Int. Fin. Markets, Inst. and Money 16 (2006) 370383
Do institutional investors destabilize stock prices?evidence from an emerging market
Martin T. Bohl a,, Janusz Brzeszczynski ba European University Viadrina, Groe Scharrnstrae 59, 15230 Frankfurt (Oder), Germany
b Heriot-Watt University, Edinburgh, UK
Received 16 April 2004; accepted 11 May 2005Available online 31 August 2005
In this paper, we provide empirical evidence on the impact of institutional investors on stockmarket returns dynamics in Poland. The Polish pension system reform in 1999 and the associatedincrease in institutional ownership due to the investment activities of pension funds are used as aunique institutional characteristic. We find robust empirical evidence that the increase of institutionalownership has changed the autocorrelation and volatility structure of aggregate stock returns. However,the findings do not support the hypothesis that institutional investors have destabilized stock prices. Theresults are interpretable in favor of a stabilizing effect on index stock returns induced by institutionaltrading. 2005 Elsevier B.V. All rights reserved.
JEL classication: G14; G23
Keywords: Institutional traders; Polish pension fund investors; Stock market volatility
Earlier versions of this paper were presented at the Brown Bag Seminar at the Arizona State University, researchseminars at the Deutsches Institut fur Wirtschaftsforschung, the European University Viadrina, the Peoples Bankof China and the Nicolaus Kopernikus University Torun, the annual conference of the Verein fur Socialpolitik andthe 11th annual meeting of the German Finance Association.
Corresponding author. Tel.: +49 335 5534 2984; fax: +49 335 5535 2959.E-mail address: email@example.com (M.T. Bohl).
1042-4431/$ see front matter 2005 Elsevier B.V. All rights reserved.doi:10.1016/j.intfin.2005.05.005
M.T. Bohl, J. Brzeszczynski / Int. Fin. Markets, Inst. and Money 16 (2006) 370383 371
The increase in the number of institutional investors trading on stock markets world-widesince the end of the 1980s has been associated with a rise in the financial economists interestin institutions impact on stock prices. In particular, there is a popular belief that institutionaltraders destabilize stock prices. Due to their specific investment behavior institutions aresupposed to move stock prices away from fundamentals and thereby induce stock returnsautocorrelation and increase returns volatility. Herding and positive feedback trading arethe two main arguments put forward for the destabilizing impact on stock prices inducedby institutional investors. Consequently, empirical investigations in the existing literaturehave been focused on the question of whether institutional traders exhibit these types ofinvestment behavior.1
However, evidence in favor of herding and positive feedback trading does not necessarilyimply that institutional traders destabilize stock prices. If institutions herd and all react to thesame fundamental information in a timely manner, then institutional investors will speed upthe adjustment of stock prices to new information and thereby make the stock market moreefficient. Moreover, institutional investors may stabilize stock prices, if they collectivelycounter irrational behavior in individual investors sentiment. If institutional investors arebetter informed than individual investors, institutions are likely to herd to undervalued stocksand away from overvalued stocks. Such herding can move stock prices towards rather thanaway from fundamental values. Similarly, positive feedback trading has been shown to bestabilizing, if institutional traders underreact to news (Lakonishok et al., 1992).
Cohen et al. (2002) provide empirical evidence on the stabilizing impact of institutionsfor US data. Institutions respond to positive cash-flow news by buying stocks from individ-ual investors, thus exploiting the less than one-for-one response of stock prices to cash-flowreports. Moreover, in case of a price increase in the absence of any cash-flow news insti-tutions sell stocks to individuals. The findings by Cohen et al. indicate that institutionalinvestors push stock prices to fundamental values and, hence, stabilize rather than destabi-lize stock prices. Barber and Odean (2003) find for the US that individual investors displayattention-based buying behavior on days of abnormally high trading volume, extremely neg-ative and positive 1 day returns and when stocks are in the news. In contrast, institutionalinvestors do not exhibit attention-based buying. While the behavior of individual investorsmay contribute to stock returns autocorrelation and volatility, institutions may induce astabilizing effect on stock price dynamics.2
We can conclude from the short discussion above that empirical findings on institutionalinvestors herding and positive feedback trading behavior are not necessarily evidence infavor of the destabilizing effect on stock prices. However, these results provide us with onlyindirect empirical evidence on the destabilizing effects of institutional investors tradingbehavior on stock prices. The existing literature on institutional trading behavior is pre-
1 Evidence on institutions trading behavior can be found in, for example, Lakonishok et al. (1992), Grinblattet al. (1995), Nofsinger and Sias (1999), Wermers (1999), Badrinath and Wahal (2002) and Griffin et al. (2003).
2 These findings are in contrast to the empirical results in, for example, Sias and Starks (1997), Sias et al.(2001) and Dennis and Strickland (2002) which come to the conclusion that institutional investors trading has adestabilizing effect on stock returns.
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dominantly forced to rely on quarterly ownership data to compute changes in institutionalholdings and in turn draws conclusions about the behavior of institutional investors. Incontrast, under the condition that the entrance date of a large number of institutions in thestock market is known, a GARCH-type event study may provide direct empirical evidenceof whether institutions change significantly the autocorrelation and the volatility structureof stock index returns. In a time series framework we are able to investigate empirically theconsequences of a structural break in institutional ownership on the stock returns behavior.
The specific history of the Polish stock market provides a unique institutional featureand opportunity allowing us to contribute to the literature on the institutional investorsimpact on stock prices, arising from the pension system reform in Poland in 1999, whenprivately managed pension funds were established and allowed to invest on the capitalmarket. We focus on the autocorrelation pattern and, in particular, on the volatility behaviorof stock returns prior to and after the first transfer of money to the pension funds on 19 May1999. The appearance of large institutional traders and the resulting increase in institutionalownership allows us to investigate the impact on stock returns autocorrelation and volatility.Specifically, we use a variant of the asymmetric GARCH model put forward by Glosten et al.(1993) to test whether the models key coefficients change after the entrance of institutionaltraders in the Polish stock market.
The remainder of the paper is organized as follows. Section 2 contains a brief descriptionof the pension system reform and its consequences for the investors structure in the stockmarket in Poland. In Section 3, the time series methodology is outlined and in Section 4, thedata as well as the empirical findings are presented. Section 5 summarizes and concludes.
2. Pension system reform and investors structure on the stock market in Poland
Re-established in 1991, the Polish stock market has grown rapidly during the last decadein terms of the number of companies listed and market capitalization. In comparison to thetwo other European Union accession countries in the region, i.e., Czech Republic and Hun-gary, the capitalization of the Polish stock market is significantly higher. The capitalizationis comparable to the smaller, mature European markets, like the Austrian stock market, andequals currently about 45 billion $-US.
The major change in the investors structure on the Polish stock market has its origin inthe pension system reform. In 1999, the public system was enriched by a private component,represented by open-end pension funds. Participation in this component, often called thesecond pillar, is mandatory for employees below certain age. They are obliged to transfer7.3% of their gross salary to the government-run social insurance institute called ZakadUbezpieczen Spoecznych (ZUS), which in turn transfers the collected contributions to thepension funds. The first transfer of money from the ZUS to the pension funds took placeon 19 May 1999. This date marks a significant change of the investors structure in thePolish stock market. In 1999, about 20% domestic institutional investors and 45% domes-tic individual investors traded at the Warsaw Stock Exchange. This situation has nearlyreversed and the number of institutional traders approximately doubled after 1999. Con-stantly about 35% of the investors on the Polish stock market adhere to the group of foreigninvestors.
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While before 19 May 1999 the majority of traders were small, private investors,after that date pension funds became important players on the stock market in Poland.There were also some mutual funds active in the market but they had relatively smallamounts of capital under management. Moreover, the role of corporate investors, i.e.,companies investing their capital surpluses, was very marginal. It is this feature in thehistory of the Polish stock market which constitutes the major change in the investorsstructure. This unique institutional characteristic allows us to compare the period before19 May 1999 characterized predominantly by non-institutional trading with the periodafter that date, where pension funds as institutional investors started to act on the stockmarket.
The number of pension funds in the 19992003 period varied between 15 and 21. Thechange in their number occurred mainly due to the acquisitions of the smaller funds bythe larger ones. It is important to note, however, that their structure as well as the structureof the assets under their management remains invariant. By the end of 2003, 17 pensionfunds operated in the Polish stock market with about 8 billion $-US under management. Incomparison, Polish insurance companies and mutual funds had only 3 and 1 billion $-US ofassets, respectively. In 2003, the pension funds invested about 3 billion $-US in stocks listedon the Warsaw Stock Exchange. Those funds account for about 17% of the Warsaw StockExchange daily turnover. Their stock holdings predominantly consist of large capitalizationstocks that are listed in the blue-chip index WIG20 and usually belong to the Top 5 in theirindustries (Karpinski, 2002). Therefore, pension funds have emerged as important playerson the Polish stock market with the capital to affect stock prices.
3. GARCH-type event study methodology
Our empirical investigation on the institutional traders influence on stock market auto-correlation and volatility relies on the following asymmetric GARCH model:
i0DtDoWit + 1Rt1 + 1DtRt1 + 2
htRt1 + 3RFt1 + t, (1)
ht = (1 + DDt)(0 + 1ht1 + 22t1 + 32t1It) (2)
1 if t 1999 : 5 : 190 if t < 1999 : 5 : 19
The index return is defined as the logarithmic difference Rt = ln Pt ln Pt1 and t =N(0, ht) denotes the unpredictable component of index returns.
5i=1DoWit are dummy
variables for Monday, Tuesday, Wednesday, Thursday and Friday i = 1,. . .,5. With thedummy variable Dt we model the structural change in the components of the mean Eq.(1) and the conditional volatility process (Eq. (2)) connected with the entrance of institu-tional traders on the Polish stock market on 19 May 1999. RFt1 denotes the logarithmic
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return on a foreign stock market index. It takes on the value of 0 if the return innovation is0 or positive, t1 0, and 1 in case the return shocks are negative, t1 < 0.
In its general form the mean equation takes into account: (1) a day-of-the-week-effect; (2)first-order autocorrelation in stock index returns; (3) non-linearity in the first-order autocor-relation pattern; (4) international interdependence of the Polish stock market as well as (5)a structural change in the autoregressive structure after the entrance of institutional traders.The inclusion of the dummy variables DoWit is motivated by the often documented season-alities in stock returns across the days of the week (French, 1980; Lakonishok and Levi,1982; Agarwal and Tandon, 1994). Moreover, substantial empirical evidence shows thatthe autocorrelation pattern of stock returns exhibits complexities that cannot be captured bythe simple first-order autocorrelation coefficient (LeBaron, 1992; Sentana and Wadhwani,1992; Campbell et al., 1993; Koutmos, 1997). To account for this effect, we assume thatautocorrelations of daily stock returns change with the square root of the conditional vari-ance of returns which are from our asymmetric GARCH model (Sentana and Wadhwani,1992). In addition, due to the interdependence of the Polish stock market with internationalstock markets, we include index returns on a foreign stock market RFt1 as a control variable(Jochum et al., 1999; Tse et al., 2003; Voronkova, 2004).
For the day-of-the-week dummies as well as the linear and non-linear first order autore-gressive components the possibility of a structural change after the entrance of institutionaltraders is modeled using the dummy variable Dt. Statistically significant coefficients i0,1 and 2 indicate a structural change in the pattern of stock returns after 19 May 1999.In particular, while 1 measures the extent of autocorrelation during the period before theentrance of institutional investors, the sum (1 + 1) provides an autocorrelation measurefor the period after the appearance of institutional investors.
The volatility Eq. (2) is a version of the asymmetric GARCH model put forward byGlosten et al. (1993) in which positive and negative shocks can have different effects onsubsequent volatility via the dummy variable It. Setting the asymmetry coefficient 3 equalto 0, yields the conventional GARCH specification as a special case of GJR model. Moreimportant for the question under scrutiny are the properties of the estimated parameter D.If institutional traders have an influence on the volatility structure of index returns, thecoefficient D should be statistically significant. The estimated coefficient D provides,thus, a measure of th...