Institutional constraints and preferences: Implications for factors and performance evaluation

Two perspectives on institutional ownership motivate this study. First, institutions display 'preferences' for stocks with certain characteristics that relate to asset pricing factors in a potentially causal way (Gompers and Metrick (2001). Second, these `preferences' often reect constraints relating to agency considerations and liquidity [Del Guercio (1996); Berk and Green (2004)]. We provide a detailed empirical analysis to distinguish between the effects of preference vs. constraints on institutional ownership (IO), and find that a constraints interpretation is most suitable for the smallest institutions. Large institutions, where one expects costs of portfolio implementation to be most severe, seem to operate in an unconstrained investable universe. We then construct IO pricing factors - standard asset pricing factors restricted to stocks that satisfy IO constraints - to evaluate asset pricing effects from implicit market segmentation relating to IO. Contrary to both intuition regarding portfolio optimization and conventional wisdom regarding academic paper-portfolio benchmarks, we find that the market-factor premium is higher for stocks predicted to have high IO. As a consequence, institutional performance is worse when evaluated against factors culled from their investment universe than traditional global factors.

Associate Professor Roger Edelen

Roger Edelen is an Associate Professor at the Pamplin College of Business Administration at Virginia Tech University. He holds a PhD in Finance from the University of Rochester and an MBA and B.S. in Mathematics from the University of Texas at Austin. Dr. Edelen was previously an Associate Professor at the University of California at Davis and as an Assistant Professor at Boston College, and at the University of Pennsylvania. His has professional experience as Director of Research at ReFlow Management, Director of Enhanced Equity Strategies at Mellon Capital Management; and in options trading with O’Connor and Associates (now UBS). Dr. Edelen's primary research interest is institutional investing, focusing on the role that operational and organizational influences play on mutual fund performance. He has specific expertise in aggregate fund flows, high-frequency price adjustment delays, indexed securities, IPO pricing strategies, post-issuance returns of secondary equity offerings, and factor-based stock market anomalies.

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