The Role of Financial Markets Institutions in Capital Allocation

Misallocation of capital can have dire consequences for the economy, as the Global Financial Crisis testifies. Institutional investors play a prominent role in capital allocation to the real economy. For example, in the United States, institutional investors hold over 70% of the equity of listed firms. Given the overwhelming importance of institutions in financial markets, it is crucial to study the drivers of their investment decisions. This proposal draws inspiration from recent developments in financial markets to study three different types of institutions and their role in capital allocation. •The first project focuses on Exchange Traded Funds, which experienced tremendous growth in the last two decades. There are currently over 2,000 ETFs in the U.S. In the last five years, more than 1000 ETFs were born, implying that almost one new ETF has come to the market every day. These developments seem to conflict with the premise that passive investing is about buying and holding a broadly diversified portfolio. What are the drivers of the launch of new ETFs? In particular, we would like to identify the location, in terms of market segments, and the timing of new ETF introductions. The main hypothesis that we will test is that new ETFs are launched in segments of the market that receive increasing attention by investors and the media. For example, there are at least six recently started ETFs in the U.S. tracking the cannabis sector, and two new ETFs track the themes ‘Trade War’ and ‘Make America Great Again’. From an asset pricing perspective, the question is whether new ETFs tend to chase securities and sectors that are subject to some form of investor sentiment. •The second project focuses on institutional brokers. This project draws its motivation from the introduction of the MiFID II directive in Europe and related regulations in Switzerland, which mandate the unbundling of research services from the commissions that asset managers pay brokers for trade execution. The impact of this evolution on capital allocation depends on the extent to which institutional investors actually rely on analysts for their investment decisions. For example, if investment ideas mainly originate from research departments inside the investment firm, then the disappearance of sell-side analysts may not have important consequences for information impounding. Therefore, an important question concerns the value that active investors actually give to analysts’ research. To address this question, the project develops a structural model of demand for brokerage services and estimates it using transaction data in the U.S. equity market. •The third project focuses on pension funds in Switzerland. In particular, I intend to focus on the asset allocation decision of Swiss pension funds and relate it to the governance structure of the pension plan and the composition of the board of trustees. Studying asset allocation is particularly relevant in the current environment of negative interest rates, which represent a serious threat to the funding status of pension plans. To overcome the low returns of fixed income allocations, pension funds are searching for yield in different directions. These efforts necessarily depend on the expertise, incentives, and biases of the governing board. The main data source for this study comes from data that the research team will gather through mixed-mode surveys consisting of a self-administered online questionnaire and in-depth interviews with Swiss pension fund executives and board trustees.