Sources of Institutional Performance

Abstract

An emerging body of empirical literature finds that institutions as a group are better investors than an average market participant. One part of the literature finds that institutions as a group outperform their benchmarks, before costs. This paper shows that outperformance of the aggregate institutional portfolio found in the previous literature can be explained by institutional preferences for stocks with high accounting profitability. In particular, risk-adjusted excess return on the institutional portfolio over the rest of the market during the 1982-2001 period can be explained by the fact that institutions avoided small stocks with low accounting profitability and overweighted large stocks with high accounting profitability. We do not find any evidence that this preference for accounting profitability is related to price momentum. The other part of the literature finds that fraction of institutional ownership positively predicts future stock returns in a crosssectional regression. We reconcile these findings with our portfolio results by showing that the fraction of institutional ownership is not a statistically significant predictor of firm-level stock returns once we take into account book-to-market, return on equity, size, and biases caused by high positive correlation between the fraction of institutional ownership and stock size.