Herding and Feedback Trading by Different Types of Institutions and the Effects on Stock Prices

This paper analyzes a comprehensive sample that categorizes the U.S. equity holdings of institutions, from 1984 to 1993, by investment advisors, banks, insurance companies, mutual funds, and internally managed pension funds and endowments. We find that with the exception of mutual funds, all types of institutions positive-feedback trade on both the buy and the sell side. Positive-feedback trading by mutual funds consists mainly of the selling of past losers. This sell-side positive-feedback trading affects the contemporaneous abnormal returns of past losers and thus appears to contribute to return-momentum. On the buy side, however, contemporaneous returns increase with the magnitude of institutional demand, regardless of past-quarter returns. Thus, we show that institutional herding affects prices beyond what can be attributed to a momentum effect. There is, however, no evidence of price destabilization. In fact, when we consider the future returns subsequent to the observed demand, we detect a significantly positive relation between institutional demand and future returns that is due mainly to investment advisors and mutual funds. For investment advisors, this relation is attributable to predictive ability, whereas for mutual funds, it is due mostly to momentum trading, with some limited predictive ability apparent on the sell side. The general impression is one of well-informed institutions, especially investment advisors, trading in a way that contributes to long-run market efficiency. Herding and Feedback Trading by Different Types of Institutions and the Effects on Stock Prices Over the last two decades institutions have become the dominant managers and traders of U.S. equities. According to Friedman (1996), the market-value fraction of U.S. equities controlled by institutions grew from 19.6 percent in 1970, to 39.1 percent in 1980 and then to 51.8 percent in 1994. The proportion of trades accounted for by institutions would appear to be even higher given Schwartz and Shapiro’s (1992) finding that institutions were responsible for about 70 percent of the trading volume on the New York Stock Exchange during 1989. The increasing dominance of institutions highlights the importance of understanding the implications of their trades for stock market efficiency. Several recent papers have addressed this issue by observing the trading patterns of either pension funds, mutual funds, or institutional investors in general. In this paper, we study a comprehensive sample in which five types of institutions report quarterly equity holdings, from 1984 to 1993. The five types include investment advisors, banks, insurance companies, and mutual funds, as well as internally managed pension funds and endowments. The quarterly changes in holdings allow us to study the trading patterns of these institutions and their effects, if any, on stock prices. The significance of considering other types of institutions, in addition to pension funds and mutual funds, is emphasized in Gompers and Metrick (1998). They show that as of 1994, the market-value fractions of U.S. equities under the control of investment advisors and banks were 20.7 percent and 12.2 percent, respectively. Mutual funds controlled only 6.4 percent, insurance companies had 4.7 percent, and all remaining institutions (including internally managed pension funds and endowments) accounted for 4.6 percent. Also, over the previous decade, from 1984 to 1994, investment advisors experienced larger increases than other types of institutions in terms of the fraction (from 10.0 to 20.7 percent) and the market value (from $175.4 billion to 942.3 billion) of U.S. equities held. Over this same period, institutions other than investment advisors saw the combined market value of their U.S. equities increase