Abstract
This study examines whether institutions are sophisticated investors that exploit stock characteristics known to predict future returns in Korea, using data from 2000 to 2018. We analyze the institutional demand, measured as a change in institutional ownership, for stocks with eight well-known anomalies as well as the future abnormal returns of institutional trading. We find that, generally, institutions do not trade consistently with stock anomaly predictions because they are reluctant to hold both highly overvalued and highly undervalued stocks. Although they use a few anomalies, they use these characteristics passively to avoid stocks known to underperform rather than to pick stocks known to outperform. Furthermore, the positive returns on long-legs are concentrated on stocks sold by institutions, while the negative returns on short-legs are concentrated on stocks bought by them. Our finding casts doubt on the widely-accepted notion that institutions are skilled investors and that institutional arbitrage trading corrects any mispricing in the market. To the contrary, institutions’ loss-averse trading behaviors cause or magnify mispricing.
Highlights
The trading behavior of institutional investors is a central concern in recent finance studies, because institutional trading has been increasing in international markets [1,2] and because institutions are widely argued to be more informed and sophisticated and equipped with advanced techniques [3,4,5,6,7]
We have reviewed eight well-known anomaly returns and investigated the relation between institutions’ trading behavior and anomalies in the Korean stock market
Institutions trade in a way consistent with the predictions of the BM, MOM, gross profitability (GP), and idiosyncratic volatility (IVOL) anomalies, in which the trading demand is concentrated on short-leg stocks
Summary
The trading behavior of institutional investors is a central concern in recent finance studies, because institutional trading has been increasing in international markets [1,2] and because institutions are widely argued to be more informed and sophisticated and equipped with advanced techniques [3,4,5,6,7]. The empirical evidence regarding whether institutional investors are skilled is mixed. While Kacperczyk et al [8], Mamaysky et al [9], and Kacperczyk and Seru [10] found evidence that some mutual fund managers are skilled enough to outperform, Jensen [11], Gruber [12], and Wermers [13] found no evidence that active funds outperform market average returns after taking fees into account, arguing that institutions are neither more informed nor more sophisticated. Recent studies on whether institutions use stock market anomalies found evidence that conflicts with commonly held notions. Lewellen [14] argued that institutional investors use anomalies to hold a market portfolio rather than gaining a return on investment. Edelen et al [15] insisted that institutional investors do not use anomalies but rather buy short-leg overvalued stocks and sell long-leg undervalued stocks, contrary to the anomaly hypothesis
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