Academic journal article ASBBS E - Journal

Institutional Investors, Security Issuance Decisions, and Decision Short-Cuts

Academic journal article ASBBS E - Journal

Institutional Investors, Security Issuance Decisions, and Decision Short-Cuts

Article excerpt

ABSTRACT

Institutional holdings are primarily guided by the expected risk-adjusted performance of portfolio stocks, but may also be influenced by the managerial decisions of the portfolio companies. We posit that the potentially suboptimal practice of following the herd, specifically in security issuance decisions, may negatively affect institutional holdings. After controlling for annual excess return (alpha), we find institutional investors reduce their holdings in small-cap companies whose security issuance choices demonstrate a pattern of following the herd, but do not adjust holdings in response to similar patterns of companies in other size groups. The findings are consistent with the premise that mimicking is viewed as a suboptimal decision shortcut when performed by smaller companies which typically possess limited analysis resources, and conversely, the coincidental product of adequate decision analysis in the case of larger companies.

INTRODUCTION

Institutional investment holdings are primarily guided by the expected risk-adjusted performance of portfolio stocks, but other factors reflecting the decision practices of the companies in those portfolios may also influence such investment decisions. One possible influencing factor to portfolio holdings is the tendency of some portfolio companies to follow the industry trend in security issuance choices (i.e., follow the herd). This may reflect a suboptimal practice of emulating the actions of competitors, and the failure to conduct an adequate analysis of the issuance decision.

Ostensibly, institutional investors are expected to discourage naïve company use of such decision heuristics, and register their objections through exercising their influence at annual stockholders' meetings. Failing in that attempt, however, institutional investors may reduce their ownership in the smaller companies that engage in this questionable practice.

REVIEW OF LITERATURE

A considerable body of literature exists on the behavior of institutional investors. Institutional investors are viewed by some as today's standard bearers for corporate governance, and coveted for their more active role in influencing corporate policy (Allen et al [2000]). Skepticism exists, however, with regard to the effect of institutional activism on operating performance (Del Guercio and Hawkins [1999]; Karpoff et al [1996]; and Smith [1996]) or shareholder wealth (Carleton et al [1998]). Beyond attempts to directly influence corporate policy, however, institutional shareholders may reduce their holdings in a given company in response to forced CEO turnover (Parrino et al [2003]), other business relationships with the company (Brickley et al [1988]), signals inferred by other institutional investor trades (Bikchandani et al [1992]), the sheer market impact of peer selling (Brown and Brooke [1993]), or liquidity considerations (Bhide [1994]; and Coffee [1991]). As an extension of this body of literature, the current paper examines how institutional investors adjust their holdings of portfolio companies in response to mimicking patterns in corporate issuance decisions.

The concept of mimicking is hardly novel to corporate financial decision making (Barberis and Thaler [2002]). International banks tend to mimic the actions of their competitors in their lending patterns, rather than conduct in-depth country analyses (Gwynne [1986]). Discussion of shortcut procedures in stock valuation exists in most practitioner literature, and decision heuristics may contribute to the diminished ability of investors to understand probability (Odean [2007]). Although shareholders of acquiring firms apparently fail to benefit from acquisitions (Roll [1986]), perhaps the best-known evidence of herding exists in the well-documented existence of merger waves (Auster and Sirower [2002]). Also, empirical evidence supports the argument that equity issuances in particular occur in surges, with patterns that appear to be fueled by recent market and IPO returns (Ibbotson et al [1994]; Lowry and Schwert [2002]). …

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