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The Influence of Institutional Investors on Financial Markets Through Their Trading & Governance Monitoring

The Influence of Institutional Investors on Financial Markets Through Their Trading & Governance Monitoring. Professor Laura T. Starks Presentation to the FMA Doctoral Seminar October 17, 2007 . Growth in institutional equity investment in the United States . 1990’s.

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The Influence of Institutional Investors on Financial Markets Through Their Trading & Governance Monitoring

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  1. The Influence of Institutional Investors on Financial Markets Through Their Trading & Governance Monitoring Professor Laura T. Starks Presentation to the FMA Doctoral Seminar October 17, 2007

  2. Growth in institutional equity investment in the United States 1990’s Source: Federal Reserve (in millions of USD)

  3. Percentage of U.S. corporate equities owned by institutional investors Source: Federal Reserve

  4. Percentage of U.S. corporate equities owned by individual investors Source: Federal Reserve

  5. Growth in institutional and individual investor equity investment in U.S. in Millions of USD Institutional Individual Source: Federal Reserve

  6. How institutional investors can affect stock prices through their actions Institutional Investors Trading Monitoring

  7. What influences the trading behavior and preferences of institutional investors? • Constraints • Incentives • from fee structures • from tournament structure of market for managers • from career concerns • from reporting (window dressing) • to engage in herding behavior

  8. Constraints • There are many constraints placed on institutional investing behavior through contracts or oversight • Research shows that these constraints can affect behavior. Koski and Pontiff (1999), Deli and Varma (2002), Almazan, Brown, Carlson, and Chapman (2004)

  9. Incentives from fee or tournament structures Can affect portfolio managers’ risk choices, both in the cross-section and time series, which can in turn, affect their investors and the financial markets in which they operate. Fee Structures Theory: e.g., Starks (1987), Grinblatt and Titman (1987, 1989), Kritzman (1987), Cohen and Starks (1988), Admati and Pfleiderer (1997), Huddart (1999), Carpenter (2000), Ou-Yang (2001) Fee Structures Empirical Evidence: e.g., Golec (1988, 1992,1993), Ackerman, McEnally, Ravenscraft (1999), Coles, Suay, and Woodbury, (2000), Goetzmann, Brown and Parks (2002), Deli (2002), Elton, Gruber and Blake (2002), Golec and Starks (2004) Tournament incentives: e.g., Brown, Harlow and Starks (1996), Chevalier and Ellison (1997), Goetzmann, Brown and Parks (1998), Daniel and Wermers (2000), Busse (2001), Goriaev, Nijman, and Werker (2001), Hu, Kale, Subramaniam (2002), Taylor (2002), Kempf and Ruenzi (2003)

  10. Research shows that portfolio managers can also be affected by • Their career concerns • Their reporting concerns, resulting in window dressing Chevalier and Ellison (1999), Khorana (1996), Lakonishok, Shleifer, and Vishny (1991) Athanassakos (1992), Griffiths and White (1993), Musto (1997, 1998), Sias and Starks (1997)

  11. Motivations for portfolio managers to herd • Rational reasons to herd • Trading strategies and similarities in preferences • Mimicking other portfolio managers; Reaction to similar signals; Stop-loss orders, portfolio insurance, margin call-induced selling • Agency problems between institutional investors and their clients • Keynes: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” • Relative performance evaluation methods • Clients’ relatively short-term evaluation periods • Legal rationales • Court cases, prudent expert rules from ERISA, and prudent man laws • Behavioral explanations

  12. Empirical evidence on institutional preferences • Correlations between institutional ownership and share characteristics Capitalization Liquidity Share Price • Falkenstein (1996) for mutual funds • Del Guercio (1996) for banks and mutual funds • Gompers and Metrick (2001) for institutional investors in aggregate • Differences in correlations across institutions and over time • Bennett, Sias and Starks (2003)

  13. Empirical evidence on institutional herding Two key questions: • Do institutional investors herd? • Does their herding impact prices? • Even if institutional herding impacts prices, it does not follow that such herding destabilizes prices.

  14. Evidence on institutional herding and feedback trading • Only weak price effects of herding in early tests • More recent tests have identified institutions herd with their own previous quarter trades as well as with other institutions, but that the herding is higher for their own previous trades • Evidence that institutions engage in momentum trading • Evidence that institutions trade on earnings news • Klemkosky (1977), Kraus and Stoll (1972), Lakonishok, Shleifer and Vishny (1992), Grinnblatt, Titman and Wermers (1995), Nofsinger and Sias (1999), Wermers (1999), Badrinath and Wahal (2003), Burch and Swaminathan (2003), Sias (2004), Sias (2003), Cohen, Gompers and Vuolteenaho (2002), Burch and Swaminathan (2003), Pirinsky and Wang (2005)

  15. Are institutional investors responsible for market anomalies? The jury is still out But expected decisions are:

  16. Are institutional investors responsible for market anomalies? • GUILTY • Short-term portfolio return autocorrelations • Monday effect • Portfolio pumping • NOT GUILTY • Turn of the year effects due to their window dressing • Lakonishok and Maberly (1990), Lakonishok, Shleifer, Thaler and Vishny (1991), Athanassakos (1992), Griffiths and White (1993), Sias and Starks (1995), Sias and Starks (1997a), Sias and Starks (1997b), Carhart, Kaniel, Musto and Reed (2002), Ng and Wang (2004), Starks, Yong and Zheng (2006),

  17. Evidence regarding the effects of institutional investors on markets • Institutional trading appears to affect stock prices • Demand shocks of institutional investors affects asset pricing • The trend toward higher turnover and firm-specific volatility in equity markets is related to the increasing dominance of institutional investors in these markets • The types of institutions holding a firm’s stock affects price reaction to the firm’s earnings announcements Brown and Brooke (1993), Chan and Lakonishok (1995), Keim and Madhavan (1995), Zheng (1999), Massa and Goetzmann (1999), Edelen and Warner (2001), Abarbanell, Bushee, and Raedy (2003), Griffin, Harris, and Topaloglu (2003), Sias, Titman and Starks (2004), Gompers and Metrick (2000), Bennett, Sias and Starks (2003). Xu and Malkiel (2003), Bushee and Noe (1999), Hotchkiss and Strickland (2000)

  18. Foreign institutional investors and markets • Evidence shows that foreign institutional investors can affect markets. • Opening markets to foreign investors affects cost of capital • Stulz (1999), Bekaert, Harvey, and Lumsdaine • More herding among foreign investors in the Japanese, Korean and Finnish stock markets. • Iihara, Kato, Tokunaga (1999), Grinnblatt and Keloharju (1999), Choe, Kho and Stulz (1999), Kim and Wei (2002) • Evidence on foreign portfolio flows and positive feedback trading • Tesar and Werner (1994, 1995a,b), Bohn and Tesar (1996), and Brennan and Cao (1997), Froot, O’Connell and Seasholes (2001), Froot and Ramadori (2005)

  19. Summary of institutional investors’ effects on markets through their trading • The evidence shows that institutional investors trading can affect asset prices. • Although there exists mixed evidence on the effects of institutional investors, there is no strong evidence that their trading destabilizes prices • Given the liquidity and major source of capital that institutional investors bring to the financial markets through their trading, their presence would appear to add value to these markets.

  20. How institutional investors can affect stock prices through their actions Institutional Investors Trading Monitoring

  21. Institutional investors and monitoring Institutional Investors Boards of Directors Stock market Large Blockhldrs Mechanisms to mitigate agency problems Labor Lenders Legal and competitive environments

  22. Role of institutional investors in monitoring • Institutions have the ability to monitor because of the size of their investments and their ability to coordinate • Grossman and Hart (1980), Shleifer and Vishny (1986), Huddart (1993), Admati and Pfleiderer (1994), Black (1992) • But they do face limiting factors from fiduciary duties and the costs of monitoring • Concerns about the liquidity of their portfolios (trade-off between liquidity and control) • Loss of potential business relations with firm • Free-rider problem • Murphy and Van Nuys, 1994, Bhide, 1994, Brickley, Lease and Smith, 1988, Shleifer and Vishny, 1986, Grossman and Hart (1980), Shleifer and Vishny (1986), Huddart (1993), Admati and Pfleiderer (1994), Roe (1990), Coffee (1991), Bhide, (1994), Kahn and Winton (1998), Maug (1998), Noe (1999)

  23. When unhappy with a company, what choices do institutional investors have? • Vote with their feet (Sell their shares)Wall Street Walk • Exercise voice (Hold shares and try to influence management decisions) Termed “engagement” in some countries. • Hold shares and do nothing

  24. How do institutional investors monitor corporate managers? Public monitoring • Submission of shareholder proxy proposals • Publicly targeting firms Private monitoring (behind the scenes) • Direct negotiations with management • Direct contact to directors

  25. Empirical evidence on institutional investor public and private activism • Who gets targeted? • Poor performing firms with high institutional ownership, poor corporate governance, and low inside ownership • Does public activism work? • Measures: Short-term market reactions, long-term performance, voting outcomes, other effects; These measures lead to mixed conclusions on whether public activism is effective. • Does private activism work? Smith, 1996; Karpoff, Malatesta, and Walkling, 1996; Carleton, Nelson and Weisbach, 1997; Gillan and Starks, 1998, Del Guercio and Hawkins, 1999; Gillan and Starks, 2000; Gillan and Starks, 2007

  26. Things to Come: New acronym Environmental ESG Social Governance

  27. Evidence on institutional ownership and firm monitoring Evidence suggests that institutional monitoring through institutional ownership affects corporate governance issues • CEO turnover • Parrino, Sias and Starks (2003) • CEO compensation • Hartzell and Starks (2003), Almazan, Hartzell and Starks (2005) • Adoption of anti-takeover amendments • Agrawal and Mandeker (1990, 1992) • Proxy voting • Gordon and Pound (1993), Davis and Kim (2007), Cremers and Romano (2007), Ashrag and Nayaraman (2007) and many more comng

  28. More evidence on institutional investors and monitoring or clientele effects • Influence on dividend policy • Allen, Bernardo and Welch (2000), Grinstein and Michaely (2005) • Influence on analysts’ incentives • Ljungqist, Marston, Starks, Wei, and Yan (2007) • Influence on corporate leverage • Sulaeman (2007) • Influence on board decisions • Del Guercio, Wallis and Woidtke (2006) • Reaction to earnings announcements • Hotchkiss and Strickland (2003) • Influence on managerial myopia • Bushee (1998), Wahal and McConnell (2000)

  29. Differences in monitoring capabilities across institutional investors • Differences in styles of trading • Differences in incentives for managers • Differences in clienteles • Differences in legal and regulatory environments • Differences in ability to gather information • Differences in costs of monitoring across firms

  30. Equity assets of different types of institutional investors in U.S. 1976-2006 Investment companies Foreign investors Pension funds Insurance Companies Source: Federal Reserve (in millions of USD)

  31. Evidence on differences in monitoring capabilities across institutions • Influences their voting behavior on corporate proxies • Brickley, Lease and Smith (1988) • Affects the abnormal return on the announcement of antitakeover amendments • Borokhovich, Brunarski and Parrino(2000) • Influences executive compensation structures • Almazan, Hartzell, and Starks (2005) • Influences corporate operating performance • Cornett, Marcus, Tehranian (2004) • Influences market for corporate control • Pinkowitz (2003),Gaspar, Massa, Matos (2005), Chen, Li, Harford (2005), Qiu (2005)

  32. Summary – Influence of institutional investors Institutions add values to markets: • Addition of liquidity to markets • Addition to informational efficiency of markets • Addition to monitoring of firm management and reduction of manager-shareholder agency conflict

  33. Still not resolved • Influence on financial markets – who is the rational trader? How do institutional trades interact with individual trades? • Influence on firm decisions – clientele effect pressure through preferences or monitoring pressure? How do the two pressures arise and interact? • Differences across institutions – effects of type versus investing style

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