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...investors have been successful managing client assets; they have added significant value by generating excess returns after controlling for underlying portfolio risk factors. Style choice is the main factor in determining overall portfolio performance, but institutional investors also displayed significant stock selection skills during the period. The stocks they choose for their portfolios have outperformed the stocks they exclude.
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Institutional investors have become important participants in the US equity markets, especially in past two decades. Over this period, both the number of institutional investors and the amount of funds they manage have grown dramatically.
Figure 1 plots the percentage of the US equity market owned by institutional investors during the 1981-2002 period. Institutional ownership has grown from 35% of the equity market in 1981 to 58% by the end of 2002. This increase represents a substantial shift in the investment preferences of American households. While only 19% (15.9 million) of US households invested in equities in 1983, the percentage increased to 36.6% (34.6 million) by 1992 and to 49.5% (52.7 million) by the end of 2002. (1)
Most household investment is channeled into the equity markets through institutional investors such as mutual funds and retirement accounts. With such a change in the institutional investor universe and its impact on the average household, it is worth asking how institutional investors have performed in management of the funds entrusted to them.
We study the investment performance of all types of institutional investors in operation in the United States during 1981-2002. Using widely accepted performance measurement methodologies, the results indicate that institutional investors in general have been quite successful in managing client money. They have been able to deliver significant risk-adjusted excess returns. Most of the returns generated can be attributed to the investment style choice of the institution, but the results indicate that significant stock selection skills have helped enhance overall portfolio performance.
The investment structures and different legal faces of particular institutional investor groups have an impact on their investment styles. Pension funds, endowments and bank trusts have earned the highest risk-adjusted returns among all institutional investor groups. Investment advisors, investment companies, and bank trust departments have displayed significant stock selection skills.
I. Data
An institutional investor can be defined as a fiduciary entity established to manage client assets with full investment discretion. Quarterly equity holdings of institutional investors are obtained from the Thomson Financial Spectrum 13F Institutional Holdings Database. The database classifies institutions into five categories: 1) Banks and bank trust departments, 2) Insurance companies, 3) Investment companies (mutual fund families), 4) Investment advisors, and 5) Endowments, public and corporate pension funds, and philanthropic foundations. (2)
Banks and bank trust departments manage personal trust funds and contracted pension assets. State Street Corporation, Mellon Bank, and JP Morgan Chase are examples. Insurance companies invest their own property-casualty and life insurance funds. AXA Financial, State Farm Insurance, and Prudential Insurance Company are examples.
Investment companies are mutual fund families managing money on behalf of fund holders. Fidelity Management and Research, Vanguard Group, and Putnam Investment Management are some of the largest investment companies. Investment advisors are money management firms that exercise investment discretion on behalf of clients. A significant portion of pension fund assets are managed by investment advisors. Barclay's Bank PLC, Morgan Stanley Dean Witter, and Goldman, Sachs & Company are three of the largest.
The last institutional investor category comprises university and private endowments, philanthropic foundations, funds that are managed in-house by private and public pension funds, and law firms acting as trustees. TIAA-CREF, CalPERS, and Teacher Retirement System of Texas are three of the larger pension funds in this category.
Under the 1978 amendment to the Securities Exchange Act of 1934, all institutional investors managing a portfolio with an investment value of $100 million or more are required to file quarterly 13F reports with the Securities and Exchange Commission within 45 days of quarter-end, listing their qualifying securities under management. Qualifying securities include stocks, bonds, and derivative instruments. In the case of equity securities, institutions are required to report common stock positions of greater than 10,000 shares or $200,000 in market value at each quarter-end.
The Spectrum database reports for each institutional investor at the end of each quarter the number of shares held of each stock meeting these criteria. The database covers 22 years, from 1981 through 2002, making our analysis one of the most comprehensive studies of institutional investments.
Finally, market-based and firm-based data are obtained from the Center for Research in Security Prices (CRSP) monthly database and Compustat.
II. Background on the Institutional Investor Universe
I note the tremendous growth of the institutional investor universe in the past two decades. The statistics in Table I clearly demonstrate the extent of this growth.
The number of institutions investing in equities has more than tripled from 600 to over 2000. Most of this increase came about during the 1990s. Growth in the amount of funds under management has been even more dramatic. While institutions managed a total of $500 billion in the early 1980s, the amount had increased to $9 trillion at the peak of the financial bubble at the end of 1999, followed by a decline to $6.5 trillion by the end of 2002. Overall, the amount of funds managed by institutional investors has grown fifteen fold over the past two decades. This tremendous increase represents a shift in the investment preferences of the American households and increased public participation in the US equity markets. As a result, the average portfolio value under management by institutional investors has quadrupled from under $1 billion to almost $4 billion dollars within the period.
Table I presents both institutional portfolio return for each year in the study period, and the returns to two broad market indices, the CRSP value-weighted index and the S&P 500 index (compounded monthly returns). Institutional portfolios are composed of equity, fixed income, derivatives, and cash positions, but the Spectrum 13F database provides only the equity positions of individual institutional investors. This limits my analysis to evaluation of the investment success of the equity portion of institutional portfolios. I use the filed portfolio holdings of an institutional investor for a given quarter to estimate the portfolio return for the next quarter as follows. I assume that throughout a particular quarter institutions hold the portfolio positions declared in the 13F filings at the end of the previous quarter. Portfolios are updated each quarter according to the new filings. Quarterly and monthly portfolio returns are calculated as value-weighted buy-and-hold returns. Portfolio weights are obtained from the number of shares reported in the 13F filings and CRSP prices.
The frequency of the data imposes certain limitations on the analysis. First, because I assume that positions reported at the beginning of a quarter remain constant throughout that quarter, calculated portfolio returns will be more representative of the actual returns for lower-turnover institutions than higher. Second, portfolio returns are calculated before management or load fees, so they represent approximate gross returns of the institutional portfolios. In practice, taxes and management fees may have a significant impact on the net returns the clients earn. Despite these limitations, the Spectrum 13F database provides the most detailed information on the equity portfolio composition of institutional investors to date.
The buy-and-hold portfolio returns of all institutions in operation during a given quarter are equally weighted to construct the quarterly return of the institutional portfolio. Survival through the end of the year is not required for an institution's inclusion in a given quarter's portfolio. The quarterly returns are then compounded to obtain an annual return. This process ensures that the institutional portfolio return is survivor-bias-free.
Table I shows the institutional portfolio performed better than the CRSP value-weighted index in 16 of the 22 years and better than the S&P 500 index in 12 of the 22. The institutional portfolio also performed better than the overall market (proxied by the CRSP value-weighted index), in both subperiods (the 1980s and the 1990s), but overall only on a par with the S&P 500. A notable observation is that, the institutional portfolio performed much better than either index during the severe market downturn in 2000-2002. Although my comparisons here do not account for any risk adjustment, one can see that the overall institutional investor universe has managed money quite successfully.
Figure 2 presents snapshots of the distribution of funds managed within the institutional investor universe during the study period. In the early 1980s, banks and trusts managed the bulk of the institutional funds, followed by investment advisors and pension funds. The mutual fund sector is quite small in this era. Investment advisors start to dominate the institutional investment universe in the 1990s.
[FIGURE 2 OMITTED]
In late 1990s, I observe a dramatic change in the institutional investment universe. With a shift in household financial assets into mutual funds, the investment companies become a major player in the institutional investor universe and the share of banks and trusts diminishes steadily. In the same period, the investment advisor group, which mostly manages delegated pension fund assets, becomes the dominant institutional investor category.
Table II presents equity investment holdings and performance by institutional investor category. I see as before that over the two decades funds under management have increased tremendously for all institutional investor groups.
Banks and trusts outperformed the CRSP value-weighted index in 17 of the 22 years in the study period; pension funds and endowments outperformed in 16 years. Insurance companies and investment advisors performed better than the CRSP index in 15 years, but the investment companies performed better in only 13 of the...
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