Institutional Investors: Arbitrageurs or Rational Trend Chasers

Abstract

This paper studies the relationship between institutional investor holdings and misvalued stocks over the last three decades in the U.S. equity market. Using multiple proxies of stock mispricings, I find that institutional investors overweigh overvalued and underweigh undervalued stocks in their portfolio, taking the market portfolio as a benchmark. Cross-sectionally, institutional investors hold more overvalued stocks than undervalued stocks. The time series studies show that institutional ownership of overvalued portfolios increases as the portfolios' overvaluation degree increases. Institutional investor riding stock misvaluation is neither driven by the fund flows from individual investors into institutions, nor industry-specific. Consistent with the agency problem explanation, investment companies and independent investment advisors have a higher tendency to ride stock misvaluation than the other institutions. My findings challenge the models which view individual investors as noise traders and disregard the role of institutional investors in stock market misvaluation.