(September 20, 2012) — Institutional participation in the US stock market in recent decades may be playing a growing role in overall stock market liquidity, according to an academic report.
The study found that in recent years, institutions, and particularly hedge funds, have increased their holdings of smaller stocks and decreased their holdings of larger stocks. “Institutions currently underweight the largest stocks and overweight the smallest stocks relative to market weights,” professors Marshall Blume and Donald Keim of the University of Pennsylvania write.
Dimensional Fund Advisors, an investment firm with institutional clients, pioneered investing in smaller-cap stocks for the long-term, but now, they’re not alone, Keim told aiCIO. “There’s a strong correlation between the degree of investment in the stock market and overall market liquidity, especially for smaller stocks,” he added. “Institutional involvement in the market is highly related to the liquidity of individual securities.”
The reason? Keim emphasized that the paper does not mean to explain the relationship between higher institutional investment in small-cap equities and market liquidity, yet he theorized that the reason for the higher liquidity could be due to greater trading of stocks and increased market competition. “The paper confirms intuition — markets are becoming more liquid and that coincides with an increase in institutional presence. The cost of buying and selling securities has lowered — that’s a good thing for investors.”
The gist of the study: the number of institutions that own and trade a stock is more important than the percentage of institutional ownership in explaining higher liquidity. In addition, the report asserted: “The proportion of equities managed by institutional investors hovered around 5% from 1900 to 1945. But after World War II, institutional ownership started to increase, reaching 67% by the end of 2010. Keim added that this trend toward decreased allocations to the largest stocks and increased allocations to the smallest stocks, while applying to institutional investors of all sizes, has been most pronounced for the smallest 25 % of institutions.