The Role of Institutional Investors in Equity Trading: An Explanation of the Home Bias Puzzle∗

This paper postulates that management performance evaluation is a source of divergence between institutional investors and households’ optimal portfolio decisions. In a partial equilibrium setting, the objective of a representative household is modeled as the maximization of expected utility (an increasing and concave function, in order to accommodate risk aversion) of final wealth. Yet, the institutional investor is assumed to maximize utility (same type of function) of final wealth minus a benchmark. Under these assumptions, the optimal portfolio choices of both types of investors are derived and compared. The specific objective function of the representative institutional investor is shown to induce a divergence between her optimal portfolio and that of the representative household. We study the effects of this optimal strategy in asset trading on a simple one-period equilibrium model and obtain a multibeta CAPM; as a novelty, a new factor-risk is brought into the analysis: the active management risk. This new beta is defined as the normalized (to the benchmark’s variance) covariance between asset’s excess return and the excess return of the market over the benchmark index. We test this model using a data sample of 220 US securities and the S&P 500 as the benchmark index. The sample consists of monthly returns from January, 1973 through December, 1997. We show that the index is relevant in order to explain the excess return of domestic securities. The test supports the predictions of the model. As an extension of the previous results to an international framework, we show that the model provides an alternative explanation of the home bias puzzle. In a partial equilibrium setting, the specific objective function of the representative institutional investor induces a home bias in her portfolio. The bias obtains for certain (and plausible) combinations of the volatilities of domestic and foreign asset markets and the covariances between the domestic and international securities.