INSTITUTIONAL INVESTORS AND THE DEPENDENCE STRUCTURE OF ASSET RETURNS

Rama Cont and Lakshithe Wagalath
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Rama Cont: Imperial College, South Kensington Campus, London SW7 2AZ, UK
Lakshithe Wagalath: IESEG School of Management (LEM CNRS), 1 Parvis de la, Défense, 92044 Paris La Défense Cedex, France3Léonard de Vinci Pôle Universitaire, Finance Lab, Paris La Défense, France

International Journal of Theoretical and Applied Finance (IJTAF), 2016, vol. 19, issue 02, 1-37

Abstract: We propose a model of a financial market with multiple assets that takes into account the impact of a large institutional investor rebalancing its positions so as to maintain a fixed allocation in each asset. We show that feedback effects can lead to significant excess realized correlation between asset returns and modify the principal component structure of the (realized) correlation matrix of returns. Our study naturally links, in a quantitative manner, the properties of the realized correlation matrix — correlation between assets, eigenvectors and eigenvalues — to the sizes and trading volumes of large institutional investors. In particular, we show that even starting with uncorrelated “fundamentals”, fund rebalancing endogenously generates a correlation matrix of returns with a first eigenvector with positive components, which can be associated to the market, as observed empirically. Finally, we show that feedback effects flatten the differences between the expected returns of assets and tend to align them with the returns of the institutional investor’s portfolio, making this benchmark fund more difficult to beat, not because of its strategy but precisely because of its size and market impact.

Keywords: Liquidity; feedback effects; institutional investors; endogenous correlations (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (10)

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DOI: 10.1142/S0219024916500102

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