How Institutional Herding Impacts Small Cap Liquidity

Abstract

Although institutional herding has been known to play an important role in the dynamics of financial markets, little is known about its effects on the liquidity of small-cap stocks. This paper examines the impact of the concentration of trading activities that are shared by institutional investors on the conditions of liquidity in small-cap markets. Based on market microstructure theories and behavioral theories of finance, the study will determine whether the liquidity constraints are aggravated by herding through amplified volatility as well as increase bid-ask spreads and decrease the trading depth. Based on empirical evidence provided by institutional holdings and trading activity, this analysis demonstrates the duality of herding: in the short-term, high levels of trading släµCorexf MD ending exist may increase the volume of trading activity, but sustained convergence of portfolio positions tends to reduce liquidity resilience among small-cap securities. Evidence indicates that herding increases not only the fragility experienced in less liquid areas of the market but also introduces risks about how to determine the price and who will participate in investing. The study also adds to the body of knowledge since it fills in the gaps between behavioral trading patterns and structural liquidity results by providing theoretical knowledge and policy relevance. Regulatory and market participant recommendations are proposed to reduce the negative effects on liquidity and a more stable trading environment is provided.