Institutional Investors and Stock Market Liquidity

Institutional Investors and Stock Market Liquidity: Trends and Relationships Marshall E. Blume* and Donald B. Keim** This draft: August 21, 2012 First draft: March, 2008 *Howard Butcher III Professor, emeritus, **John B. Neff Professor of Financial Management of Finance Finance Department Finance Department The Wharton School The Wharton School University of Pennsylvania University of Pennsylvania 2300 Steinberg Hall - Dietrich Hall 2300 Steinberg Hall - Dietrich Hall Philadelphia, PA 19104-6367 Philadelphia, PA 19104-6367 Ph: (215) 898-7633 Ph: (215) 898-7685 Email: blume@wharton.upenn.edu Email: keim@wharton.upenn.edu (Corresponding author) An earlier version of this paper circulated under the title “Changing Institutional Preferences and Investment Performance: A Stock Holdings Perspective.” We thank Bob Litzenberger, Craig MacKinlay, Andrew Metrick, David Musto, David Ng, Rob Stambaugh and

seminar participants at the FTSE World Investment Forum, the Q-Group and Wharton for helpful comments, and Sameer Kirtane and Yifei Mao for excellent research assistance. Errors are our own. Institutional Investors and Stock Market Liquidity: Trends and Relationships Abstract In this paper we show that institutional participation in the U.S. stock market in recent decades has played an ever increasing role in explaining cross-sectional variation in stock market illiquidity. We first document trends in the growth of institutional stock ownership using the 13F holdings, extending the evidence by thirteen years to the end of 2010. In contrast to previous research, we find that institutions, and particularly hedge funds, have increased their holdings of smaller stocks and decreased their holdings of larger stocks over this period. Institutions currently underweight the largest stocks and overweight the smallest stocks relative to market weights. We then examine the relation between illiquidity and two measures of institutional stock ownership – the percentage of a stock owned by institutions and the number of institutions that own the stock – both in the cross section and through time. We find that: (1) the number of institutions that own and trade a stock is more important than the percentage of institutional ownership in explaining the cross-sectional variability of illiquidity; and (2) the power of the number of institutional owners in explaining illiquidity is significantly stronger in the second half of our sample period. Keywords: Institutional investors, Institutional stock ownership, SEC 13F filings, Hedge funds, Market liquidity JEL Classification: G11, G12, G23 1. Introduction Since the Congressional repeal of fixed non-competitive commission rates in 1975, there have been numerous, and sometimes important, regulatory changes in the equity market. To name two: the gradual reduction in the tick size, which allowed tighter spreads as between the quoted bid and ask prices; and Regulation National Market System (NMS) in 2005, which mandated the electronic integration of trading in all listed equities and allowed high-frequency trading. Concurrent with these changes was the growth of investing through institutions and an increase in stock market liquidity, or equivalently a decrease illiquidity. In this paper, we examine the role of institutions in explaining illiquidity across stocks and over time. We first address recent changes in institutional preferences for common stocks. An extensive academic literature documents the overall growth in institutional equity ownership as well as the changing composition of the types of stocks in which...

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