Abstract
This paper estimates the effects of peer benchmarking by institutional investors on asset prices. To identify trades purely due to peer benchmarking as separate from those based on fundamentals or private information, the paper exploits a natural experiment involving a change in a government imposed underperformance penalty applicable to Colombian pension funds. This change in regulation is orthogonal to stock fundamentals and only affects incentives to track peer portfolios allowing the authors to identify the component of demand due to peer benchmarking. The authors find that peer effects among pension fund managers generate excess in stock return volatility, with stocks exhibiting short-term abnormal returns followed by returns reversal in the subsequent quarter. Additionally, peer benchmarking produces an excess in comovement across stock returns beyond the correlation implied by fundamentals.
Highlights
In financial markets, institutional investors manage a significant portion of the total assets and account for an even greater portion of the trading volume
To isolate the component of demand which arises solely due to peer benchmarking, we study trading behavior by Colombian pension fund managers in the presence of a peer-based under-performance penalty known as the Minimum Return Guarantee (MRG)
The primary object of interest in this paper is to test whether trades by pension funds affect stocks’ contemporaneous returns, subsequent returns, and the level of comovement across domestic stock prices
Summary
Institutional investors manage a significant portion of the total assets and account for an even greater portion of the trading volume. A commonly held view among practitioners and market observers is that institutional investors “herd”, or trade excessively in the direction of the recent trades of other managers, which in turn has important implications for equilibrium prices. Managers may receive correlated private information, perhaps from analyzing the same indicator (investigative herding) or by eliciting information from the past trades of better-informed managers (informational cascades) and trade in the same direction (e.g Bikhchandani et al, 1992; Hirshleifer et al, 1994; Sias, 2004). Managers might disregard private information and trade with the crowd due to the reputational risk of acting differently from their peers (reputational herding).. Managers might disregard private information and trade with the crowd due to the reputational risk of acting differently from their peers (reputational herding). Due to the fact that only trades are observed and not the incentives driving these trades, identification of the explanations for institutional herding is an outstanding empirical challenge
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