The Impact of Large Institutional Investors on Financial Markets

This is the conclusion from, “The Granular Nature of Large Institutional Investors” by Ben-David, Franzoni, Moussawi and Sedunov, NBER May 2016.

In this study, we provide novel evidence that large asset managers have a positive causal impact on the volatility of the securities in which they invest. The result is economically significant: a 1% increase in stock ownership leads to an increase in stock volatility of about 12 to 18 basis points, relative to a daily average of 3.5%. This finding does not seem to only be the result of greater information production or faster price discovery. In fact, the presence of large institutions correlates with lower price efficiency, as the stocks in which they trade have higher absolute autocorrelations of returns. In addition, the stocks in the portfolios of large institutions display abnormal return co-movement.

In studying the origins of this effect, we provide evidence suggesting that the trading volume of large institutions generates a large price impact. Moreover, we find that large institutions’ trades are, on average, less diversified than the trades of a control group of smaller institutions with the same combined assets, which can explain their greater price pressure. Although large firms’ trades become less concentrated over time, the effect of interest remains significant even in the latest years of the sample. Finally, we show that the flows to the funds under the same institutional umbrella are more correlated than the flows to funds belonging to different families. This result provides one potential explanation for why the different units within an institution trade in a less diversified way than a set of independent institutions.

We believe that these results are informative for regulators. The evidence suggests that large institutional investors are more likely to destabilize financial markets than a set of small institutions that trade in a less correlated way. The effect that we find is likely to be exacerbated during times of financial crisis when large trades are executed in an illiquid market. Any policy prescription cannot, however, overlook the beneficial role played by large institutions in terms of economies of scale, information production, corporate governance, and liquidity provision. These other dimensions deserve further investigation to assess the overall impact of large financial institutions on financial markets. Hence, we see the main contribution of our empirical work as drawing attention to the special role played by large institutional investors in today’s economy.

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