Inflation illusion and institutional ownership in REITs

This paper attempts to uncover institutional rationality (or irrationality) in the US public REITs market by exploring portfolio implications of the Modiglian and Cohn (1979) inflation-illusion hypothesis. Modigliani and Cohn (1979) hypothesize that stock market investors may suffer from inflation illusion by mistakenly using nominal interest rates to discount real earnings. As a result, stocks will generally be undervalued in times of high inflation and thus are poor hedges against inflation. Consequently, bad hedges are underpriced in times of high inflation and overpriced when inflation is low. Rational investors, facing a market of inflation-illusioned investors, would then liquidate their positions in good hedges and tilt their portfolios toward bad hedges when inflation is high and away from the bad hedges from inflation is low. I test the above rational portfolio-tilting hypothesis using data on institutional ownership in the public REITs market. Specifically, I use cross-sectional data on institutional ownership and use the Fama-Schwert (1977) methodology to identify whether or not a particular REIT stock is a good inflation hedge. I then examine whether institutional investors' preferences change with the level of expected and unexpected inflation. I find that institutions do in fact tilt their portfolios away from REITs that are superior inflation hedges and tilt toward REITs that are bad hedges in periods of high expected inflation , holding constant other reasons that may influence institutional ownership (e.g. size, liquidity, and momentum). Furthermore, these assets are less likely to be mispriced because institutional ownership decreases with the amount of mispricing in these securities.