Patterns of Institutional Investment, Prudence, and the Managerial "Safety-Net" Hypothesis

Abstract

Patterns of Institutional Investment, Prudence, and the Managerial Safety-Net Hypothesis Introduction The December 7, 1987 issue of Barron's reported that, as of September 30, 1987, the outstanding supply of equity in the U.S. capital markets was estimated to be $3.802 trillion. Of this amount, $1.427 trillion or 37.5 percent was in the hands of institutions. In the third quarter of 1987 alone, institutions purchased $142.393 billion worth of equity and sold $147.960 billion [Palmer (1987)]. Barron's also reported that, in the 13-month period of march 1986 to March 1987, on an average institutions accounted for 43.12 percent of the number of shares bought and 41.48 percent of the shares sold each month on the New York Stock Exchange [Norris (1987)]. (1) The law, recognizing the importance and the welfare implications of the monetary power of institutions, has laid down several crucial constraints, including severe penalties in case of imprudent management, on the investment behavior of institutional portfolio managers. similarly, researchers have long acknowledged the major role of institutional investors in U.S. capital markets [see Cummins, Percival, Westerfield, and Ramage (1980), Ledolter and Power (1984), Cummins and Westerfield (1981), and Demsetz and Lehn (1985)]. However, institutional portfolio managers' methods for selecting their investments in this environment hs received scant attention. Because their activities are governed by laws not applicable to an individual investor, it is conceivable that traditional portfolio selection criteria, such as minimizing portfolio variance for a given level of target return, may not adequately capture all the relevant aspects of institutional investment. Earlier research on institutional investment examined the effect of the passage of the Employee Retirement Security Act of 1974 (ERISA) on private pension plans. For example, Cummins et al (1980) present survey evidence regarding te impact of ERISA on the investment policies of private pension plans. They find that ERISA has caused these plans to adopt written statements of investment policy and guidelines, to purchase fiduciary liability insurance, to place greater emphasis on performance measurement, and to seek an oerall decrease in portfolio risk. Cummins and Westerfield (1981) investigate the impact of ERISA on the level of diversification in the portfolios of private pension plans, and suggest that the observed decline in their portfolio concentration ratios may be due to ERISA which evaluates prudence in the framework of modern portfolio theory. This differs from the traditional rule under common law in which each security in the portfolio had to indiidually qualify as a prudent investment. (2) These authors also documented evidene supporting the two-tier market hypothesis which implies that institutional investors concentrate their activity on the stocks of large firms. (3) This study of institutional investment behavior attempts to determine the impact of the prudent man rule in a broder sense. Particularly, the study investigates patterns of institutional ownership of common stock without discriminating between types of institutional investors. The interest is in determining factors which influence the investment choices of the institutional portfolio manager. The perspective taken is unique in that it incorporates the propensity of institutional portfolio managers to protect their income potential in determining investment choices. The decisions of institutional portfolio managers are distinguished owing to the fiduciary responsibility arising from the handling of client capital. Since managers' performance and investment choices are continually monitored and evaluated, they tend to insure that not only are their investment decisions intrinsically sound, but would be considered by others to be decisions which are reasonable, well-informed, and prudent. This external evaluation of investment choices becomes substantially more significant during times of lack-luster performance. …