Aurora Borealis
1 June 2016 CFA Institute Journal Review

Are Individual or Institutional Investors the Agents of Bubbles? (Digest Summary)

  1. Derek Bilney, CFA

Bubbles in financial markets are generally believed to be driven by the actions of uninformed individual investors. But the authors’ detailed study of trading activity in the South Korean equity market suggests that trading by institutional investors, particularly foreign institutional investors, tends to be trend driven. Individual investors, however, appear to trade in a contrary manner.

What’s Inside?

Investment bubbles are more likely to be caused by momentum trading than countertrend trading. The authors show that individual investors in South Korea’s equity market tend to trade in a manner contrary to price trends in large-cap stocks but follow price trends to a limited extent for small-cap stocks. In contrast, foreign investors tend to follow price trends for both large-cap and small-cap stocks in both upwardly and downwardly trending markets. In South Korea, foreign institutional investors are more likely to be the driver of financial bubbles.

How Is This Research Useful to Practitioners?

Rarely do researchers have access to such a detailed source of trading data. Although every market has its own nuances, evidence of the role of foreign investors in driving prices is informative.

Hedge funds with global mandates that apply momentum-based strategies are aware of the potential impact of their trading activities on valuation levels. Despite the increasing sophistication of investment markets generally, it can still be difficult to short sell securities in sufficient volume to counter bubbles. In theory, valuation-based strategies should act to curb some of the excesses, but overvaluation can continue for longer periods than most benchmark-aware investors can tolerate.

Regulators in individual countries may use the authors’conclusions to justify curbing the trading activities of certain types of investors in times of market stress. For example, many equity markets placed restrictions on the short selling of financial stocks during the global financial crisis. But regulators are typically cautious about interfering in upwardly trending markets, preferring instead to be actively involved in the aftermath.

How Did the Authors Conduct This Research?

The authors use a dataset that includes detailed information on trading activity on the Korea Exchange for 1995–2005. The dataset shows total buy and sell details (value and volume) for four different investor types: domestic individuals, foreign investors, domestic corporations, and domestic institutional investors, which are further broken down into six categories. Trading activity by the South Korean government is excluded. The summary statistics show the early dominant role played by individual investors in South Korea’s market, which tapered off as investment restrictions were lifted and as the importance of foreign institutional investors increased.

The authors calculate trade imbalance measures to determine whether each investor type was a net buyer or seller of a stock at a given date and the size of the imbalance. The authors then scale the imbalance measure by the number of outstanding shares. They calculate equally weighted and market-capitalization-weighted summary statistics for each investor type across all stocks for a given date to provide insight into whether imbalances were concentrated in small- or large-cap stocks. Similarly, they construct return series on both an equally weighted and a volume-weighted basis. Correlations between investment returns and trade imbalances are calculated to provide initial evidence of the investor segment driving price trends and any differentiation between large- and small-cap stocks.

The authors next model the impact of lagged trade imbalances on current levels of security pricing by investor type. In particular, the model allows the authors to consider the impact of lagged trade imbalances of one investor group on the contemporaneous trade imbalances of a different group. Coupled with security returns, this approach allows the authors to form conclusions on the relative order of investor trading—that is, leaders versus followers.

Conventional wisdom suggests that the uninformed individual investor is typically “late” to the trade and suffers the most in the inevitable unwind. But using their model, the authors suggest otherwise.

In their robustness checks, the authors test their results by using monthly versus daily data and incorporating the impact of currency returns into the model. The results are generally unaffected.

Abstractor’s Viewpoint

It may have been informative to identify pockets of the markets, at either the stock or sector level, that exhibit extreme levels of overvaluation under a range of valuation metrics. These pockets could be considered examples of potential bubble-like conditions. The trading activities of the different investor groups in the preceding period could then be assessed to confirm the results of this study. Since 2005 (the end of the study’s sample period), the role of institutional investors has generally increased in importance relative to individual investors. In addition, global investing has become more prevalent as investors have strived to overcome a domestic investment bias, which suggests that the role of foreign investors in contributing to investment bubbles is likely to have only increased over time.

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