Although institutional investors have a preference for large capitalization stocks, over time they have shifted their preferences toward smaller, riskier securities. These changes in aggregate preferences have arisen primarily from changes in the preferences of each class of institution, rather than changes in the importance of different classes. Evidence also suggests that recent growth in institutional investment combined with this shift in preferences helps explain why markets in general, and smaller stocks in particular, have exhibited greater firm-specific risk and liquidity in recent years. Additional analyses suggest that institutional investors moved toward smaller securities because such securities offer "greener pastures."

This paper considers a dynamic real exchange model of international trade in commodities and equities. Given “generalized Cobb-Douglas” intraperiod tastes that differ across countries, we find a closed-form solution with properties that are noteworthy, not because they reverse our presumptions, but because they exceed them. A consumption-based model of international equity investment might be expected to have the following properties: (i) The optimal portfolios should reflect the international pattern of commodity expenditure. (ii) A country’s portfolio should be biased toward equities in commodities that attract a large share of its expenditure. (iii) A country would short some equities, given an appropriate structure of equity returns. (iv) Short sales of equities would allow the international economy to move toward the situation that would prevail if risk markets were complete. In our model solution, these properties take strong forms:

Although institutional investors have a preference for large capitalization stocks, over time they have shifted their preferences toward smaller, riskier securities. These changes in aggregate preferences have arisen primarily from changes in the preferences of each class of institution, rather than changes in the importance of different classes. Evidence also suggests that recent growth in institutional investment combined with this shift in preferences helps explain why markets in general, and smaller stocks in particular, have exhibited greater firm-specific risk and liquidity in recent years. Additional analyses suggest that institutional investors moved toward smaller securities because such securities offer “greener pastures.”