Institutional investors

Question 1

How institutional investors generate investment ideas?

Answer 1

1 Fundamental analysis.
2 Technical analysis.
3 Herding and conformity (minimizing responsibility).
4 Mass media.
5 Social interactions (word-of-mouth).

Question 2

Return-chasing behavior of mutual fund investors

Answer 2

Return chasing behavior of individual investors: The average equity mutual fund investor tends to buy past outperformers and sell past underperformers.
Dumb money (Frazzini and Lamont 2008):
Individual investors send their money to mutual funds which own stocks that do
poorly over the subsequent few years.
In contrast to individual investors, institutional investors
Likely do know the available investment options, Should have more time to decide on fund selection, Usually are formally trained in portfolio analysis.

Question 3

Delegated investment management

Answer 3

Delegation is a trade-off:

– Investors may lack required level of expertise or sufficient scale. – Vs. costs and agency conflicts.

Question 4

Why delegate?

Answer 4

1 Prefer delegation over internal asset management.
Reduces responsibility for potentially poor performance.
Use consultants to share even the responsibility for picking investment managers.
2 Prefer active over passive asset management.
Job preservation incentives: Passive management makes a lot of jobs within the
pension fund redundant.
In practice, one of the most important job of pension fund managers is to hire and fire external active investment management firms.
These decisions may be distorted due to both behavioral biases as well as agency conflicts (e.g., “scapegoats”).

Question 5

Which pension funds delegate decisions?

Answer 5

Pension funds that are more prone to headline risk. More sensitive to public scrutiny.

Question 6

What determines pension funds’ decision to hire a particular asset manager?

Answer 6

Reasons why plan sponsors hire investment managers:
New inflows need to be invested.
Changes in the asset allocation policy (investing in new styles). Replace terminated investment managers.
Pension funds condition their hiring decisions on past performance.

Question 7

What determines pension funds’ decision to fire a particular asset manager?

Answer 7

1 Activities or events specific to the investment management firm:
Merger of two investment management firms.
Regulatory action against the investment management firm.
Personnel turnover.
Poor performance.
2 Reasons related to the plan sponsor:
Reorganization of the plan sponsor.
Reallocation across asset classes.

Poor performance and regulatory actions are the only reasons with negative returns.

Question 8

Does hiring and firing decision generate value?

Answer 8

• Post-firing excess returns for nonperformance-based firings are close to zero.
• But the post-firing excess returns for performance-based firings are positive.

After the hiring/firing decision, the performance of the fired firms exceeds that of the newly hired firms but with larger standard errors.

If pension funds had stayed with fired investment managers, their excess returns would be no different from those delivered by newly hired managers.

Question 9

Headline risk

Answer 9

Headline risk - sensitivity to public scrutiny in the event of underperformance.
In public institutions, appointments of executives are either direct political decisions or result of behind-the-scenes political maneuvering. Headline risk-sensitive plans are local, state and miscellaneous public plans, unions, and public universities.

Question 10

Who benefits from the hiring-firing round trips?

Answer 10

Pension funds experience positive opportunity costs (with high error).
In addition, sponsors also pay transition costs around 2% of mandate size.
Transition management firms benefit - companies moving assets from the legacy portfolio of the fired investment manager to the portfolio of the hired manager.
The size of this transition business is estimated to be around $2 trillion annually. Consultants also experience some benefits.

Question 11

Why pension funds make continuously costly decisions?

Answer 11

Three potential explanations:
1 Overconfidence - hubristic belief among plan sponsors that they can time the
hiring and firing decisions successfully.
2 Job preservation - plan executives must show that they are doing some work to preserve their position.
3 Termination decision improves performance:
- Diseconomies channel - investment managers have a constrained capacity and
removal of mandate might allow the investment manager to improve returns. - Disciplinary channel - termination induces greater effort.

Question 12

Why pension funds continue to delegate the asset management decision and hire-fire managers?

Answer 12

Need escape goat!

Question 13

Buying activity of mutual funds and media coverage

Answer 13

More media coverage is associated with more buys. Nonmonotonic relationship.

Question 14

Selling activity of mutual funds and media coverage

Answer 14

Funds’ sells are not influenced by media coverage: Mutual fund managers can sell only stocks they already hold.

Question 15

Alternative explanation for media coverage and institutional buys

Answer 15

1 Flow-catering hypothesis by Solomon, Soltes, and Sosyura (2012): Investors are attracted to media-covered stocks, and they channel money into
funds that hold such stocks.
Fund managers buy these stocks to cater to investors’ taste.
Test result: Media coverage of stocks bought by funds has limited impact on future fund flows.
2 Positive vs. negative media coverage: Indirect measure based on stock returns.
Test result: Positive and negative tones are significantly associated with both more buys and sells.
Trading seems to be due to coverage drawing attention.

Question 16

Summary: Media coverage and mutual funds’ trading

Answer 16

Mutual funds tend to buy more heavily stocks that receive high media coverage (public information).
There is a negative relation between funds’ propensity to buy stocks covered by the media and their performance in the cross-section.
No significant results for sells.
Attention is limited even for professional investors.
Limited attention can affect performance beyond the very short run.

Question 17

Social networks

Answer 17

network structures composed of nodes (usually people or institutions) that are connected through various social relationships ranging from casual to close bonds.
Allow a piece of information to flow.
Usually formed ex ante, sometimes years in the past.

Examples of social networks:
Education networks.
Sport networks.
Religious networks.
Location (neighbourhood) networks.

Question 18

Do fund managers trade stocks that they learn about via their social networks?

Answer 18

Holdings and trades of fund managers who work in the same city are correlated.

Question 19

Explanations of location effects in funds’ investments

Answer 19

1 Social hypothesis - information travels through informal person-to-person relationships (word-of-mouth communication).
2 Alternative community effects - news travels through formal information channels:
Exposure to same local media outlets.
Exposure to same corporate executives during road-shows.
Herding due to geographic job market segmentation and career concerns.
3 Similar preference hypothesis - managers choosing the same residential areas may have similar preferences also with respect to their security selection and trading activity.

Question 20

Do social interactions influence fund holdings and trades?

Answer 20

The coefficient on Neighbors variable indicates that social interactions have a significant effect on fund holdings.

Results for other control variables:
Having a common manager has the largest effect on holdings overlap. Matching on fund style (large cap/small cap and value/growth) is important. When two funds have managers who manage a third fund together, the portfolio overlap is higher.
Funds that belong to the same fund family also have higher overlap.
Living in the same city and exposure to the same media market are significantly related to the overlap in mutual fund holdings.

Question 21

Is information shared through social (neighbor) networks value relevant?

Answer 21

1. Neighbors performance and stock characteristics:
   - Stocks with lower information efficiency provide more opportunities for acquiring an information advantage.
   - Neighbor funds are more likely to coordinate trades in opaque stocks.
   - Long-short strategy of buying hard-to-research stocks that neighbors buy together and selling those that they sell together significantly outperforms its benchmark, delivering abnormal return of 199bps per month.
2. Neighbor trading and past performance:
   - Since similarities in portfolio choices arise from social interactions, neighbor managers who make successful similar trades in the past will be more likely to discuss ideas again in the future, and enter into coordinated trades.

The word-of-mouth influence among mutual fund managers likely represents the transmission of value-relevant information.
Neighbor portfolios earn positive returns, especially in hard-to-research securities.

Question 22

Disentangle social interactions from community and similar preference effects.

Answer 22

This overlap are motivated by social interactions, not similar preferences.

Question 23

Managers have greater commonality in their trades and holdings if they:

Answer 23

1 Work at the same fund family.
2 Are of similar age.
3 Have the same ethnic background.
4 Are both experienced portfolio managers.
5 Attended same college.