Are asset managers causing volatility?

Over the last four decades, the concentration of institutional investors in equity markets has increased dramatically, so that they can no longer be seen as a collection of smaller independent entities. In their paper “The Granular Nature of Large Institutional Investors”, Itzhak Ben-David, Francesco Franzoni, Rabih Moussawi, and John Seduonov find that due to the size of their holdings and trades, institutional investors have a massive effect on the stock market and impact stock prices significantly.

Their study finds evidence for the cause relationship of institutional ownership and stock volatility. Through their trades, they create price pressure which translates into higher volatility. An increase of one percent in stock ownership by institutional investors pushes volatility upwards by 12 to 18 basis points. Pursuing the study with data from the first quarter of 1980, the impact was particularly strong during the financial crisis because asset managers faced high levels of withdrawals leading to liquidations and rebalancing.

Thereby larger institutions have a bigger effect on price volatility. The researchers assume that their trades are larger and concentrated on fewer stocks than those of smaller firms. A larger number of small entities will diversify more while one large institution will make granular investments.