Institutional investors and the limits of arbitrage

The returns and stock holdings of institutional investors from 1980 to 2007 provide little evidence of stock-picking skill. Institutions as a whole closely mimic the market portfolio, with pre-cost returns that have nearly perfect correlation with the value-weighted index and an insignificant CAPM alpha of 0.08% quarterly. Institutions also show little tendency to bet on any of the main characteristics known to predict stock returns, such as book-to-market, momentum, or accruals. While particular groups of institutions have modest stock-picking skill relative to the CAPM, their performance is almost entirely explained by the book-to-market and momentum effects in returns. Further, no group holds a portfolio that deviates efficiently from the market portfolio.

► I study the returns and stock holdings of institutional investors from 1980 to 2007.
► Institutions, in aggregate, do not earn significant alphas.
► Institutions, in aggregate, take almost no bet on characteristics known to predict returns.
► Some groups of institutions beat the CAPM but performance is explained by other factors in returns.
► Institutions do not hold portfolios that deviate efficiently from the market portfolio.