Institutional investors are generally considered “smart money” that exploits the behavioral biases of “dumb” retail money. However, there have been some holes poked in that idea recently.
For instance, Roger Edelen, Ozgur Ince and Gregory Kadlec, authors of the study “Institutional Investors and Stock Return Anomalies,” which was published in the March 2016 issue of the Journal of Financial Economics, write that while prior research had found a positive relationship between smart money and return anomalies at shorter time horizons (three to 12 months), it turns negative for longer horizons.
They found: “Not only do institutional investors fail to tilt their portfolios to take advantage of anomalies, they trade contrary to anomaly prescriptions. Most notably, they have a strong propensity to buy stocks classified as ‘overvalued’ (i.e., the short leg of anomaly portfolios). For example, during the anomaly portfolio formation window (prior to anomaly returns) there is a net increase in both the number of institutional investors and fraction of shares held by institutional investors in short-leg stocks for all seven of the anomalies we consider. In four of the seven anomalies there is significantly greater institutional buying in short-leg stocks than in long-leg stocks. There is significantly greater buying in long-leg stocks in only one case.”
This surprising finding was in sharp contrast to prior research on performance, with the difference being the horizon period studied. They confirmed this horizon effect, finding a significant positive relation between quarterly changes in institutional holdings and next-quarter returns that turns significantly negative as the time horizon extends to a year or longer. Thus, the authors concluded that “while institutional trades seem to be informed when evaluated over short horizons, that assessment seems premature when evaluated over a longer horizon.”
These findings suggest that institutional investors actually fail to exploit well-known anomalies. Instead, they contribute to their persistence. Thus, the short-term outperformance may not be the result of a “smart money” effect, but instead a result of the price pressure associated with persistent institutional trading, as opposed to informed trading.
This hypothesis is consistent with the findings of George Jiang and H. Zafer Yuksel, authors of the study “What Drives the ‘Smart-Money’ Effect? Evidence from Investors’ Money Flow to Mutual Fund Classes,” which was published in the January 2017 issue of the Journal of Empirical Finance.
By studying mutual fund flows for retail (unsophisticated) and institutional (sophisticated) investors, they found that short-term persistence in performance is not due to the so-called smart money effect, but was instead caused by persistent flow. And the persistence of short-term performance then experiences a long-term reversal. In other words, institutional investors (at least institutional mutual funds) are also noise traders who can contribute to mispricings.
Who Exploits Anomalies?
Because someone owns the long leg of the anomalies, it begs the question: Who is exploiting these well-known anomalies? Mustafa Onur Caglayan and Umut Celiker provide the likely answer through their January 2017 study, “Hedge Fund vs. Non-Hedge Fund Institutional Ownership and the Book-to-Market Effect,” which covers the period July 1982 to June 2014.
The book-to-market (or value) effect is a good choice to study, as it’s well-known, and there are both risk-based and behavioral-based explanations for it in the literature. While naive investors’ overreaction could contribute to the book-to-market effect even if it’s partly explained by a risk premium, sophisticated investors—namely, institutions—should exploit this return predictability, take advantage of the anomaly and therefore mitigate the extent of overreaction. However, we saw previously that, at least in the case of mutual funds, institutions are contributing to any price overreaction, not correcting it.
Caglayan and Celiker tested whether there is a difference between hedge funds and nonhedge-fund institutional investors in terms of their ability to adjust their positions in order to take advantage of the book-to-market effect, and whether hedge funds’ decisions to invest or disinvest in a particular stock predicts future stock returns in the context of the book-to-market anomaly.
The authors focused on hedge funds and non-hedge funds’ change in stock ownership in the most recent quarter prior to the return measurement window of anomaly returns. They found evidence of a statistically significant and drastic change in hedge funds’ behavior as they adjust their preferences from growth to value stocks immediately after the book-to-market values of equities become public knowledge.
Hedge Funds Act On Information
In addition, they show that hedge funds detect overpriced growth securities and trade them to their advantage, especially when non-hedge funds move aggressively in the opposite direction. This is consistent with the idea that hedge funds are the informed investors. On the other hand, they found that non-hedge fund institutional investors do not alter their positions significantly when the information becomes public knowledge.
Specifically, the authors write: “Overvalued (growth) stocks heavily bought by non-hedge funds and simultaneously sold by hedge funds in the most recent quarter underperform significantly in the next year, generating an eye-opening three-factor alpha of -1.33% per month with a t-statistic of -5.54 and a four-factor alpha of -1.23% per month with a t-statistic of -5.21…. On the other hand, we do not find any significant negative subsequent abnormal returns for stocks sold by non-hedge funds and heavily bought by hedge funds.”
They concluded that their findings “support the notion that hedge funds detect negative information on stocks and trade them to their advantage by unloading them especially when non-hedge funds move aggressively in the opposite direction.”
They added: “It is also noteworthy to indicate that the underperformance of growth stocks heavily bought by non-hedge funds and contemporaneously sold by hedge funds lasts in all four quarters analyzed. In other words, the underperformance of these stocks in the subsequent year is not due to an underperformance in one or two quarters, but is due to underperformance in each of the four quarters, showing that our results exist in each quarter during the return measurement window of anomaly returns, and hence the impact of price pressure is completely ruled out.”
Finally, they also noted that their results held not only for the full period, but for both subperiods they studied as well.
It’s important to observe that the evidence showed a stronger ability for hedge funds to detect overpriced securities compared with underpriced securities. This aligns with the theory of limits to arbitrage and short-sale constraints, which allow mispricings to persist even after publication.
The Limits Of Arbitrage
As the authors note: “It is well known that the arbitrage of underpriced securities requires only the purchase of such stocks, while the arbitrage of overpriced securities requires the short-sale, which is much more costly for investors. Therefore, the disappearance of underpriced stocks takes much less time compared to the disappearance of overpriced securities.”
The issue of how limits to arbitrage allow anomalies to persist is discussed in detail in “Your Complete Guide to Factor-Based Investing,” my latest book, which I co-authored with Andrew Berkin.
While the evidence shows that hedge fund managers are skilled, unfortunately the historical evidence also demonstrates that they keep any “economic rent” (as you should expect, because the ability to generate alpha is the scarce resource) that results from their skill. An indication of this can be found in the fact that investors in hedge funds have not been well rewarded.
For example, for the 10-year period ending in 2016, the HFRX Global Hedge Fund Index lost 0.6%, underperforming every major equity and bond asset class. The underperformance ranged from 0.4 percentage points when compared to the MSCI EAFE Value Index to as much as 8.8 percentage points when compared to U.S small-cap stocks.
Thus, if you want to capture the premiums provided by anomalies (such as the book-to-market effect), you should invest in low-cost, passively managed funds that seek to capture the returns available in a systematic way.
This commentary originally appeared February 10 on ETF.com
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