Institutional Investors Drive Large Cap Prices

Large institutional investors have come to own an ever-larger percentage of the country's equities, and large institutional investors prefer to buy large-cap stocks.

In the early 1980s, economists discovered that --over the long run-- small-cap stocks outperform large-cap stocks. Since then, however, the so-called small-cap premium has disappeared: from 1926 through 1979, the mean annualized return for small-cap stocks was 12.2 percent, compared with 8.2 percent for large caps; from 1980 to 1996, it was small caps 13.3 percent, large caps 15.9 percent.

The disappearance of the small cap premium has been the subject of much discussion among both investors and economists, but it hasn't been fully explained. In Institutional Investors and Equity Prices (NBER Working Paper No. 6723) , NBER Faculty Research Fellows Paul Gompers and Andrew Metrick offer one possible rationale. Put simply: Large institutional investors have come to own an ever-larger percentage of the country's equities, and large institutional investors prefer to buy large-cap stocks.

Using the "13F" disclosures that institutions with more than $100 million of securities under management must file with the SEC, Gompers and Metrick find that the share of the U.S. equity market held by such institutions grew from 26.8 percent in March 1980 to 51.5 percent in December 1996. Over that same period, the share held by the 100 largest institutions grew from 19 percent to 37 percent. Gompers and Metrick also find that these institutional investors show a strong, consistent preference for large, liquid stocks.

Together these two phenomena add up to an increase in demand for large-cap stocks. And that increased demand helps explain the disappearance of the small-cap premium, Gompers and Metrick conclude.

-- Justin Fox