But a new research paper and a report from the Conference Board – both recently released – suggest there may be a mitigating force at play that actually adds to market inefficiency just as those efficiencies are under attack from hedge funds and other investors around the world. In their paper “Stock volatility, institutional ownership and analyst coverage“, Jean Michel Sahut and Sami Gharbi of the University of Poitiers in France and Hidaya Othmani Gharbi of the University of Aix Marseille explore the “possible herding behaviour of institutional investors” among French stocks. As those who lived through the dot-com bubble and the financial crisis know, when big investors “herd,” market inefficiencies are sure to result.
But as background, check out some of the data in a 2010 report released last week by the Conference Board in the United States. According to the report, institutional ownership of all outstanding financial assets in the US stood at 50.6% by the end of 2009.
That’s actually down a little since the end of 2008 and a little below the average over the past 10 years. But the proportion of the largest 1000 US companies (i.e. those that you might think were the most efficiently traded) is near an all-time high at 73% (“institutions” defined as anything non-retail, including mutual funds and insurance companies).
The number is even higher (76%+) in the sweet spot between numbers 250 and 750…
Many studies have suggested that institutional investors (and analysts) have a dampening effect on volatility because they reduce the information asymmetry between management and investors. As a result, more institutional investors (and analysts) means less chance of surprises and sudden gyrations in stock prices.
But Sahut, Gharbi and Gharbi hypothesize that “greater institutional ownership is associated with higher stock volatility” since:
“…institutional investors’ use of large orders, their possible desire to over perform market benchmarks, their short term focus and their herding behaviour, could all contribute to increasing volatility…”
They found that while the simple percentage of shares owned by institutions isn’t actually a good indicator for information asymmetry, the concentration of that institutional ownership is associated with information asymmetry and the resulting volatility that flows from it. The amount of institutional investor holding blocks of shares had a “positive [and statistically significant] impact on stock volatility.”
But wait. Maybe institutional investors don’t cause that volatility. Maybe they just like to invest in volatile stocks. Maybe they have compensation schemes that reward high returns and don’t symmetrically punish low returns.
The trio of researchers also tested this “bilateral” relationship between institutional ownership and stock volatility and concluded that institutional investors willing to own significant blocks of shares do tend to seek out companies with higher volatility. So the relationship between institutional ownership and stock volatility may be a two-way street (especially when you’re talking about block holders).
Assuming this finding applies to the US equity markets examined by the Conference Board, this suggests that as market efficiencies are arbitraged away by the institutionalization of investing, new inefficiencies may be springing up to take their place.
Music to the ears of contrarian hedge fund managers.