The effect of financial institution objectives on equity turnover

Academy of Accounting and Financial Studies Journal, Sept, 2005 by Vaughn S. Armstrong, Norman Gardner

ABSTRACT

We examine the share and dollar turnover on the New York Stock Exchange and on NASDAQ and find that investor objectives affect their contribution to stock turnover. We control for transactions costs and information (previously identified as factors affective turnover) to determine how different investment objectives of financial institutions affect turnover. We find that although all financial institutions have relatively low transactions costs and broad access to information, some institutions' holdings are associated with increased stock turnover while others' reduce turnover. We also find evidence that institutions' effect on turnover differs across different types of stocks, indicating that objectives may differ over different types of investments.

INTRODUCTION

Turnover measures the portion of a company's stock that trades during a period of time. Prior studies have shown that turnover decreases as the cost of trading increases and increases with the rate the firm or market generates new information. Information and trading costs affect how frequently investors alter their expectations regarding the firm and adjust their holdings in response to changed expectations. No other factors affecting equity turnover have been identified. This paper examines whether investors' objectives are a third factor that affects turnover. We find that even when two investors have comparable access to information and equal trading costs, they do not necessarily contribute equally to turnover. The investors we test are financial institutions, all of which have comparable access to information about equity value and trade at low cost relative to individual investors. Larger equity holdings by some financial institutions are associated with higher market turnover, while the opposite is true for other institutions. Similarly, turnover increases as some financial institutions increase their equity holdings but declines with increases in equity holdings of other institutions. We also find that the effect a financial institution has on equity turnover differs for different types of equity. The results indicate that trading costs and access to information are not the only factors affecting turnover. Investors' strategy with respect to holding and trading are an additional factor.

In the last twenty years, equity markets in the United States have experienced increased turnover. Table 1 presents turnover rates (in shares and dollars) for the New York Stock Exchange and for NASDAQ from 1985 through 2002. Turnover of shares on the New York Stock Exchange increases from 0.54 in 1985 to 1.04 in 2002. Turnover in NASDAQ increases from 0.72 to 2.80, reaching a high of 3.05 in 2000. Dollar turnover on the NYSE increases from 0.53 to 0.98 and on NASDAQ from 0.93 to 3.18 over the same period. The increased turnover indicates that the average holding period decreases from 22 months to 11 1/2 months on the NYSE and from 13 months to 4 months on NASDAQ.

Trading by financial institutions contributes to turnover. All financial institutions enjoy similar access to information and relatively low trading costs. However, different institutions pursue different investment objectives. We examine how contribution to turnover differs across financial institutions. To determine whether observed differences arise in fact from differences in financial institution objectives, we control for the other two factors that have been identified as affecting turnover, trading costs and information volatility. We find that greater equity holdings by depository institutions, private pensions, closed end funds and brokers and dealers increase NYSE turnover while greater holdings by bank-managed trusts and estates, insurers other than life insurers, open-end mutual funds and state and local governments and their pensions reduces it. We also find that differences exist among financial institutions when we examine NASDAQ turnover. Those differences are not identical to the results for NYSE turnover, indicating that financial institutions may pursue different objectives with different types of stocks. The results confirm that, in addition to information and transactions costs, investment objective affects turnover.

LITERATURE DEALING WITH FACTORS THAT AFFECT TURNOVER

The academic literature examining equity turnover identifies two factors that affect turnover--information and transactions costs, Karpoff (1986). The association between turnover and information arises because the intensity of trading increases with the frequency that investors alter their expectations regarding the firm, its industry and the market. As a result, when information about a firm, an industry or the market is more volatile, when investors' access to information improves, and when there is greater divergence in investors' expectations, turnover increases. Several papers find this relationship in U.S. equity markets. Covrig and Ng (2004) find a positive correlation between information arrival and trading volume. Pollock and Rindova (2003) find that the volume of media-provided information about an initial public offering stock is positively correlated with the IPO's first day trading volume. The finding of Lee and Swaminathan (2000) that turnover depends on the type of stock, with "value" stocks having relative lower turnover than "growth" stocks reflects the greater relative volatility of information for growth stocks.