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Some capital market investors — sovereign wealth funds, public and private pension plans, universities, and endowments — have longer investment horizons than others. They may differ from investors with shorter horizons in many ways: in their approach to risk, in their engagement with the firms that they invest in, and in their overall investment objectives.

Recent events have raised a host of new challenges for long-term investors. The expected return on some asset classes appears to have declined, most evidently for relatively safe long-term assets. This has pushed some investors to reach for returns by increasing the risk levels in their portfolios. At the same time, valuations in some equity markets are near all-time highs. These developments challenge long-term investors and raise questions about whether their future returns will match the average returns that they have earned in the last few decades. The NBER, with the support of the Norwegian Finance Initiative, has convened a series of conferences to explore long-term asset management. These meetings have brought together researchers who are exploring the theory and practice of long-term investing. The conference, held in London on May 18-19, 2017, was the second in this series. The researchers who gathered at this meeting examined a range of issues that are important for long-horizon investors, including the market implications of the growing importance of institutional investors, the role of informed and less-informed traders in the determination of securities prices and market dynamics, and the role of new financial instruments in affecting asset market equilibrium.

Summary

Replicating Private Equity with Value Investing, Homemade Leverage, and Hold-to-Maturity Accounting
Author(s):
Erik Stafford, Harvard University
Discussant(s):
Ludovic Phalippou, University of Oxford
Abstract:

Stafford studies how private equity funds tend to select small firms with low EBITDA multiples. Public equities with these characteristics have high risk-adjusted returns after controlling for common factors. Hold-to-maturity accounting of portfolio net asset value eliminates the majority of measured risk. A passive portfolio of small, low EBITDA multiple stocks with modest leverage and hold-to-maturity accounting produces an unconditional return distribution that is highly consistent with that of the pre-fee aggregate private equity index. The passive replicating strategy represents an economically large improvement in risk- and liquidity-adjusted returns over direct allocations to private equity funds, which charge estimated fees of 3.5% to 5% annually.

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Do Institutional Incentives Distort Asset Prices?
Author(s):
Anton Lines, Columbia University
Discussant(s):
Christopher Polk, London School of Economics
Abstract:

The incentive contracts of delegated investment managers may have unintended negative consequences for asset prices. Lines shows that managers who are compensated for relative performance optimally shift their portfolio weights towards those of the benchmark when volatility rises, putting downward price pressure on overweight stocks and upward pressure on underweight stocks. In quarters when volatility rises most (top quintile), a portfolio of aggregate-underweight minus aggregate-overweight stocks returns 3% to 8% per quarter depending on the risk adjustment. Prices rebound in the following quarter by similar amounts, suggesting that the changes are temporary distortions. Consistent with the growing influence of asset management in the U.S. equity market, the distortions are stronger in the second half of the sample, while placebo tests on institutions without direct benchmarking incentives show no effect. Lines' findings cannot be explained by fund flows and thus constitute a new channel for the price effects of institutional demand. The effects come into play precisely when market-wide uncertainty is rising and distortions are less tolerable, with implications for the real economy. Additionally, the paper offers novel evidence on a prominent class of models for which empirical investigations have been relatively scarce.

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ETF Arbitrage under Liquidity Mismatch
Author(s):
Kevin Pan, Harvard University
Yao Zeng, University of Pennsylvania
Discussant(s):
Francesco Franzoni, Swiss Finance Institute
Abstract:

A natural liquidity mismatch emerges when liquid exchange traded funds (ETFs) hold relatively illiquid assets. Pan and Zeng provide a theory and empirical evidence showing that this liquidity mismatch can reduce market efficiency and increase the fragility of these ETFs. They focus on corporate bond ETFs and examine the role of authorized participants (APs) in ETF arbitrage. In addition to their role as dealers in the underlying bond market, APs also play a unique role in arbitrage between the bond and ETF markets since they are the only market participants that can trade directly with ETF issuers. Using novel and granular AP-level data, the researchers identify a conflict between APs’ dual roles as bond dealers and as ETF arbitrageurs. When this conflict is small, liquidity mismatch reduces the arbitrage capacity of ETFs; as the conflict increases, an inventory management motive arises that may even distort ETF arbitrage, leading to large relative mispricing. These findings suggest an important risk in ETF arbitrage.

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The Relevance of Broker Networks for Information Diffusion
in the Stock Market
Author(s):
Marco Di Maggio, Harvard University and NBER
Francesco Franzoni, Swiss Finance Institute
Amir Kermani, University of California, Berkeley and NBER
Carlo Sommavilla, Swiss Finance Institute & USI
Discussant(s):
Péter Kondor, London School of Economics
Abstract:

This paper shows that the network of relationships between brokers and institutional investors shapes the information diffusion in the stock market. Di Maggio, Franzoni, Kermani, and Sommavilla exploit trade-level data to show that central brokers gather information by executing informed trades, which is then leaked to their best clients. The researchers show that after large informed trades, a significantly higher volume of other institutional investors execute similar trades through the same broker, allowing them to capture higher returns in the first few days after the initial trade. In contrast, the researchers find that when the informed asset manager is affiliated with the broker, such imitation does not occur. Similarly, they show that the clients of the broker employed by activist investors to execute their trades tend to buy the same stocks just before the filing of the 13D. This evidence also suggests that an important source of alpha for fund managers is the access to better connections rather than superior skill.

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Efficiently Inefficient Markets for Assets and Asset Management
Author(s):
Nicolae B. Gârleanu, University of California, Berkeley and NBER
Lasse H. Pedersen, Copenhagen Business School
Discussant(s):
Dimitri Vayanos, London School of Economics and NBER
Abstract:

Gârleanu and Pedersen consider a model where investors can invest directly or search for an asset manager, information about assets is costly, and managers charge an endogenous fee. The efficiency of asset prices is linked to the efficiency of the asset management market: if investors can find managers more easily, more money is allocated to active management, fees are lower, and asset prices are more efficient. Informed managers outperform after fees, uninformed managers underperform after fees, and the net performance of the average manager depends on the number of “noise allocators.” Small investors should be passive, but large and sophisticated investors benefit from searching for informed active managers since their search cost is low relative to capital. Hence, managers with larger and more sophisticated investors are expected to outperform.

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This paper was distributed as Working Paper 21563, where an updated version may be available.

Chasing Private Information
Author(s):
Marcin Kacperczyk, Imperial College London
Emiliano Pagnotta, Imperial College London
Discussant(s):
Dong Lou, London School of Economics
Abstract:

Do market-based signals reveal the trading of privately informed investors? Kacperczyk and Pagnotta examine this question using a novel sample of over 5,000 equity and option trades documented in the SEC’s insider trading investigations. The researchers find that: (1) Trades based on information about fundamentals do impact information signals. (2) The relation between private and public signals is complex and, for commonly used liquidity metrics, contrary to standard theories. (3) Trade volume is more informative in option markets than in stock markets, with the combination of both being most informative. Evidence from the SEC’s Whistleblower Reward Program addresses potential selection concerns.

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Institutional Investors and Information Acquisition: Implications for Asset Prices and Informational Efficiency
Author(s):
Matthijs Breugem, Frankfurt School of Finance and Management
Adrian Buss, INSEAD
Discussant(s):
Anna Pavlova, London Business School
Abstract:

Institutional investors nowadays account for a majority of the transactions and equity ownership. In this paper, Breugem and Buss develop an asset pricing model with endogenous information acquisition that explicitly incorporates the incentives of institutions. This allows the researchers to jointly determine equilibrium information and portfolio choices as well as resulting asset prices. They show that institutional investors’ portfolios are less sensitive to private information. Thus, they value private information less and, consequently, acquire less of it. An increase in the fraction of institutional investors is accompanied by a decline in price informativeness which can induce a decline in stock price. Moreover, an increase in institutional ownership leads to higher return volatility and a lower Sharpe ratio.

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This paper was distributed as Working Paper 23561, where an updated version may be available.

Asset Insulators
Author(s):
Gabriel Chodorow-Reich, Harvard University and NBER
Andra C. Ghent, University of North Carolina at Chapel Hill
Valentin Haddad, University of California, Los Angeles and NBER
Discussant(s):
Bo Becker, Stockholm School of Economics
Abstract:

Chodorow-Reich, Ghent, and Haddad propose that financial institutions can act as asset insulators, holding assets for the long run to protect their valuations from consequences of exposure to financial markets. They illustrate the empirical relevance of this theory for the balance sheet behavior of a large class of intermediaries, life insurance companies. The pass-through from assets to equity is an especially informative metric for distinguishing the asset insulator theory from Modigliani-Miller or other standard models. The researchers estimate the pass-through using security-level data on insurers’ holdings matched to corporate bond returns. Uniquely consistent with the insulator view, outside of the 2008-2009 crisis insurers lose as little as 10 cents in response to a dollar drop in asset values, while during the crisis the pass-through rises to roughly 1. The rise in pass-through highlights the fragility of insulation exactly when it is most valuable.

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