Institutional Investors and Stock Prices: Destabilizing and Stabilizing Herds

From 1980 to 2005, institutional trading destabilizes stock prices. Specifically, stocks with herds of institutional buying in a given quarter suffer price declines of nearly three percent from four to eight quarters after the herding. Moreover, institutions do not suffer losses from the destabilization; they exit before prices reverse. These results extend the “riding the bubble” findings of Brunnermeier and Nagel (2004) beyond just hedge funds’ trading of technology stocks in the 1990s. Evidence that institutions are aware of the overpricings of the stocks they enter extends across time, across stocks, and across institutions. We also find that the entry buys of institutions are the drivers of the destabilization, while sell herds do not destabilize. In fact, exit sells actually stabilize prices. In other words, entries tend to push prices above their intrinsic levels while exits tend to push prices toward their correct levels. However, on net, the destabilization effect of institutional trading dominates. ∗Gutierrez is at the Lundquist College of Business, University of Oregon. Kelley is at the Eller College of Management, University of Arizona. Institutional investors are increasingly larger players in the stock market. Their equity ownership has more than doubled in the past twenty years to over 60% of the total market value, and their trading volume accounts for over 90% of the total dollar volume.1 Much interest therefore arises about the effects of institutional investors on stock prices (as well as on other aspects of the financial marketplace and on firms’ decision making). Beginning most notably with Lakonishok, Shleifer, and Vishny (1992), economists have recognized the possibility that many institutions relying on similar information and facing similar incentives might trade in the same direction.2 Such herding by institutions can possibly push prices away from intrinsic values.3 However, there is scant empirical evidence suggesting that such destabilization occurs when institutions trade together (e.g., Wermers (1999) and Sias (2004)). As many have noted, herding is not a sufficient condition for price destabilization. For example, several institutions might correctly respond to signals of undervaluation by purchasing shares. Their herding, in this case, can adjust prices to appropriate levels. In short, institutional herding might have a stabilizing effect on stock prices, consistent with the common perception of institutions as sophisticated and better-informed traders. Institutional ownership is estimated from 13F filings provided by Thomson Financial. The trading volume estimates come from Kaniel, Saar, and Titman (2006) who examine all orders executed on the NYSE from 2000 to 2003 for all common U.S. stocks. Hirshleifer and Teoh (2003) and Brunnermeier (2001) provide a detailed and rich review of the large literature on herding, providing overviews of theories as well as the evidence from financial markets. We can separate herding into two general types: coincidental and mimicking. If institutions observe or acquire the same (or positively correlated) information about stock valuation, they can be expected to trade similarly and so coincidentally herd. Due to agency issues and other concerns, institutional money managers generically may favor stocks with certain characteristics, for example prudent, liquid, and better-known stocks, and so coincidentally herd. Money managers wanting to maintain or develop their reputations as good managers will tend to mimic the trades of other managers, since being wrong and trading with the herd is less damaging to reputation than being wrong and trading against the herd who is expected to be partially informed. Mimicking may also stem from institutions’ inferring stock-valuation signals from others’ trades; the more institutions observed purchasing a stock raises the probability of that stock being undervalued. Some specific references regarding these theories are: Scharfstein and Stein (1990) for reputation concerns; Banerjee (1992), Welch (1992), Bikhchandani, Hirshleifer, and Welch (1992), and Avery and Zemsky (1998) for signal inferences; Froot, Scharfstein, and Stein (1992), Hirshleifer, Subrahamanyam, and Titman (1994), and Irvine, Lipson, and Puckett (2007) for common information; and Falkenstein (1996), Del Guercio (1996), and Gompers and Metrick (2001) for characteristic preferences. Chan and Lakonishok (1995), Keim and Madhavan (1997), Kaniel, Saar, and Titman (2006), Campbell, Ramadorai, and Schwartz (2007), and others, find evidence of institutional trades impacting prices. Griffin, Harris, and Topaloglu (2003), however, find little evidence of price pressure from institutional trades. Kaniel, Saar, and Titman (2006) suggest that this difference might emanate from Griffin, Harris, and Topaloglu’s (2003) imprecision in identifying trader identity, as they must rely on broker identity and trade venue to characterize trade parties as institutional, individual, or market maker.