Working Paper: CEPR ID: DP9120
Authors: Suleyman Basak; Anna Pavlova
Abstract: Empirical evidence indicates that trades by institutional investors have sizable effects on asset prices, generating phenomena such as index effects, asset-class effects and others. It is difficult to explain such phenomena within standard representative-agent asset pricing models. In this paper, we consider an economy populated by institutional investors alongside standard retail investors. Institutions care about their performance relative to a certain index. Our framework is tractable, admitting exact closed-form expressions, and produces the following analytical results. We find that institutions optimally tilt their portfolios towards stocks that comprise their benchmark index. The resulting price pressure boosts index stocks, while leaving nonindex stocks unaffected. By demanding a higher fraction of risky stocks than retail investors, institutions amplify the index stock volatilities and aggregate stock market volatility, and give rise to countercyclical Sharpe ratios. Trades by institutions induce excess correlations among stocks that belong to their benchmark index, generating an asset-class effect.
Keywords: asset class; asset pricing; general equilibrium; indexing; institutions; money management
JEL Codes: G12; G18; G29
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Institutional investors' performance incentives relative to benchmark indices (G23) | Portfolio tilting towards index stocks (G11) |
| Portfolio tilting towards index stocks (G11) | Asset prices (G19) |
| Institutional investors' performance incentives relative to benchmark indices (G23) | Asset prices (G19) |
| Institutional trading (D47) | Stock market volatility (G17) |
| Institutional trading (D47) | Leverage of institutional investors (G23) |
| Leverage of institutional investors (G23) | Stock market volatility (G17) |
| Institutional investors (G23) | Excess correlations among stocks within their benchmark index (C10) |
| Excess correlations among stocks within their benchmark index (C10) | Asset-class effect (G19) |