Gabaix and Koijen calculated the effects of fund flows on individual prices as well as on the market in aggregate. They used a variety of data sources—piecing together a picture using various public filings and reports containing information on holdings and flows in stock and bond markets, generally covering the years 1993 to 2020. Before posting their paper, they asked 102 academic researchers in economics and finance to predict what every $1 entering the stock market would do to prices. The prevailing view, held by just over half of respondents, was that it would have no price effect. Of those who said it would have some effect, only three people said it would have a multiplier effect greater than one—as in, every $1 entering the market would push up prices by $2.
But in the inelastic markets hypothesis, money that flows into the stock market leads to stronger price effects because there are essentially a set number of available shares, and many of those are not being actively traded. Pairing their theory with an empirical analysis, the researchers estimate that every $1 put into the market pushes up aggregate prices by $5.
The researchers say that while this may seem like a big multiplier, it’s roughly in line with what other researchers find at a micro level. For example, AQR’s Andrea Frazzini and Ronen Israel and Yale’s Tobias J. Moskowitz estimated the price impact one large trader had on prices.
Jean-Philippe Bouchaud, chairman of Capital Fund Management in Paris, this past summer released his own research, in which he writes that Gabaix and Koijen’s “rather awesome recent paper” validates what he has found over two decades. He calculates that the multiplier for dollars invested can be even higher for volatile stocks—or lower for companies for which a smaller fraction of the market cap is actively traded.
“The mystery of apparently random movements of the stock market, hard to link [to] fundamentals, is replaced by the more manageable problem of understanding the determinants of flows in elastic markets,” Gabaix and Koijen write. Their work, they continue, “might lead to a more concrete understanding of the origins of financial fluctuations across markets.”
Deconstructing market moves
This logic implies that it’s possible to trace fluctuations in markets back to who caused them, which is something Koijen and his colleagues have been doing. The idea of tracing movements back to investors isn’t new, but academics abandoned it decades ago, in part because the data weren’t easily available, or available at all.
Now it’s easier to obtain measurements of holdings and fund flows, and to compare those with price data. Koijen, New York University’s Robert J. Richmond, and Princeton’s Motohiro Yogo deconstructed fund flows in the roughly $50 trillion US stock market to determine what and who is moving prices. Day traders might like meme stocks, they write, while some pension and sovereign wealth funds have mandates to invest in sustainable, more environmentally friendly companies. Many hedge funds, meanwhile, look for arbitrage opportunities. (Read “Who is driving stock prices?” as well as “The investors with the most influence over companies’ market capitalization.”)
The researchers developed a framework that starts with a simple model they applied to data to identify the characteristics that determine demand and ultimately prices. They then divided investors into eight groups according to investor size and strategy—from huge, passive investment advisers to smaller, actively managed advisers and hedge funds. Then they imagined a world in which the assets of one of those groups flows to all other institutional investors.
“For example, we ask by what percent does the average stock price move if we take BlackRock’s assets and redistribute these assets to all other institutional investors,” they write. “Because BlackRock has certain portfolio tilts, this experiment would lower the stock price along characteristics that BlackRock favors.”
Performing this portfolio thought experiment leads to many observations, among them that certain small, active investors have the largest influence on valuations. Hedge funds hold less than 5 percent of the equity market, Koijen, Richmond, and Yogo find—and yet, controlling for size, they are the most influential players in the market, more so than far larger pension funds and insurance companies.
“At the other end of the spectrum, we find that passive investment advisors (both small and large) and long-term investors have a relatively small impact on valuations,” the researchers write. That’s in line with the inelastic markets hypothesis that when many players are sitting on the sidelines, the ones on the field are moving prices and most responsible for fluctuations as well as outright volatility.
The international picture
With international holdings data, Koijen and Yogo performed a similar decomposition exercise, applying the idea to international stock, bond, and currency markets. “Global investors hold financial assets across many countries and have exchange rate exposure not only through short-term debt but also long-term debt and equity,” they write. “The portfolio decisions of these investors across countries and asset classes are important for exchange rates, long-term yields, and stock prices.”
While they’re making a case that demand matters, they’re not saying it’s the only thing that matters. Many other forces can move markets, including government and monetary policies, volatility, sovereign debt ratings, and macroeconomic conditions. To tease apart the various forces at work, they developed a model to study what moved exchange rates, long-term yields on bonds, and stock prices across 36 countries between 2002 and 2017. The International Monetary Fund’s annual Coordinated Portfolio Investment Survey provided information on the holdings of investors worldwide, and they essentially mapped investor portfolios at the country level with asset prices, estimating the demand for assets.