investors' horizons and the amplification of market shocks cristina cella stockholm school of...
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Investors' Horizons and the Amplification
of Market Shocks
Cristina CellaStockholm School of Economics
Andrew EllulIndiana University
Mariassunta GiannettiStockholm School of Economics, CEPR and ECGI
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Research Motivation Severe market shocks cause panic selling precisely
when potential buyers are financially constrained
Investors with shorter trading horizons are inclined or forced to sell in bad times
Because of preferences or specialization, they care about short-term returns
Because they face constraints, such as investor outflows or margin constraints, shortening their horizons
De Long, Shleifer, Summers, Waldmann (1990)
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Theoretical MechanismsSelling pressure Limits to arbitrage
Shleifer and Vishny, 1997 Expectations of outflows due
to negative performance may lead investors to sell undervalued stocks
Financial market runs Bernardo and Welch, 2003; Morris
and Shin, 2004 Short horizon investors sell in
anticipation of sales of other market participants
Investors with long horizons can wait out the storm and generate less selling pressure
Margin constraints Brunnermeier and Pedersen, 2009
Lack of potential buyers Market frictions
Duffie, 2010; Duffie and Strulovici, 2009
Market frictions prevent buying capital from moving quickly to buy temporary undervalued stocks
Sales of distressed assets Shleifer and Vishny, 1992
When a distressed seller tries to sell an asset, she faces two types of potential buyers: (a) from the same industry and (b) outside the industry
If investors in the same industry are distressed as well, then buyers have to come from outside the industry
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This Paper
Can institutional investors’ trading horizons amplify the price effects of severe market shocks?
Such shocks will naturally impact stocks’ fundamentals
Stocks’ returns may vary cross-sectionally depending on the horizons of investors Do stocks of firms held by short horizon investors
experience larger temporary drops after negative shocks?
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Hypotheses
During severe market shocks, stocks mostly held by short-term investors should experience:
Larger drops – returns drop below their normal (expected) returns
Larger reversals If prices fall below their fundamental values then
reversals should occur as buyers move in to buy these stocks. Reversals should be largest precisely for stocks that have suffered the most severe drops.
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Related literature Fire sales
Coval and Stafford (2007), Mitchell, Pedersen and Pulvino (2007), Pulvino (1998), Campbell, Giglio and Pathak (2008) and Ellul, Jotikasthira and Lundblad (2009)
We explore the role of investor horizon in accentuating fire sales
Literature exploring the effects of investor horizon on corporate policies
Bushee (1998 and 2000); Gaspar, Massa, and Matos (2005) etc…
Papers exploring the effects of firm characteristics on returns during financial crises
E.g. Fahlenbrach and Stulz (2011); Lemmon and Lins (2003); Mitton (2002)
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The Main Event
Large stock market declines after Lehman Brothers’ bankruptcy in September 2008
S&P 500
-70%
-60%
-50%
-40%
-30%
-20%
-10%
0%
-15 -10 -5 0 5 10 15 20 25 30
Week
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Data Sources
Quarterly ownership information reported by Thomson Financial in 13Fs over the period 1990-2006
CRSP
COMPUSTAT
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Investor Horizons Horizon is identified as average holding period
(e.g., Carhart (1997), Barber and Odean (2000), Bushee (1998, 2000 and 2001), Gaspar, Massa and Matos (2005) and Yan and Zhang (2009))
We use the average investor’ turnover from 1990 to 2006
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Investor Horizons
Large variation in investor portfolio turnover 5th percentile turns over less than 1% of their portfolio
in a quarter 95th percentile turn over more than 50% of their
holdings in a quarter
Short horizon investors are not necessarily active investors Portfolio turnover has low correlation with the proportion of the
portfolio that deviates from the relevant index (Cremers and Petajisto, 2009)
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Investor Turnover
The average Investor Turnover (IT) of a high IT firm is 0.37 and that of a low IT firm is 0.19
An average turnover of 0.37 (0.19) implies that institutional investors holding these stocks rotate almost 19% (9.5%) of a portfolio in each quarter, and 76% (37%) in each year
This means that on average investors in high turnover firms hold their position for less than 16 months, while investors in low turnover firms hold their position for almost 33 months
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Trading and Investors’Horizons
In the aftermath of the Lehman shock, short-term investors sold 21% of their holdings compared to 7% sold by long-term investors
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Investors’ Horizons and Selling Pressure Selling pressure during episodes of market turmoil
may not necessarily be related to investors’ trading horizons
Some hedge funds had strict lock-up periods that limited outflows and had a lower propensity to sell during the crisis (Ben-David, Franzoni, and Moussawi (2010))
Index mutual funds without the protection of lock-up periods may face severe redemptions leading to severe selling pressure during periods of crisis
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Investors’ Horizons and Selling Pressure
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Investors Horizons and Selling Pressure In periods of market turmoil, all institutional
investors’ net sales increase by the equivalent of almost 0.3 standard deviations for an investor with average net sales and average churn ratio
The increase in net sales is equivalent to over 0.65 standard deviations for an investor with a churn ratio in the top quartile of the distribution but to less than 0.15 standard deviations for investors with a churn ratio in the lowest quartile
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Cumulative Abnormal Returns Two (main) definitions of normal (expected) returns
Based on the market model Estimated using weekly returns from the beginning of 2003
until the end of the first quarter of 2008
Based on contemporaneous returns of 100 portfolios sorted on size and book to market
Ikenberry, Lakonishok and Vermaelen, 1995
Robustness tests using (two) multifactor models including VIX and Pastor and Stambaugh’s liquidity factor
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CARs: Market Model
The stocks held to a larger extent by investors with shorter horizons The stocks held to a larger extent by investors with shorter horizons experience more severe price drops and larger price reversalsexperience more severe price drops and larger price reversals
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CARs: Size & Value Portfolios
Fama and French's 100 Portfolios CARs
-7%
-5%
-3%
-1%
1%
3%
5%
7%
9%
11%
-15 -10 -5 0 5 10 15 20 25 30
Week
Stocks mostly held by short-term institutions Stocks mostly held by long-term institutions
Non-financial stocks mostly held by short-term institutions Non-financial stocks mostly held by long-term institutions
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Economic and Statistical Significance
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Innovations in Implied Volatility
Innovations in time-varying market volatility, considered to reflect the probability of a market-wide meltdown, may either change the risk-return trade-off, or the expectations of future returns (Campbell (1996) and Chen (2002))
It can be argued that the price dynamics we uncover just reflect differences in the stocks’ exposure to the probability of a meltdown
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Innovations in Implied Volatility
Differences in exposure to aggregate volatility risk?
We estimate abnormal returns using Ang, Hodrick, Xing, and Zhang’s (2006) multifactor model
We use changes in aggregate volatility, measured by the VIX, as an additional factor in the computation of normal returns
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Exposure to Aggregate Volatility
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Exposure to Liquidity Risk
Heterogeneity between the two groups of stocks driven by their differences in the exposure to liquidity risk?
We estimate a multifactor model including the market return and the aggregated liquidity factor as in Pastor and Stambaugh (2003)
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Exposure to Liquidity Risk
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Rest of Talk
I will try to convince you that the previous striking figure does not depend on
firm heterogeneity
characteristics of the investors trading strategy (other than investor horizon)
i.e., indexers vs active investors; momentum traders
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Do Low and High IT Firms Differ?
Low and High IT firms differ along a number of dimensions
High IT firms have lower insider ownership
High IT firms are more liquid and more volatile
High IT firms have lower leverage
Yet, it’s important to notice that:
High IT firms have beta only slightly larger relative to low IT firms
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Is it Really Investor Horizon?
Portfolio sorts – looking at subsamples of more homogeneous firms Our benchmarks already take into account differences
in size and book-to market We find larger drops and reversals for stocks held by
short-term investors within portfolio quintiles sorted on Share turnover Not merely a liquidity effect Return volatility Past returns Not merely a momentum effect
Cross-sectional & panel regressions
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Portfolio Sorts
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Price Drop - Cross-section Analysis
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Price Drops – Panel Regressions
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Price Reversals
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Testing the Mechanisms (I)
Investors with short horizons may sell more for some (unobserved) reason related to returns
Investor portfolio turnover captures
trades whose motivation is to generate profits (or limit losses)
trades forced by other reasons such investor flows Historical correlation between assets under management and
past performance related to forced trades It can be used as an instrument
Instrumental variable estimates confirm the results shown so far
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Testing the Mechanism (II) Do short-term investors sell also the stocks mostly held
by long-term investors in their portfolios? If not some stock unobservable characteristics could explain
their trades
Net Asset Position as % of Total Asset Value (invested in each type of stock)
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Other Major Market Shocks
Do we point out something specific to the fall 2008?
Other events during the 2007-2008 crisis
Large mkt declines (15% drop in the S&P500 in one month)
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Other Major Market Shocks
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Other Major Market ShocksMultivariate Analysis
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Conclusions
Evidence that investors’ short trading horizons amplify negative shocks
Future research: What determines investor horizon?