What did different groups of investors do when equity markets tanked earlier this year? How did institutional investors – the so-called ‘smart money’ – reconfigure their portfolios in response? What stock credentials dictated these shifts? And was this behaviour reflected by retail investors?
The answers to these questions – based on an analysis of Russell 3000 non-financial stocks by researchers from the Universities of Virginia and Zurich – may surprise.
Chief among these findings was that stock price performance during what the researchers describe as the ‘fever’ period – from 24 February to 20 March, during which time the Russell 3000 index dropped by a third – was negatively correlated to a company’s institutional ownership ratio after adjusting for cash, leverage, environmental, social and governance (ESG) scores and other industry characteristics. In other words, the more a stock was held by institutional investors, the worse it performed during the period (see chart, below).
Within this pattern, the researchers made three further observations: stocks favoured by passive investors performed better, as did those held by long-term investors, while companies held by local US institutional investors tended to see more pronounced price falls.
At the same time, actively managed institutional investors sold out of stocks far more heavily in the first quarter of 2020, relative to both the final quarter of 2019 and passive investors.
Except for hedge funds – whose aggregate holdings changed without any apparent regard to leverage, cash or ESG scores, and therefore presumably to shore up their own liquidity – this selling behaviour was not indiscriminate.
“We find that [institutional ownership] fell more in highly levered firms and in firms with less cash, suggesting that institutions were the marginal investors setting the stock prices of firms that were more resilient,” the paper notes. For all their lip service to corporate responsibility, large active managers preferred strong balance sheets over environmental or social credentials when everything really hit the fan. Surprisingly, given their long-term approach, the researchers found this pattern repeated among pension funds.
Given institutional investors were aggregate sellers during the ‘fever’ period, this begs the question as to which groups took the other side of these trades. Using the changes in popularity of stocks on the Robinhood Markets trading app – which already had 10m users at the start of this year – the researchers hypothesise that retail investors were net buyers of the kinds of highly leveraged stocks dumped by large active equity holders.
Whether this episode has any applicable lessons for the next market crash, is a moot point. To the researchers, the results suggest “that when a tail risk occurs hard measures of firm resilience (cash and low leverage) are more important to institutional investors than soft measures (environmental-social)”. On one level, this observation appears supported by both the statistical evidence from the ‘fever’ period and common sense. As the paper notes, institutional investors must also balance the risk of a surge in redemptions, which is likely to have informed stock selling and stock selection decisions.
And the researchers are of course right to point out that Covid-19 was “a truly exogenous shock” and that “few firms had identified pandemics as a material risk”. That the early stages of the crisis precipitated active money managers’ preference for financially resilient stocks (or hedge funds’ mad dash out of everything) looks like another mark against a short-term view of markets.
But tail risk is, by its nature, always particular. It’s impossible to say how institutional investors might have behaved if the Federal Reserve had signalled it would do whatever necessary to support the economy at an earlier point in the pandemic.
Indeed, the problem with truly unprecedented events is that investment decisions are coloured by concerns over losses and liquidity, on an indeterminate timescale. When the next disaster strikes, the effects are likely to be different, too.
Where do institutional investors seek shelter when disaster strikes? Evidence from Covid-19 by Simon Glosser and Pedro Matos (University of Virginia) and Stefano Ramelli and Alexander F. Wagner (University of Zurich) is co-published by the European Corporate Governance Institute and the Swiss Finance Institute, and can be downloaded here.
