New Developments in Long-Term Asset Management

Supported by Norges Bank Investment Management
Monika Piazzesi and Luis Viceira, Organizers
Fourth Annual Conference
Cambridge, MA

May 9-10, 2019

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Which Investors Matter for Global Equity
Valuations and Expected Returns?

By Ralph S.J. Koijen, Robert J. Richmond, and Motohiro Yogo

A large literature in asset pricing studies how much of the variation in valuation ratios, both across assets and over time, can be accounted for by variation in expected future returns and expected future profits. The typical approach is to regress future returns or profits on current valuation ratios and potentially other predictor variables. This literature leaves two fundamental questions unaddressed. First, what information do investors use in portfolio choice? Second, how important are various investors in the price formation process?

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The Benchmark Inclusion Subsidy, Anil K. Kashyap, Natalia Kovrijnykh, Jian Li, and Anna Pavlova

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To answer these questions, we develop a simple theoretical model that guides the empirical analysis. Profits are assumed to follow a factor model and investors use the characteristics of a firm (e.g., productivity and profit margins) to predict future profits and to assess their riskiness (i.e., the factor loadings). Importantly, investors may disagree on how the characteristics map to the future distribution of profits, generating heterogeneity in portfolio holdings as observed in the data. The model implies that an investor’s demand depends on prices, characteristics, and latent demand. By imposing market clearing, equilibrium prices depend on characteristics as in hedonic pricing models. The coefficients on characteristics are a weighted average of the preferences of investors, where the weights depend on assets under management.

To bring the model to the data, we show that a small set of six characteristics explains most of the variation in a panel of firm-level valuation ratios in the Euro area, Great Britain, Japan, and the United States. We then estimate an international asset-demand system using investor-level holdings data in Great Britain and the United States, allowing for flexible substitution patterns within and across countries. The use of holdings data is entirely new to the literature on firm valuations.

To measure the contribution of different institutional types, we recompute prices under the assumption that one group of investors switches to holding the market portfolio. We re-run the valuation regressions using these new prices, which allows us to estimate the contribution of different types of institutions (e.g., mutual funds, hedge funds, …) in linking characteristics to prices and long-horizon expected returns. How much different investors matter depends on the amount of assets under management and the extent to which their demand differs from the demand curve of other investors.

We find that investment advisers are most influential among all institutional types, which is driven by their large size. Per dollar of assets under management, hedge funds are the most influential; long-term investors, such as insurance companies and pension funds, are the least influential. We estimate the direct impact of broker-dealers, which have been the focus of much of the recent asset-pricing literature on intermediaries, to be small as a result of the small amount of assets that they manage.

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