Distorting the market
Markets tend to be efficient most of the time, but sometimes they can become very inefficient. In particular, if investors herd and all pile into a small number of fashionable stocks, the valuation of these stocks can deviate very far from fundamentals. Interestingly, this kind of piling on to a stock and thus pushing its price away from fundamentals seems to happen all the time in markets without us really noticing it. The biggest flows in the stock market are created by institutional investors like pension funds, asset managers, and hedge funds. Almost 30 years ago, academics looked at the quarterly reported portfolio holdings of institutional investors and found no herding behaviour that could be used to trade the market.
However, institutional investors often build their portfolio positions over a longer time frame than three months and it could be that by gradually building positions in a stock, they inadvertently push the price of the stock in one direction or another. That, at least, is what James Bulsiewicz found. He looked at the cumulative net buying and selling of institutional investors in a stock over 10 quarters. Then he did what academics love to do to find a new anomaly: he split stocks up into groups ranging from the 10% stocks with the highest institutional net buying to the 10% stocks with the lowest institutional net buying.
If institutional investors dislocate the share price, then it should pay to buy the stocks that have been bought the least and short the stocks that have been bought the most (because these should be too expensive due to aggressive buying by institutions). And indeed, the raw performance of these long/short-portfolios is quite impressive. For small-cap stocks it was 5.8% per year between 1980 and 2010, while for large-cap stocks it was a little bit lower at 4.9% per year. Notably, while his analysis spanned the time from 1980 to 2010, the outperformance was larger in the 2000s than in the 1980s, indicating that institutional investors have become somewhat more influential in the 21st century.
Outperformance by market cap of stocks
Source: Bulsiewicz (2020).
That stocks of smaller companies react more to buying and selling pressure from institutional investors isn’t a surprise. There are typically fewer investors in smaller companies so that institutional investors tend to have a bigger share of the market. What I do find interesting, though, is that the research also finds that more liquid stocks are more prone to these dislocations than less liquid stocks. This shouldn’t be, because less liquid stocks should react more to institutional buying. The only explanation I have for this behaviour is that institutional investors tend to shun less liquid stocks and thus have less of an influence in that market segment. But if anyone can explain this result to me, I would be very happy. In the meantime, I will go back to my desk and start looking at institutional investor buying and selling.
Outperformance by liquidity of stocks
Source: Bulsiewicz (2020).