Asset Prices and Institutional Investors

Abstract

We consider an economy populated by institutional investors alongside standard retail investors. Institutions care about their performance relative to a certain index. Our framework is tractable, admitting exact closed-form expressions, and produces the following analytical results. We find that institutions tilt their portfolios towards stocks that compose their benchmark index. The resulting price pressure boosts index stocks. By demanding more risky stocks than retail investors, institutions amplify the index stock volatilities and aggregate stock market volatility and give rise to countercyclical Sharpe ratios. Trades by institutions induce excess correlations among stocks that belong to their benchmark, generating an asset-class effect. (JEL G12, G23)