From 1980 to 2007, the share of U.S. common equity held by mutual funds, hedge funds, pensions, bank trust departments and other institutions more than doubled, from 32 percent to 68 percent of total market value. Given their market share, the performance of these institutional investors is of great interest.
The 2010 study Institutional Investors and the Limits of Arbitrage examined the performance of this group of investors. The study started with about 500 institutions in 1980 and finished with nearly 2,700 at the end of 2007. The following is a brief summary of his findings:-- Institutions showed little tendency to bet on any of the main characteristics known to predict stock returns -- such as book-to-market, momentum or accruals. Instead, they held portfolios that closely mimic the market.
-- There was little evidence of stock-picking skill.
-- Pre-cost returns had nearly perfect correlation with the value-weighted index.
-- Performance was almost entirely explained by a four-factor model (beta, size, value and momentum). This holds true when ranking by past performance. (There was no persistence beyond the randomly expected.)
-- Stock-picking ability was reliable only for smaller stocks, which made up a tiny fraction of holdings. For example, institutions' investment in micro-cap stocks (stocks below the NYSE 20th percentile) outperformed a value-weighted index of those stocks by a significant 0.57 percent quarterly, but represented just 1 percent of their total holdings.
-- Institutions' investment in large-cap stocks (stocks above the NYSE 80th percentile) outperformed a value-weighted index of those stocks by just 0.01 percent quarterly and represented nearly 80 percent of their holdings.
It seems that institutions, in aggregate, did little more than hold the market portfolio. However, because of efforts to generate alpha they generated significant costs and fees. Because most of the trading was done by institutional investors, active trading by one institution largely offset active trading by other institutions. In other words, there just weren't enough victims (less-sophisticated individual investors) to exploit to fully cover the costs of the effort and generate alpha. In fact, institutions that traded the least seemed to do the best.
Also, the apparent stock-picking skills in small caps can perhaps be explained by the types of stocks individual investors prefer. Many investors hope to strike it rich by purchasing low-priced stocks, stocks in bankruptcy and IPOs, essentially playing the lottery and hoping they'll come up with the winning ticket. Institutions could generate alpha in the small-cap asset class simply by avoiding stocks with these characteristics. In addition, it's also possible that institutions benefited from allocations to good IPOs, while individuals got stuck with the bad ones.
Finally, if there ever was a time when institutions could generate alpha by exploiting less-sophisticated individual investors, that time seems long past as institutions now hold a large majority of assets and account for an even larger share of trading. The study's author confirmed prior research that has demonstrated that while institutional investors hired managers with past persistent alpha, they didn't continue delivering alpha after hiring.