Ebook Institutional Investors and Stock Market Efficiency: The Case of the January Anomaly
Since the late 1970s, researchers have discovered several seasonal patterns in stock returns that constitute a challenge to the efficient markets hypothesis. Regularities in stock returns or stock market anomalies comprise, among many others, the January effect (abnormally high returns in January), the Monday seasonal (significantly lower Monday returns), and the size effect (higher average risk-adjusted returns for small stocks). In this paper, we focus on the following aspect of stock market anomalies: if stock returns exhibit exploitable regularities, then smart traders are expected to take advantage of these patterns, thereby earning abnormal profits. Consequently, on stock markets with a sufficiently large number of smart traders, anomalies are supposed to disappear as the trading of this investor group arbitrages away seasonal patterns in stock returns.
Recent empirical findings suggest that institutional investors play the role of smart traders on stock markets and, therefore, may have an impact on stock market anomalies. Institutional investors can be characterized as informed traders who speed up the adjustment of stock prices to new information, thereby rendering the stock market more efficient. Institutions can obtain an informational advantage by exploiting economies of scale in information acquisition and processing. The marginal costs of gathering and processing information are lower for institutional than for individual traders. In addition, institutional investors may be better trained and have superior resources than individual investors. Moreover, for many years it has been common practice of companies to inform securities analysts in advance about company-specific news, and only recently regulatory measures have been launched (namely the SEC’s Regulation FD) to prevent this habit. Hence, institutional investors’ trading decisions may be stronger information driven than those of individual investors.
Dennis and Weston (2001) support this view by providing evidence for U.S. stock exchanges that institutions are better informed than individual investors. Cohen, Gompers, and Vuolteenaho (2002) show that institutional investors push stock prices towards their fundamental values by exploiting individual traders’ sentiment. Following Barber and Odean (2005), individual investors display attention-based buying behavior, whereas institutions do not exhibit this kind of non-fundamental trading pattern. The impact of institutional trading on stock market anomalies has recently been covered by two papers. Kamara (1997) and Chan, Leung, and Wang (2004) highlight the role of institutional investors on the Monday seasonal. They present evidence for U.S. stock markets that an increase in institutional ownership decreases the magnitude of the Monday effect. Gompers and Metrick (2001) show that an increase in institutional trading is partly responsible for the disappearance of Banz’ (1981) small stock premium.
In this study, we focus on the impact of institutional trading on a third major anomaly, namely the January effect. Two of the most prominent explanations for the January effect refer to the specific trading behaviors of individual and institutional investors. First, the tax-loss-selling hypothesis explains the January anomaly with tax-motivated trading of individual investors. As the end of the year approaches, individual investors sell stocks that declined in value in order to realize tax losses. After the turn of the year they re-invest in these securities, which pushes stock prices up (Ritter (1988)). Second, the window-dressing hypothesis suggests that institutional investors’ portfolio rebalancing activities are responsible for the January anomaly. Institutions are evaluated relative to their peers and, therefore, buy winners and sell losers in order to present respectable year-end portfolio holdings (Lakonishok et al. (1991)). The findings in Sias and Starks (1997) are favorable for the tax-loss-selling hypothesis and show that individual traders are primarily responsible for the January anomaly.
This study highlights the impact of institutional traders on the January effect in Poland and Hungary. The history of both emerging stock markets provides a unique institutional environment to investigate the influence of individual and institutional investors on the January anomaly. In Poland, the pension system reform on May 19, 1999, separates the history of the stock market into a period of predominantly individual trading and a period dominated by institutional trading. Similarly, in Hungary, private pension funds were founded in 1997 and started their financial activities in 1998. Before 1998, primarily small individual investors populated the Hungarian stock market.
The pension system reform in both countries changed the investor structure drastically due to the enrichment of the old pay-as-you-go system with a privately managed pension funds pillar. Since 1999, these pension funds are the most important group of institutional investors on the Polish and Hungarian stock markets. In addition to the change of the investor structure, in both countries capital gains taxes do not exist, which rules out the tax-loss-selling hypothesis as a rationale for the January effect. Consequently, if a January effect can be detected in the data during the period before the entrance of pension fund investors in both stock markets, then itmust be driven by an anomalous trading behavior of Polish and Hungarian individual investors. We exploit the shift in the institutional environment in both emerging capital markets to provide evidence on the impact of individual and institutional investors’ trading decisions on the January anomaly.
Relying on the institutional background of the Polish and the Hungarian stock markets, we contribute to the literature answering the following two questions. First, is there evidence in favor of a January effect during the period of individual trading? If this is the case, we can conclude that individual investors’ non-fundamentally driven trading decisions led to the January anomaly. Second, in which way did Polish and Hungarian pension fund investors contribute to the January anomaly after 1999 and 1998, respectively? In case pension funds exhibit window-dressing behavior, we expect a strengthening effect on the January anomaly. In contrast, if pension funds’ trading decisions are more influenced by fundamental information, a dampening effect on unusually high stock returns in January can be expected.
The remainder of the paper proceeds as follows. Section 2 outlines the institutional background for Poland and Hungary. Section 3 characterizes the data set, while the econometric methodology is described in section 4. Section 5 contains the empirical findings, and section 6 summarizes and concludes.
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