Destabilizing Noise Trading: Evidence from Pension Fund Reallocations

Z. Da, B. Larrain, C. Sialm, J. Tessada

Discussed by Yong Chen

Texas A&M University

WU Gutmann Symposium, Vienna

August 19, 2015

Liquidity Timing

The debate about the effect of noise trading dates back to Keynes (1936) and Freedman (1953).

De Long, Shleifer, Summers, and Waldmann (1990): Noise traders cause asset prices to deviate from fundamentals, if risk-averse arbitrageurs have short trading horizons.

Empirically, noise trading has been shown to affect asset prices (e.g., Baker and Wurgler, 2006; Barber, Odean, and Zhu, 2009; Da, Engelberg, and Gao, 2014). Further, systematic exposure to noise trader risk is priced in security returns (Chen, Han, and Pan, 2015).

Summary (1)

Yong Chen Slide 2

Liquidity Timing

This paper uses the setting of Chilean pension system to study “coordinated noise trading.”

Chilean pension system has several unique features: Pension investors have freedom to and often do switch

between stocks and government bonds.

Since 2011, such switches were influenced by recommendations of an advisory firm called “FyF”.

To accommodate massive switches, pension fund companies trade a sizable portion of their portfolios within a few days.

Summary (2)

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Liquidity Timing

The main findings are: Large price pressure in both stock and bond markets

follows FyF recommendations. Abnormal turnover occurs for large stocks and long-

term bonds, main holdings of pension funds, right after FyF recommendations.

Excessive volatility is associated with heavy price pressure proxied by flow-induced pressure (FIP).

Pension funds react with more cash holdings.

Summary (3)

Yong Chen Slide 4

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Very important topic. Unique setting of Chilean pension system. Carefully-executed analysis. Many interesting results.

Summary (4)

Yong Chen Slide 5

Liquidity TimingWhat’s Un-coordinated Noise trading like?

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Liquidity TimingWhat’s Coordinated (Noise) trading like?

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Liquidity TimingWhat’s Coordinated (Noise) trading like?

Yong Chen Slide 8

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The paper (Fig. 3) looks at cumulative raw returns of following FyF recommendations, which is not very impressive especially after 2012.

But, by switching between stocks and bonds, the strategy may have lower market risk than buy-and-hold.

Suggestion: Report risk-adjusted return (i.e., alpha) for the strategy

of following FyF; Test the strategy’s market-timing performance, via

Treynor-Mazuy or Henriksson-Merton market-timing model.

Information vs. Noise?

Yong Chen Slide 9

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Can the story be that some information arrived right before FyF recommendations and its effect lasted until after the recommendations?

Suggestion: Include dummies of days prior to FyF recommendations,

say, Day –1, Day –2, Day –3, into the regressions.

Information vs. Noise?

Yong Chen Slide 10

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Why do pension investors follow FyF?– The paper mentions marketing efforts on social media. – Suggestion: Provide some details about how FyF became

popular.

What can FyF do about the noise trading?– “Front running”?

If Noise, then …

Yong Chen Slide 11

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What do sophisticated investors (Institutional Investors) do about FyF recommendations?─ Suggestion: Use change in holdings of Institutional Ownership (IO) as a comparison group.

What should pension investors do?─ Think about the welfare implication of coordinated noise trading.

If Noise, then …

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Thank You!

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