Increased liquidity in U.S. stock markets may be correlated with the habits and growing prevalence of institutional investors, two Wharton professors have found.

In their working paper, “Institutional Investors and Stock Market Liquidity: Trends and Relationships,” Wharton emeritus finance professor Marshall E. Blume and finance professor Donald B. Keim analyze patterns in institutional stock ownership from 1980 to 2010, a period in which the volume of institutional investors in the market nearly doubled. During that time, institutional investors, especially hedge funds, decreased their holdings of larger stocks and increased holdings of smaller stocks, which “has implications for the liquidity of U.S. equity markets,” Blume and Keim write.

According to the researchers, concurrent with this growth in institutional stock investing has been a significant increase in stock market liquidity in recent decades. “Having liquid and well-functioning securities markets is important,” Keim says. “Liquid securities markets permit buying and selling of securities at the lowest possible cost [thus ensuring supply equals demand], thereby enabling the determination of accurate prices that facilitate the fairest allocation of resources in the economy.”

Blume and Keim point out that their analysis does not explicitly find that the growth of institutional participation in the market caused the increase in stock market liquidity. By examining the cross-sectional relation between stock ownership and liquidity, however, the researchers find that as the number of institutions that own a stock rises, so does the liquidity of the market for that stock. Also, this correlation between liquidity and the number of institutions owning a stock increased during the sample period, and was significantly stronger from 1996 to 2010 compared to 1982 to 1995.

The growth of the institutional investor’s role in the stock market began to increase after World War II, Blume and Keim note in their paper. Before that, from 1900 to 1945, the proportion of equities managed by institutional investors hovered around 5%. After World War II, however, institutional ownership started to increase, and by 1980, institutions held $473 billion, or 34%, of the total market value of U.S. common stocks. By 2010, institutions held $11.5 trillion, or 67% of all stocks.

“This trend is in part due to the increased importance of retirement plans in recent decades, and the resulting increase in delegation of portfolio management to institutions,” according to Keim.

Blume and Keim found that between 1980 and 2010, institutional investors increased holdings of smaller stocks and decreased holdings of larger stocks relative to market weights. “Specifically, over the last three decades, institutions as a whole gradually increased their portfolio allocations to the stocks that make up the smallest 10% of the value of the market,” they write.

Institutions seemed to follow this pattern no matter what their size, although it was more pronounced among the smaller institutions. In the 12 years between 1998 and 2010, hedge funds in particular showed an affinity for smaller stocks, the authors found. As a result, institutional investors now tend to be underweight in large stocks and overweight in small stocks relative to their market weights.

Institutional attraction to smaller stocks may be due in part “to the increasing percentage of the institutional investor population represented by hedge funds and smaller institutions with fewer assets under management,” Keim says. “These smaller institutions have greater ability to invest in the less-liquid smaller-cap stocks and not incur large transaction costs by impacting the prices at which they trade.”

The institutions gravitating toward small-cap stocks do so for diversification reasons, and also possibly for the higher returns often associated with these stocks, Keim notes. The increased institutional ownership of stocks has not necessarily translated into higher stock market volatility or risk, he adds.

For perspectives on the ongoing volatility of the market, see: “In or Out? The Case for — and Against — the Stock Market.”