This article explains in clear terms for individual investors how the risk budgets, tracking error and rebalancing used by institutional investors affect share prices. The relationship between the constraints facing institutional investors managing substantial amounts of capital and market supply and demand can produce price movements that cannot be fully explained by the news alone.
Share price movements cannot be explained by corporate value alone. The investment rules applied by institutional investors and changes in supply and demand also have a significant impact. As pension funds, mutual funds and insurance companies manage substantial amounts of capital, they need to adjust their position weights and deviations from their benchmarks.
A risk budget is a framework for determining the level of risk that is acceptable for a portfolio as a whole. Tracking error is the approach used to manage the range within which a portfolio is allowed to deviate from its benchmark index. Rebalancing refers to returning asset allocations to their original weights.
Institutional investors do not make trading decisions based solely on whether a company’s performance is good or poor. They must also satisfy constraints such as position weights, industry concentration, deviations from their benchmarks and whether they are experiencing fund outflows. As a result, share prices can move for reasons unrelated to the news.
For individual investors seeking to assess share prices, it is important to consider corporate value separately from supply-and-demand factors. Understanding that capital inflows and outflows and risk management activity can produce short-term price movements can provide useful perspective.