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On institutions, financial markets and asset returns

Francesco Mainolfi, 1999
Faculty Advisor: Silverio Foresi
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This thesis examines the impact the behavior and interactions of institutional investors in financial markets have on the distribution of asset returns. The thesis is comprised of two distinct essays concerning issues of empirical asset pricing that are linked by this general theme. The first paper examines market timing strategies employed by mutual and other investment funds. This essay develops an innovative way to value the performance of such funds along this dimension by first considering the strategic asset allocation problem as an option investment strategy. The market timing performance evaluation test is then a stochastic dominance exercise which involves empirically estimating the probability that the option is ‘in the money’. To test for market timing ability, we test the hypothesis that the market timing signal is statistically significant in explaining the probability of positive excess returns. The test procedure builds on Cumby and Modest's (1987) extension of the Henriksson-Merton test in three important ways. First, we extend the test to control for public information. That is, we model the probability of positive excess returns as a function of the market timing signal and of other publicly available predictors. Second, it is natural to extend this procedure to allow the predictors to affect the probability of positive excess returns in a possibly nonlinear fashion. Results from these empirical tests conclude that as a whole funds were poor market timers and that many display negative performance ability. The third contribution of this paper is to consider a tests for market timing ability that examines the entire distribution of excess returns rather than the mean alone, as most tests of performance ability do. The results indicate that many funds have statistically significant predictive ability for various thresholds in the tails of the distribution. This suggests a performance ability on the part of the funds previously ignored. The second paper examines the relationship between institutional investors and asset returns. Specifically, we measure the impact of institutional ownership on the distribution of equity returns. In this essay, we first document the differences in the return distribution of stocks that result from differing levels of institutional ownership. In the second part of the paper, we move towards constructing an asset pricing model where ownership structure is a viable factor in the generating faction of equity returns. Institutional ownership does very well at explaining the cross-sectional variation in the moments of the returns distribution after controlling for the impact of beta, size and the market-to-book ratio. This suggests that institutional ownership is a viable candidate for an asset pricing factor. A major point made in both essays is that one should consider the impact of an investment strategy or asset pricing factor on the entire distribution of returns and not just the first moment in order to completely assess its influence.

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