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Benefits and Pensions MonitorHow Are We Doing?
As we finish yet another year, it is worthwhile to ask how institutional investors stack up in their market performance, and whether or not they are truly ‘the smart money’ in equity markets. Three new academic studies answer this question with a resounding … ‘it all depends.’ The first study comes from Brad Barber and Terrance Odean. In a paper entitled ‘All That Glitters: The Effects of Attention and News on the Buying Behavior of Individual and Institutional Investors,’ they tested the idea that individual investors are more likely to buy, rather than sell, those stocks that catch their attention. Individuals, being human after all, face limits on how much information they can both receive and process at any one time. This “bounded rationality,” as it is called in decision theory, should lead to individuals limiting their searches to a more manageable set of choices. One way of doing this would be to include only highly notable stocks. This includes stocks that are in the news, stocks that are experiencing relatively abnormal trading volumes, and stocks with extreme one-day returns. Net Buyers For example, investors at a large discount brokerage make nearly twice as many purchases of stocks that experienced high trading volume on the previous day than they do sales. These stocks that were heavily purchased by attention-based investors subsequently underperformed, with the underperformance being greatest following periods of high attention. Institutional investors, including market makers, exhibited no such attention-based buying.
Barber and Odean look at the actions of institutional and individual investors in another paper entitled ‘Who Gains From Trade? Evidence From Taiwan.’ In this case, the ‘trade’ that the authors speak of is not the trade between countries, but rather the trading of stocks between investors. For every buyer, there is a seller, and, therefore, for every winner there is a loser. The authors use a remarkable data set which includes the entire transaction data, including the identity of each trader, for a five-year period of the Taiwan stock market, the world’s 12th largest financial market. Their findings are quite clear. Institutions win, while individuals lose. The stocks that are bought by institutions reliably outperform those that are sold at various time horizons. Conversely, stocks bought by individuals reliably underperform those sold at each horizon. But before we go jumping into the Taiwan market, the authors note that these calculations ignore transaction costs (including commissions and transaction taxes). These costs substantially reduce the trading profits of institutions (though there are profits that remain after incurring these costs), while transaction costs only exacerbate the losses felt by individual investors. Time Horizons This warning comes via a paper by Amit Goyal and Sunil Wahal entitled ‘The Selection and Termination of Investment Managers by Plan Sponsors.’ The authors examined the hiring and firing decisions by approximately 3,700 plan sponsors (including public and private pension funds as well as non-profit assets including endowments and foundations) between 1994 and 2003. Returns over various time horizons were examined before and after a hiring decision was made (in other words, comparisons were made by judging a manager’s post-hiring return against their own pre-hiring return). Plan sponsors tended to hire investment managers after these managers had outperformed the market in the period prior to hiring. Performance of these same managers tended to drop significantly after hiring, this despite a general persistence in investment manager returns (the probability that a top quartile money manager in one year stays in the top quartile the next year is well above randomness, which suggests that choosing the right manager can lead to outperformance, if done correctly). Plan sponsors have tended to fire investment managers after periods of underperformance, though the performance of these same managers tended to outperform in the years after termination. Putting this all together, they find that the returns would have been greater if they had stayed with the fired fund manager. So we are doing some things right (at least compared to individual investors), but are a long way from being perfect. But you knew that all along, didn’t you? Jim Helik is co-author of ‘Energy Markets Risk Management,’a textbook published by the Canadian Securities Institute. He also teaches at the School of Business, Ryerson University in Toronto. |
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