Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Institutional Investors

Granit San has an interesting paper at SSRN about institutional and individual trading (San, Granit, “Who Gains More by Trading – Individuals or Institutions?”, June 2005. http://ssrn.com/abstract=687415)

The conclusion of the paper is that institutions are momentum traders who buy stocks that have done well in the last few quarters and sell those that have not done well. On the other hand individual investors trade in a more contrarian manner and earn higher returns. The superior performance of individuals persists after adjusting for risk using (a) the CAPM or (b) the three factor model of Fama and French or (c) the four factor model of Carhart. The data is consistent with the hypothesis that institutions are noise traders while individuals are informed, rational traders.

What is more interesting is that the same conclusion is true even during the technology stock bubble of the late 1990s. Individual entered technology stocks and exited them more rationally than institutions and earned superior returns during the process as well.

In India, the regulatory regime for foreign portfolio investors has been that foreign institutional investors (FIIs) are welcome while foreign individuals and hedge funds are barely tolerated. San’s results would suggest that this policy is completely misguided. If FIIs are momentum investors, then their presence would exacerbate the booms and busts in the stock market. Encouraging non institutional investors would be a far better idea.

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