Trading Opportunities and the Portfolio Choice of Institutional Investors

Abstract

I theoretically and empirically investigate how institutional investors with different holding horizons make investment decisions. Long-term and short-term institutions have persistent differences in their portfolio tilt with short-term institutions more willing to invest in low-return stocks. To explain this phenomenon, I propose a model in which short-term institutions can trade more frequently than long-term institutions. The optimal portfolio of short-term institutions is to tilt towards stocks that are more exposed to future speculative demand, which creates transient trading opportunities. Short-term institutions can take advantage of these trading opportunities by selling at better prices. In equilibrium, these speculative stocks have lower buy-and-hold returns, making them less desirable for long-term investors. Empirical findings are consistent with my model: in the cross-section, stocks with more short-term institutional investors have higher CAPM beta, higher idiosyncratic volatility, and lower buy-and-hold abnormal returns. From these stocks, short-term institutions make more trading profits, offsetting the reduced buy-and-hold returns of these stocks. My paper shows that the desirability of investing in speculative stocks depends on one’s trading horizon.

Keywords: institutional investor, investment horizon, mispricing, performance

JEL Classification: G11, G12, G14