Institutional Investors and Asset Prices
In this dissertation, I study the sources and consequences of heterogeneity in the behavior of different institutional investors in financial markets. In particular, I show that (i) institutional investors respond to the incentives generated by their organizational structures, (ii) the strategy a particular institutional investor pursues depends on their skill, and (iii) institutional investors have heterogeneous impacts on equilibrium market prices.
In the first chapter, I begin by documenting the substantial heterogeneity in portfolios across different types of investors. To explain this phenomenon, I build a model in which investors have different information processing capabilities. The model predicts that highly capable investors specialize in factor timing, hold more volatile and dispersed portfolios, and reduce average risk premia and volatility. Using novel empirical measures of investors' capabilities and information choices, I find that hedge funds are the most capable investors, while insurance companies and pension funds are the least. Variation in factor timing ability is the primary driver of these differences. Investors' portfolios exhibit properties consistent with the model's predictions. Using a demand system approach, I show that hedge funds have the greatest per-dollar impact on expected returns, shrinking expected returns in the factor zoo by nearly 40% per $1 trillion of invested capital.
In the second chapter, I examine whether hedge fund managers respond to the incentives generated by their compensation contracts. To do this, I present a model in which hedge fund managers maximize their expected compensation subject to leverage constraints. This allows me to explore the impact of hedge funds' prototypical contract structure on their dynamic risk allocations and on asset prices in general. One implication of the model is that risk taking varies as a function of a fund's distance to its high-water mark. My empirical work is consistent with the implications of the model in that hedge funds at and furthest from their high-water marks take on significantly greater levels of risk. This increased risk is accomplished in part by investing in more volatile securities. Further, as more hedge funds approach their high-water marks, aggregate hedge fund risk taking increases, the security market line flattens, and betting against beta returns increase, consistent with evidence that these funds increase investment in high beta securities. This work highlights the importance of misaligned preferences between financial intermediaries and investors in explaining asset prices.
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