Playing the Market: Turnover of Institutional Ownership and Stock Returns

1. Playing the Market:Turnover of Institutional Ownership and Stock Returns Valentin Dimitrov Rutgers University Vladimir Gatchev UCF February 5, 2010

2. 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)

3. 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)

4. 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”

5. 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

6. 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

7. 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)

8. 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

9. 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

10. 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)

11. 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))

12. Summary Statistics (1)

13. Summary Statistics (2)

14. Future 12-month Hedge Returns Based on Total Turnover of Institutional Ownership

15. Future 12-month Hedge Returns Based on Turnover of Institutions with Individuals

16. Future 12-month Hedge Returns Based on Turnover Among Institutions

17. Portfolio Analysis (1)

18. Portfolio Analysis (2)

19. Portfolio Analysis (3)

20. Regression Analysis:Base Specification

21. Regression Analysis:Additional Controls (1)

22. Regression Analysis:Additional Controls (2)

23. Conditional Portfolio Analysis (1)

24. Conditional Portfolio Analysis (2)

25. Conditional Portfolio Analysis (3)

26. Conditional Regression Analysis

27. Changes in Turnover and Returns

28. Institutional Ownership

29. Change in Institutional Ownership

30. Change in Breadth of Ownership

31. Persistence

32. 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

33. 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

34. 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