information asymmetries & portfolio concentration

INFORMATION ASYMMETRIES & PORTFOLIO

CONCENTRATION

DECEMBER, 2014 INDIAN INSTITUTE OF MANAGEMENT, LUCKNOW

Prabandh Nagar, Lucknow - 226013

Submitted By:

Syed Danish Hasan

(PGP 29194)

Under Guidance of

Dr. Ajay Garg

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Contents

I. Introduction ....................................................................................................................... 3

II. Review of Literature ....................................................................................................... 4

III. Gap ....................................................................................................................................... 9

IV. Hypothesis Development .............................................................................................. 9

V. Research Design ............................................................................................................ 11

VI. Results ............................................................................................................................... 14

VII. Conclusion ........................................................................................................................ 18

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Abstract

We document evidence of the superior performance of portfolios constructed

by agents with strong informational advantage. The portfolios constructed by

such agents outperform the benchmark by average excess return of 1.22%

on a monthly basis. Further evidence has been documented that these

portfolios tend to give superior performance without any intentional

diversification. Such portfolios may have high industrial concentration and

relatively less number of stocks, however, they have exhibited excess returns

over long periods. This result can be used as one of the explanations to

portfolios biases like aggregate home equity bias, bias of individual investors

to invest in assets that are highly correlated with non-financial income, bias

to invest in employer stocks etc.

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I. Introduction

Financial economists have debated the Efficient Market Hypothesis (EMH) for

decades. There have been instances of inefficiencies even in most developed

markets. Empirical evidence suggests that inefficiencies in the market give rise

to information asymmetries that if exploited by skilled investors, ensure

persistent excess returns. Further, a number of studies have concluded that the

investors often exhibit biased tendencies towards portfolio construction that

cannot be explained by modern portfolio theory. Excessive concentration,

investing in home equity more heavily, investing in assets that are strongly

correlated with financial income etc. are some of the most popular biases. In

this paper, we attempt to explain a rational justification for such irregularities in

the market place. Some literature suggests that the retail investors make their

decision arbitrarily and are more often than not guided by over confidence

making irrational choices. Our study, attempts to explain that there can be more

rational reasons for such biases like existence of information asymmetries in the

market place that encourage the participants to deviate from regular portfolio

theory to exploit most of the benefits derived from such inefficiencies. We

hypothesize that the portfolios constructed on basis of superior informational

advantage beat the market and it is acceptable for a market participant to violate

basic portfolio laws like diversification across industries, asset classes or

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geographies to earn excess returns in such instances. The proposed study is

divided into six sections. The first sections involves review of literature and

explores previous studies conducted in the area of information asymmetry,

portfolio concentration and equity biases. The second section lists the gap in the

area of study, which is the area we intend to cover in this paper. The following

section deals with the hypothesis development after studying existing literature

and initial examination. The fourth section lays down the research design, which

explains the variables chosen, the data used and its sources and detailed

methodology used to conduct the proposed study. The next section documents

the result of our study and its implications. The last sections concludes the study

with interpretations of the result in explaining the equity biases we had listed

earlier and summarized the performance of concentrated portfolios constructed

with superior informational advantage.

II. Review of Literature

In this section of our paper, we intend to explore previous studies conducted in

the area of portfolio concentration, information asymmetries and the ability of

investors to earn excess returns. The ability to earn excess returns consistently

demonstrate instances of inefficiencies or existence of some informational

advantage in the markets.

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To begin with, we find that Coval, Hirshleifer, and Shumway (2002) document

that individual investors that have performed abnormally well in the past

continue to perform abnormally well in the future. Thus, it appears that some

skillful individual investors might be able to exploit market inefficiencies to earn

abnormal profits.

Another study by Ivković and Weisbenner (2004) find that households exhibit a

strong preference for local investments and further show that, on average,

individuals’ investments in local stocks outperform their investments in non-local

stocks, suggesting that investors are able to exploit local knowledge. The excess

return is particularly large for stocks not included in the S&P 500 Index, in regard

to which informational asymmetries between local and non-local investors may

be the largest.

The empirical literature studying the performance of individual investors finds

that, on average, households’ stock investments perform poorly. For example,

Odean (1999) reports that individual investors’ purchases tend to underperform

their sales by a significant margin. Barber and Odean (2000, 2001) further show

that, on average, individual investors who hold common stocks pay a substantial

penalty in performance for trading actively. These results are consistent with the

hypothesis that individual investors are overconfident and trade excessively.

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Consistent with Odean (1999), we find that, on average, the stocks bought by

individual investors underperform the stocks they sell by a wide margin.

However, we find that the reverse is true for households with concentrated

investments. This result is particularly strong for households with large account

balances. The purchases of diversified investors with account balances of at least

$100,000 underperform their sales by 1.8 percentage points per year. On the

other hand, the purchases of concentrated investors with such large account

balances outperform their sales by 3.0 percentage points per year. The excess

return associated with concentration is stronger for investments in local stocks

and stocks that are not included in the S&P 500 Index (which tend to have less

analyst coverage and national media attention), potentially reflecting

concentrated investors’ ability to exploit informational asymmetries.

In sum, these findings are consistent with the hypothesis that skilled investors

can exploit informational asymmetries by concentrating their portfolios in the

stocks about which they have particularly favorable information.

The empirical literature has documents a number of portfolio biases among retail

investors that are beyond rational explanation of portfolio economics. The

“equity home bias” being perhaps the best known example. The term refers to

the observation that aggregate national portfolios are strongly biased towards

holding domestic equity assets and generally exhibit a low propensity for

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investing in foreign equity assets (see among others French and Poterba (1991),

Tesar and Werner (1998), and Ahearne et al. (2004)). This can be justified on

many grounds. Equity investment in foreign companies requires understanding

of different accounting practices and legal environments. Domestic investors are

exposed to a wide array of sources of local news that can convey useful

information about the performance of domestic companies. In addition,

geographical proximity allows for face-to-face contacts with local corporate

executives, employees and other individuals that may have valuable private

information.

A number of other portfolio biases have also been identified at the individual

investor level. Huberman and Sengmueller (2004), Poterba (2003), Benartzi

(2001), find that investors overinvest in the stock of their own employer or in

the stock of other companies in the same industry. Ivkovi´c and Weisbenner

(2005) and Huberman (2001) find that investors exhibit a “local bias” – the

tendency to overinvest in assets that are geographically close to the investor’s

place of residence. Massa and Simonov (2006) show that investors tilt their

portfolios away from the market portfolio, and towards assets with a significantly

higher correlation with their non-financial income. Goetzmann and Kumar (2008)

show that the stocks individual investors hold are highly correlated with each

other, which suggests that they are driven by the same risk factors. All these

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findings indicate that retail agents tends to concentrate their investments in

assets that are closely related to their domicile, work place, profession etc.

Such aggressive investments in non-financial income related assets go against

the law of diversification and can be a result of over confidence of these investors

with regard to assets they presume they have a superior understanding about.

On the other hand, such concentration can be an outcome of informational

advantage which is then a rational justification.

Another important study in the area of informational asymmetries and portfolio

biases explain the relationship between agent’s capacity to process information

and portfolio concentration. Rosen Valchev (2014) finds that that portfolio

concentration has a non-monotonic relationship with an agent’s capacity to

process information. Agents with a low capacity find it optimal to specialize in

acquiring information about only one asset and thus allocate any extra

information capacity to the same asset, while agents with a high capacity choose

to spread their efforts across a variety of different assets. Thus, the resulting

information asymmetry and hence the degree of portfolio concentration is

increasing in the capacity for information acquisition when the capacity is low,

and decreasing when it is high.

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III. Gap

Literature exists for studies on the information asymmetries in the market and

relative portfolio construction. We explore the empirical evidence regarding the

portfolios constructed with superior information and their performance against

the benchmark portfolios or portfolio constructed by average informed investors.

We seek to test the evidence in Indian equity markets that the superior

information based portfolios outperform the market and unnecessary

diversification should be avoided as it dilutes the informational advantage in the

portfolio.

IV. Hypothesis Development

For the purpose of our study we divide agents for every security into two broad

heads:

1. Average (Informed) Agents: These agents have access only to publicly

available information for a given asset. Moreover, it is quite possible that

these agents do not assimilate all publicly available information due to

their processing constraints. The major constraints in this regard may be

cost of accessing information, time constraints etc.

2. Superior (Informed) Agents: These agents have access to information

beyond public domain. They may also have superior information

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processing capabilities involving quick access to information, expertise to

understand the asset traded etc. Such agents, in sum, have a sustainable

competitive advantage as participants in the financial markets against

their average informed counterparts.

It is on these grounds, that we hypothesize that the informed agents can

produce excess returns consistently due to their competitive advantage in the

market. The information asymmetry should theoretically place them ahead of

their less informed counterparts. Hence, the following hypothesis:

Hypothesis 1: Portfolios constructed by superior informed agents should

demonstrate greater returns than those produced by average informed agents.

Moreover, in order to test our hypothesis, we would need instances where the

superior informed agents had high informational advantage. It is for this

purpose, we need to identify instances of maximum information asymmetries in

the market place. Looking into literature in the area, a study by Ivković and

Weisbenner (2004) state that the excess return for investors investing in local

stocks, is particularly large for stocks not included in the S&P 500 Index, in

regard to which informational asymmetries between local and non-local investors

may be the largest. Thus, our second hypothesis in this regard:

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Hypothesis 2: Degree of information asymmetry is directly proportional to

magnitude of excess returns produced.

V. Research Design

This section deals with laying out the structure of the research done under three

broad heads, the variables chosen for the study, the source of the data and the

methodology to arrive at the results.

(a) Variables

For the purpose of our study, we chose relevant proxies for superior informed

agents and instances of high information asymmetries.

The proxy for superior informed agents in our study shall be management of a

company. It is assumed that the management has better insights in the business

it manages than an average informed investor that has access to public domain

information only. Further, management has an ability to better process the

information available regarding their company as compared to an average

investor due to advantages in cost of acquiring information and more relaxed

time constraints. Hence, the management of the company has better

understanding of the underlying business of a company and can better forecast

the operating performance of the business.

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The second proxy is for instances of high information asymmetries in the market

place. Literature suggests that the companies that are not a part of major indices

and have relatively less number of analysts following them have higher

information asymmetries. This is because a major part of the public domain

information and analysis is provided by analysts at brokerage houses and

investment funds for their clients. For smaller and relatively unknown companies,

the sources of reliable public information are few and may be sometimes limited

to only financial statements, annual reports and shareholder general meetings.

Thus, in such scenarios, the company’s traded volumes also remain low and

relatively higher percentage of the trades are performed by agents who have

some superior insights as a cause of their trade. Hence, we have companies with

relatively low trading volumes as proxies for assets that have high information

asymmetry.

(b) Data

Bloomberg Professional Services Terminal was used to collect data for the test.

Equity Screening was done to find companies that rank high on the decided ratio.

The screening criteria included companies that were a part of an Indian Stock

Exchange; had management buying a considerable stake in the company that it

gets reported and ranked in top 125 companies on the basis of decided ratio and

had the Bloomberg services covering them.

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(c) Methodology

Our study involves construction of portfolios whose assets are selected based on

superior informational advantage and in circumstances where the gap of

information between superior informed and average informed agents is

maximum. To achieve this objective, we device the following ratio which shall

be used to select companies for our portfolio:

𝑀𝑎𝑛𝑎𝑔𝑒𝑚𝑒𝑛𝑡 𝐵𝑢𝑦 𝑉𝑜𝑙𝑢𝑚𝑒 𝑓𝑜𝑟 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑦 𝑋 𝑖𝑛 𝑚𝑜𝑛𝑡ℎ 𝑌

𝑇𝑜𝑡𝑎𝑙 𝑉𝑜𝑙𝑢𝑚𝑒 𝑇𝑟𝑎𝑑𝑒𝑑 𝑜𝑓 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑦 𝑋 𝑖𝑛 𝑚𝑜𝑛𝑡ℎ 𝑌

Examining all Indian securities on this parameter, we shall be selecting assets

that rank high on the stated ratio. The stated ratio ensures that the securities

that are thinly traded are and have relatively high management buy share for a

month get added to the portfolio. Further, it was ensured that the management

buy volume came from management buying from open market in anticipation of

capital appreciation indicating strong business prospects and not from exercise

of ESOPs that may be quite unrelated to business performance forecasts.

Such portfolios have been constructed for every month from November 2009 to

October 2014 creating 60 instances of portfolios constructed with such superior

informational advantage. Each of these 60 portfolios represent a different time

frame and their performance is tested against the performance of the benchmark

for the concerned time frame. The benchmark for the purpose of the study has

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been chosen as BSE 500 index as it makes a fair representation of the market

both in terms of number of stocks chosen and the breadth of the securities on

basis of market capitalization to industries covered.

The monthly returns achieved for each of the 60 portfolios were recorded and

compared against the benchmark return. Excess returns (Portfolio return –

Benchmark Return) was calculated for each of the 60 instances. The average of

these excess returns was calculated which represents the average performance

of these portfolios constructed on basis of this strategy of the specified.

This excess return was statistically tested for significance to see if the results

obtained are significant to prove that such portfolios offer superior return.

VI. Results

The t-test results on the significance of excess returns proves that the returns

of the constructed portfolio are superior of the returns obtained by the

benchmark at 99.9% confidence level. The summarized results of the test are

presented below:

Average Monthly Returns of Constructed Portfolio 2.96%

Average Monthly Returns of Benchmark 1.74%

Average Excess Returns 1.22%

Standard Deviation of Excess Returns 2.27%

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T-Stat for Significance of Excess Returns 4.181

Confidence Level of Significance of Results 99.98%

Thus, the study proves that the portfolios constructed with superior

informational advantage in instances of high information asymmetry beat the

market. Now, studying the implications of this result, the first conclusion is that

the market is not strongly efficient in the sense Fama (1970) defined strong

efficiency. This makes practical sense as strong efficiency in markets if proved

would make all insider trading and anti-trust laws useless.

Secondly, analyzing the portfolios so constructed, it should be kept in mind that

no conscious efforts were made to diversify them on the basis of industrial

composition, number of stocks etc. to reduce unsystematic risk. Hence, as

expected the standard deviations of the returns of these portfolios is more than

that of the benchmark. The standard deviation of the portfolios and the

benchmark was found as below:

Standard Deviation of Constructed Portfolio Returns 3.069%

Standard Deviation of Benchmark Returns 0.999%

However, it should be noted that the number of stocks in these portfolios is fairly

large and still the standard deviation of the returns in our constructed portfolio

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is significantly more than the standard deviation of the benchmark that too at

high confidence levels.

The number of stocks in each of the 60 constructed portfolios is given as under:

Portfolio Beginning No. of Stocks Portfolio Beginning No. of Stocks

November 2009 7 May 2012 44

December 2009 14 June 2012 59

January 2010 13 July 2012 49

February 2010 10 August 2012 60

March 2010 10 September 2012 67

April 2010 20 October 2012 57

May 2010 5 November 2012 51

June 2010 10 December 2012 58

July 2010 17 January 2013 51

August 2010 18 February 2013 77

September 2010 15 March 2013 109

October 2010 16 April 2013 106

November 2010 16 May 2013 72


January 2011 16 July 2013 97




May 2011 17 November 2013 62

June 2011 21 December 2013 71

July 2011 29 January 2014 73

August 2011 32 February 2014 66

September 2011 43 March 2014 102

October 2011 40 April 2014 116

November 2011 34 May 2014 66


January 2012 51 July 2014 50




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We observe that the average number of stocks in the portfolio is 48.5 which is

quite high to diversify most of the component of unsystematic risk. The observed

beta of the portfolio is 2.65. Literature in portfolio theory suggests that it is

usually difficult to produce statistically significant alphas if we have large number

of stocks in a portfolio. However, the excess returns the portfolio has produced

have certainly backing of strong information asymmetries that the portfolio has

exploited resulting in superior returns.

Also, it can be argued that the risk adjusted returns of these portfolio should

also be statistically superior. However, it should be noted that the conventional

methods to measure risk here should not be used as they primarily rely on

standard deviation as a measure of risk. In our case, all risk measures based on

the variation of returns will yield low risk adjusted returns because of the nature

of our strategy. We had consciously chosen stocks that trade thinly which directly

implied that any trading will cause heavy price movements and thus high

volatility.

We should understand that the investments made by the management in their

company are essentially with a long term horizon and monthly deviation of

returns would not be much relevant. These investments are usually based on

long term forecasts regarding the performance of the business and hence the

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performance should also be measured over same horizon and not on a daily or

monthly basis.

VII. Conclusion

The result provides evidence that it can be economically rational for an investor

to invest in stocks he knows about well, i.e., in stocks in which he has a

competitive advantage based on strong information asymmetry and avoid

unnecessary diversification.

This result also explains several biases that have been documented that are

considered a deviation from rational portfolio economics. First, the home equity

biases in which national aggregate equity portfolios are heavily weighted with

domestic assets, could be rationally justified as domestic investors may be

having a competitive advantage on home stocks in terms of information and our

study documents that such a strategy also provides superior returns in the long

run. Similarly, tendency of investors to invest in assets highly correlated to their

non-financial income such as concentrated investment in industry one works in,

investment in employer’s equity or equity of employer’s competitors could be

explained on similar lines.

In sum, concentrated portfolios with strong informational advantage should be

preferred over well diversified portfolios constructed with public information.

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information asymmetries & portfolio concentration

Economy & Finance