Investors' Horizons and the Amplification

of Market Shocks

Cristina CellaStockholm School of Economics

Andrew EllulIndiana University

Mariassunta GiannettiStockholm School of Economics, CEPR and ECGI

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)

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

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?

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.

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)

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

Data Sources

Quarterly ownership information reported by Thomson Financial in 13Fs over the period 1990-2006

CRSP

COMPUSTAT

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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1 Firm ofTurnover

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)

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

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

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

Investors’ Horizons and Selling Pressure

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

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

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

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

Economic and Statistical Significance

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

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

Exposure to Aggregate Volatility

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)

Exposure to Liquidity Risk

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

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

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

Portfolio Sorts

Price Drop - Cross-section Analysis

Price Drops – Panel Regressions

Price Reversals

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

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)

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)

Other Major Market Shocks

Other Major Market ShocksMultivariate Analysis

Conclusions

Evidence that investors’ short trading horizons amplify negative shocks

Future research: What determines investor horizon?