Idiosyncratic Volatility, Institutional Ownership, and Investment Horizon

Published date01 September 2015
Date01 September 2015
Idiosyncratic Volatility, Institutional
Ownership, and Investment Horizon
Doina C. Chichernea, Alex Petkevich and
Blerina Bela Zykaj
John and Lillian Neff Department of Finance, College of Business and Innovation, University of Toledo,
Mail Stop 103, 2801 W. Bancroft Street, Toledo, Ohio 436063390, USA
This paper reevaluates the crosssectional effect of institutional ownership on
idiosyncratic volatility by conditioning on institutionsinvestment horizon. Prior
literature establishes a positive link between growing institutional ownership and
idiosyncratic volatility. However, this effect may vary depending on the type of
institutional ownership. We document that shortterm (longterm) institutional
ownership is positively (negatively) linked to idiosyncratic volatility in the cross
section. These opposite effects persist after controlling for institutional preferences
and informationbased trading and remain qualitatively unchanged after
controlling for endogeneity. This suggests that shortterm (longterm) institutions
exhibit higher (lower) trading activity, which increases (decreases) idiosyncratic
Keywords: institutional investors, idiosyncratic volatility, investment horizon,
trading preference
JEL classification: G12, G23
1. Introduction
This article investigates the crosssectional relation between institutional ownership and
idiosyncratic volatility (IV), accounting for differences in the trading horizon of
institutional investors. The connection between institutions and IV has been extensively
studied in the literature, mainly in the context of identifying the determinants of aggregate
IV. For example, Campbell et al. (2001), Dennis and Strickland (2004), Sias (1996), and
The authors wish to thank an anonymous referee and John Doukas (the editor) for insightful
comments and useful suggestions. We are also thankful to Sachin Modi, Lawrence
Kryzanowski, Andrey Ukhov, and participants at the Financial Management Association,
European Financial Management Association and Midwest Finance Association Meetings
for helpful comments. Any remaining errors or omissions are the authorsalone.
European Financial Management, Vol. 21, No. 4, 2015, 613645
doi: 10.1111/j.1468-036X.2013.12033.x
© 2013 John Wiley & Sons Ltd
Xu and Malkiel (2003) nd a positive relation between total institutional ownership and
IV and argue that the upward trend in institutional ownership is primarily responsible for
the increase in aggregate idiosyncratic risk over time. Conversely, Zhang (2010) shows
that since 2001 aggregate IV consistently declined, while institutional ownership has
maintained an upward trend. Brandt et al. (2010) argues that, given the trend reversal of
aggregate IV, its episodic increase is more likely to be due to retail investors than to
institutional investors.
Rather than focus on the aggregate timeseries trend, our study investigates whether
different types of institutional ownership have different effects on the crosssectional
variation in IV. We argue that ignoring the heterogeneity of institutions and studying them
as a group can produce confounding results. Todays trading environment is characterised
by not only a signicant increase in the presence of institutional investors,
but also large
variation in their trading behavior, due to their different objectives, characteristics, limits,
and so forth. The fact that we often see institutions on both sides of the same trade is the
best supporting evidence that not all institutional trades are similarly motivated.
We verify this claim by examining the crosssectional relation between IV and
institutional ownership conditional on the investment horizon of institutional investors.
There are at least two reasons to believe that the relation between institutional ownership
and idiosyncratic risk is conditional on the investment horizon of institutional investors.
First, the average investment horizon of shareholders is indicative of the amount of
trading a particular stock will face. Ownership by institutions with different investment
horizons indicates different trading frequencies. In particular, stocks with primarily short
term institutional ownership are exposed to higher trading activity, while the opposite is
true for stocks with primarily longterm institutional ownership. In this case, short and
longterm institutional ownership represents trading (or lack thereof) of a stock and hence
should have opposite effects on the level of IV in the crosssection. The relation between
trading volume and volatility has long been documented in the literature.
Therefore, if
institutional ownership is indicative of stock trading volume, we expect shortterm
institutional ownership to increase IV and longterm institutional ownership to decrease it.
The remainder of this study refers to this as the trading argument.
Second, recent literature documents that institutionsinvestment horizon is a good
indicator of informational trading. For example, Yan and Zhang (2009) document that
shortterm institutions can forecast likely future stock returns due to their informational
advantage. On the other hand, Cremers and Pareek (2011) study the effect of institutional
Brandt et al. (2010) show that by 2003, aggregate IV had decreased to pre1990s levels. They
nd no evidence that institutional investors caused the increase in IV in early 2000. As such,
the authors conclude that the increase could have been caused by retail investors.
See Jones and Lipson (2003) and Kaniel et al. (2008) for evidence of institutional investor
dominance in the nancial market.
See Karpoff (1987) for a review on the early literature in this area. His synthesis of previous
research concludes that while there is a positive correlation between the absolute value of price
changes and volume, the relation between price changes per se and volume is nonmonotonic
and asymmetric (i.e., the correlation between volume and positive price changes is positive,
while that between volume and negative price changes is negative). Schwert (1989) and
Gallant et al. (1992) also provide good reviews of the empirical and theoretical research in this
© 2013 John Wiley & Sons Ltd
614 Doina C. Chichernea, Alex Petkevich, Blerina Bela Zykaj
investment horizon on the efciency of stock prices and conclude that shortterm
institutions are behaviorally biased and mostly overcondent and their presence helps
explain many stock returns anomalies. Regardless of whether this behavior is generated
by overcondence or informational advantage, this line of thinking provides convincing
reasons to believe that institutionsinvestment horizon affects the relation between
institutional ownership and IV.
This argument also raises an important point, namely, that institutions with different
horizons can have different attitudes (preferences) toward idiosyncratic risk exposure.
Whether they are better informed (Yan and Zhang, 2009) or overcondent (Cremers and
Pareek, 2011), shortterm institutions are more likely to prefer stocks with higher IV
because they can take advantage of the (perceived) mispricing. The opposite is true for
institutions with longer investment horizons. Therefore, the investment horizon of
institutional investors could capture their preferences and hence inuence the relation
between institutional ownership and IV. We henceforth refer to this as the preference
Following Yan and Zhang (2009), we use quarterly institutional holdings to construct
an investment horizon measure based on institutionsportfolio turnover. Based on this
measure, we classify institutions as shortterm (highturnover) and longterm (low
turnover) investors and calculate the percentage ownership of shortand longterm
institutions at the stock level. Using daily data, we follow Ang et al. (2006) to estimate
quarterly IV relative to the FamaFrench threefactor model. Although our focus is not on
aggregate trends, we show that our measures are, in the aggregate, consistent with
previous literature. Specically, we conrm that aggregate IV increases until 2001
(Campbell et al., 2001; Xu and Malkiel, 2003) and reverses after 2001, with the exception
of the 2008 nancial crisis (Brandt et al., 2010; Zhang, 2010). Conversely, total
institutional ownership consistently increases during our entire sample period (from 20%
in 1980 to almost 60% in 2010). After decomposing total institutional ownership into its
shortand longterm components, we nd that that aggregate longterm institutional
ownership consistently dominates its shortterm counterpart after 2001.
After documenting the general aggregate dynamics of our variables of interest, we
focus on the crosssectional relation between IV and components of institutional
ownership. First, we examine the average IV of portfolios sorted independently by their
previous quarter institutional ownership and size. Univariate analysis shows that for the
entire sample period stocks with higher shortterm (longterm) institutional ownership
have higher (lower) subsequentquarter IV. This relation is less pronounced among small
stocks, which can be explained by the low level of institutional presence in these stocks
Motivated by the above results, we use a standard Fama and MacBeth (1973) approach
to test whether our conclusions persist after controlling for other determinants of IV, such
as size, illiquidity, past IV, earnings volatility, and performance. Shortterm (longterm)
institutional ownership is persistently positively (negatively) linked to future IV in the
cross section, providing additional support for the trading hypothesis. Subsample analysis
shows that although the relation between shortterm institutional ownership and IV is
relatively stable in the pre and post2001 period, the relation between IV and longterm
ownership seems to weaken after 2001. Further investigation shows that changes in the
relative proportions of small capitalisation stocks in the market after 2001 might be
responsible for this result. Given the high level of IV and low institutional presence within
the group of small stocks, we expect that the relationship between ownership measures
© 2013 John Wiley & Sons Ltd
Idiosyncratic Volatility, Institutional Ownership, and Investment Horizon 615

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