Does Investment Horizon Matter? Disentangling the Effect of Institutional Herding on Stock Prices

Date01 November 2015
Published date01 November 2015
The Financial Review 50 (2015) 637–669
Does Investment Horizon Matter?
Disentangling the Effect of Institutional
Herding on Stock Prices
H. Zafer Y¨
College of Management, University of MassachusettsBoston
This study finds that, over short horizons, herding by short-term institutions promotes
price discovery. In contrast, herding by long-term institutions drives stock prices away from
fundamentals over the same periods. Furthermore, while the positive predictability of short-
term institutional herding for stock prices is more pronounced for small stocks and stocks with
high growth opportunities, the negative association between long-term institutional herding
and stock prices is stronger for stocks whose valuations are highly uncertain and subjective.
Finally, we show that the destabilizing effect of institutional herding persistence documented
in the recent literature is entirely driven by persistent herding by long-term institutions.
Keywords: institutional herding, investment horizon, price impact
JEL Classifications: G11, G12, G14, G20
Corresponding author: Accounting and Finance Department, College of Management, University of
Massachusetts Boston, 100 William T Morrissey Boulevard, M5-257 Boston, MA 02125; Phone: (617)
287-7671; Fax: (617) 287-7877; E-mail:
I would like to thank George J. Jiang, Eric Kelley,Christopher Lamoureux, and Lubomir Litov. Addition-
ally, I appreciate the valuablecomments and help from Scott Cederburg, Thomas Copeland, Edward Dyl,
Albert Kyle, Richard Sias, Pengfei Ye,Andrew Zhang, and seminar participants at the 2011 FMA Annual
Meetings and the 2011 FMA Doctoral Consortium. I would also like to thank Travis Box, Januj Juneja,
Jung Hoon Lee, Amilcar Menichini, Geoffrey Smith, Huacheng Zhang, and all presentation participants
at the University of Arizona, the University of San Diego, and the University of Massachusetts Boston.
Special thanks to Jordan Neyland and Laura Cardella for continuous feedback, as well as to Theresa
Gutberlet and Tara Sklar for constant support. I am grateful to two anonymous referees and Bonnie Van
Ness for many insightful comments and suggestions.
C2015 The Eastern Finance Association 637
638 H. Z. Y¨
uksel/The Financial Review 50 (2015) 637–669
1. Introduction
A large body of empirical literature shows that institutional investors exhibit a
tendency to herd, that is, they buy or sell the same stocks during the same period.1
These studies also show that stock prices continue in the same direction as herding
over the subsequent one to three quarters. For example, Wermers (1999) shows that
stocks bought in herds by mutual funds outperform those sold in herds by mutual
funds during that quarter and over the subsequent three quarters. Sias (2004) finds
a positive correlation between the direction of institutional herding and future stock
returns over the following four quarters. These findings are consistent with the notion
that institutional herding enhances market efficiency by speeding up price discovery.
We extend the existing literature by disentangling the effect of institutional
herding on future stock prices across different groups of institutions. In particu-
lar, previous studies document differences in the level of informed trading among
institutional investors with different investment horizons. These studies show that
institutions with short investment horizons tend to be better informed than those with
long investment horizons. For example, Yan and Zhang (2009) find that changes
in short-term institutional ownership (i.e., institutions with high portfolio turnover)
predict future stock returns and are positively associated with future earnings sur-
prises. In contrast, changes in long-term institutional ownership (i.e., institutions with
lower portfolio turnover) are not related to future stock returns or earnings surprises.
Their interpretation is that short-term institutions trade aggressively to profit from
their informational advantage. If the level of informed trading varies between insti-
tutions with short- and long-term investment horizons, then their herding could have
a different effect on future stock prices. Specifically, if short-term institutions trade
based on information, we would expect herding by these institutions to promote price
discovery. Conversely, if long-term institutions trade for reasons unrelated to new
information, their herding could potentially drive prices away from fundamentals.
We examine the above hypothesis by disentangling the effect of herding between
short-term and long-term institutions.
Following Yan and Zhang (2009), we classify institutional investors as short-
or long-term on the basis of their portfolio turnover over the past four quarters. To
disentangle the effects of short- and long-term institutional herding, we construct the
herding metric of Lakonishok, Shleifer and Vishny (1992) for short- and long-term
institutions separately. This measure reflects the tendency of a given subgroup of
institutions (short- vs long-term institutions) to buy or sell the same stocks during the
same period.
1See Lakonishok, Shleifer and Vishny (1992), Wermers(1999) and Sias (2004). Broadly, the theoretical
literature offers two reasons why institutions could herd. First, they trade based on the new information
(Froot, Scharfstein and Stein, 1992; Hirshleifer, Subrahmanyam and Titman, 1994). Second, institutions
could herd for reasons unrelated to information, such as the reputational risk or preferences for specific
stock characteristics (Scharfstein and Stein, 1990; Banerjee, 1992; Falkenstein, 1996; Bikhchandani and
Sharma, 2001).
H. Z. Y¨
uksel/The Financial Review 50 (2015) 637–669 639
We find that herding by all institutions, both short- and long-term, is persistent,
and the persistence in institutional herding is mainly driven by long-term institutions.
As noted by Hirshleifer, Subrahmanyam and Titman (1994), the sequential nature of
information arrival leads investorsto herd, since the trades of early informed investors
(i.e., leaders) lead those of the late informed (i.e., followers). If short-term institutions
are better informed than long-term institutions, long-term institutional herding would
be positively correlated with the lagged herding measures of short-term institutions.
We showa strong positive relation of long-term institutional herding with short-term
institutional herding over the previous quarters. In contrast, we find no evidence that
short-term institutional herding is positively correlated with the previous quarter’s
long-term institutional herding.
Webegin by examining the price impact of herding by all institutions as a group.
We compute quarterly abnormal returns using the characteristic-matched benchmark
of Daniel, Grinblatt, Titman and Wermers (1997). This analysis shows there is no
significant difference between a portfolio of stocks that institutions buy in herds and
the portfolio of stocks that institutions sell in herds during the subsequent quarter
following the portfolio formation period (a price stabilizing effect the subsequent
quarter). However, a return reversal follows this effect over the next two to four
quarters. More specifically, after stock returns are adjusted for certain stock char-
acteristics, the price-stabilizing effect of herding by all institutions does not persist
over one- to three-quarter horizons. This finding challenges the conclusion of earlier
studies (Wermers, 1999; Sias, 2004).2
Next, we examine the price effects of short- and long-term institutional herd-
ing, respectively. Our results show that the stabilizing effect of institutional herding
reported in the previous literature is mainly driven by short-term institutional herd-
ing. Contrary to the results of earlier studies, the strong return reversal following
long-term institutional herding is evidence that herding by these institutions tends
to drive stock prices away from their equilibrium values. This finding alters the
perception of institutional herding as solely benefiting price discovery over short
horizons. Fama–MacBeth (1973) cross-sectional regressions confirm the differential
price impact of short- and long-term institutional herding, even after controlling for
the change in breadth, institutional demand, and various stock characteristics. In ad-
dition, our results hold for different subperiods, and are robust to the use of alternative
methodologies for the investment horizon of institutional. Further, the informational
advantage of short-term institutional herding is stronger for smaller firms and firms
with more growth opportunities. In contrast, the return reversal observed following
long-term institutional herding is particularly pronounced for firms whose valuations
2Wermers (1999) examines the effect of herding by mutual funds and future stock returns adjusted for
size portfolios. Sias (2004) examines the correlation between institutional herding and future stock (raw)
returns. Due to the high correlation between institutional herding and stock characteristics, that is, size
as well as book-to-market ratio and momentum, Daniel, Grinblatt, Titman and Wermers(1997) provide a
stronger test for the price impact of institutional herding.

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