Academic journal article Journal of Applied Finance

Volatility and Institutional Investor Holdings in a Declining Market: A Study of NASDAQ during the Year 2000

Academic journal article Journal of Applied Finance

Volatility and Institutional Investor Holdings in a Declining Market: A Study of NASDAQ during the Year 2000

Article excerpt

We investigate the differences in the holdings of institutional investors relative to individual investors during an eight-month period between March and November 2000, where the Nasdaq Composite index fell 46.23% in value. We find evidence that during that market decline, institutional investors held stocks with less return volatility than individual investors. Our evidence of institutional investor preference for holding lower volatility stocks in a declining market may indicate their relatively greater sensitivity to downside risk. As a consequence, institutional investors are found to perform better than individual investors during that specific time period. [G12, G23]

There is mixed empirical evidence on the hypothesis that institutional investors are attracted to less risky stocks. Badrinath, Gay, and Kale (1989) and Aggarwal and Rao (1990) find evidence that links the level of institutional holdings with lower risk stocks. On the other hand, Kothare and Laux (1995) find evidence to suggest that institutional investors are associated with more volatile stocks.

Using a comprehensive data set covering the period 1980-1996, Gompers and Metrick (2001) find that institutional investors compared to individual investors prefer stocks in larger market capitalization companies that are more liquid and have higher book-to-market ratios. They do not, however, detect any significant relation between institutional holdings and stock return volatility. In a study that documents the preferences of US open-end mutual funds, Falkenstein (1996) considers only the years 1991 and 1992, and finds that mutual funds display a preference for high-volatility stocks.

Sias (1996) argues that institutional investors are likely to choose less volatile stocks for several reasons: 1) many institutions are governed by the prudent man rule; 2) greater institutional interest may imply more and better information; and 3) institutional investor behavior is less susceptible to fads or noise trading influences. Contrary to this intuition, Sias (1996) finds that higher levels of institutional ownership for NYSE listed securities, over the period 1977-1991 are associated with higher contemporaneous stock return volatility. He concludes that the evidence is against an interpretation that institutional investors tend to select riskier stocks, but that an increase in institutional ownership may itself be the cause of increased volatility.

While the results of Gompers and Metrick (2001) and Sias (1996) are inconclusive with respect to whether institutional investors prefer less risky or more risky stocks over long periods of time, we might observe different results in rising and declining markets. In fact, Falkenstein's (1996) result showing that mutual funds managers prefer high-volatility stocks might in part be due to a rising stock market during his sample period.

We posit that institutional holdings during a market downturn will be inversely related to stock return volatility. That is, institutional investors tend to hold less-volatile stocks than individual investors in a declining market. A possible reason for this behavior could be the fiduciary responsibilities that are specific to institutional investment management.

This hypothesis is tested by investigating the differences in the holdings of institutional investors and individual investors during a period the Nasdaq experienced a pronounced decline. For an eight-month period during March-November 2000, the Nasdaq Composite index fell 46.23 % in value. For the same period, the NYSE index remained relatively flat (-2.43%). As a control sample, we conduct the same tests on NYSE listed stocks where the market did not experience a significant downward movement.

The evidence for this period indicates that for Nasdaq there is a strong and consistent cross-sectional relation between the level of institutional ownership and contemporaneous means and standard deviations of individual security daily returns. …

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