Connected Stocks

We connect stocks through their common active mutual fund owners. We show that the degree of shared ownership forecasts cross-sectional variation in return correlation, controlling for exposure to systematic return factors, style and sector similarity, and many other pair characteristics. We argue that shared ownership causes this excess comovement based on evidence from a natural experiment—the 2003 mutual fund trading scandal. These results motivate a novel cross-stock-reversal trading strategy exploiting information contained in ownership connections. We show that long-short hedge fund index returns covary negatively with this strategy, suggesting these funds may exacerbate this excess comovement. Barberis and Shleifer (2003) and Barberis, Shleifer, and Wurgler (2005) argue that institutional features may play an important role in the movement of stocks’ discount rates, causing returns to comove above and beyond the comovement implied by their fundamentals. In this paper, we propose a new approach to document that type of institutional-based comovement. Based on mounting evidence since Coval and Stafford (2007) that mutual fund flows result in price pressure, we focus on connecting stocks through active mutual fund ownership. Specifically, we forecast cross-sectional variation in return correlation for stock pairs using the degree of common ownership by active mutual funds. Our bottom-up approach allows us to measure institutional-driven comove∗Miguel Antón is with Department of Finance, IESE Business School. Christopher Polk is with Department of Finance, London School of Economics. We are grateful to Ken French, David Hsieh, and Bob Shiller for providing us with some of the data used in this study. We are deeply indebted to two anonymous referees, an Associate Editor, and the Editor, Cam Harvey, for numerous comments that significantly improved the paper. We are also grateful for comments from Andriy Bodnaruk, John Campbell, Randy Cohen, Jonathan Cohn, Owen Lamont, Augustin Landier, Dong Lou, Narayan Naik, Belén Nieto, Jeremy Stein, Dimitri Vayanos, Tuomo Vuolteenaho, and Paul Woolley, as well as from conference participants at the Summer 2008 LSE lunchtime workshop, Spring 2009 Harvard PhD brownbag lunch, 2010 HEC 2nd Annual Hedge Fund Conference, 2010 Paul Woolley Research Initiative Workshop, 2010 Spanish Finance Forum, 2010 WFA, 2010 EFA, 2010 Yale University Whitebox Graduate Student Conference, and 2010 Paul Woolley Conference, and seminar participants at Bristol University, IESE-ESADE, Imperial College, London School of Economics, and the University of Amsterdam. Financial support from the Paul Woolley Centre at the LSE is gratefully acknowledged. Antón also gratefully acknowledges support from the Fundación Ramón Areces, the European Commission (Project EMAIFAP–FP7-PEOPLE-2011-Marie Curie CIG (GA no. 303990)), and the Public-Private Sector Research Center at IESE Business School. DOI: 10.1111/jofi.12149