Which Institutional Investors Trade Based on Private Information About Earnings and Returns?

Abstract

Recent work suggests that institutional investors execute profitable trades based on private information about earnings and returns. We provide new evidence on the prevalence and sources of such informed trading by (1) testing for the creation and liquidation of positions based on private information, (2) introducing private information proxies that reflect the size and nature of an institution's position in each portfolio firm, and (3) using a methodology that examines multiple investor characteristics simultaneously at the institution-firm level. We find that changes in ownership by institutions with large positions in a firm are consistent with informed trading. However, other previously documented proxies for private information produce results more consistent with risk-based trading (e.g., investment style) or insignificant in the presence of other proxies (e.g., fiduciary type). We also find that informed trading is more prevalent in small firms and when the large positions are taken by investment advisers and large institutions. We appreciate helpful comments and suggestions from Cathy Schrand, Shyam Sunder, Ro Verrecchia, and workshop participants at the Carnegie-Mellon University Accounting Conference. We are grateful for the funding of this research by the Wharton School and the University of Arizona. Disciplines Accounting Which institutional investors trade based on private information about earnings and returns?Abstract Recent work presents evidence that certain groups of institutional investors are able to trade profitably based on private information about earnings and returns. We contribute to this literature in three ways. First, we test whether certain private information proxies are consistent with the creation and liquidation of positions based on private information. Second, we introduce private information proxies that reflect the size and nature of an institution's position in each portfolio firm. Third, we use a methodology that examines multiple investor characteristics simultaneously at the institution-firm-level. We find that changes in ownership by institutions that have large positions in a specific firm are consistent with trading based on private information. However, other previously-documented proxies for private information produce results that are more consistent with risk-based trading (e.g., investment style, portfolio turnover) or that are insignificant in the presence of the other proxies (e.g., fiduciary type). We also find that informed trading is more prevalent in return-based measures (vs. earnings-based measures) and in smaller firms. Tests for interactions among private information proxies reveal that informed trading is most evident when the large positions in firms are newly initiated and when they are taken by investment advisers and by large institutions. Finally, we find that institutions following growth strategies exhibit momentum trading in positions held less than one year and informed trading in positions held more than one year, suggesting that the ...

The Effect of Regulation FD on Transient Institutional Investors' Trading Behavior

“…Existing research in accounting and finance finds that active institutional investors often exhibit a strong preference for concentrated stock portfolios. For example, Coval and Moskowitz [1999, 2001] show that mutual funds prefer to invest in locally headquartered firms while Kacperczyk, Sialm, and Zheng [2005] find that actively managed mutual funds often concentrate their stock portfolios in a few industries (see also Bushee and Goodman [2007]). Consistent with institutional investors having an information advantage, these studies further show that the concentrated portfolios earn positive abnormal stock returns.…”

When Is a Firm's Information Asymmetry Priced? The Role of Institutional Investors

“…Because prior work (e.g., Sias et al. ; Bushee and Goodman ) suggests that changes in ownership by institutional investors may proxy for institutional trading associated with informed trading, we expect to find a significant and positive relation between this variable and the information asymmetry measures.…”

Business Ties and Information Advantage: Evidence from Mutual Fund Trading

“…These findings are consistent with the previous literature that examines informed trading by institutions. For example, Bennett et al (, 1,205) show a trading advantage is concentrated in smaller stocks which “provide greater opportunities for institutional investors to exploit their information advantages.” Bushee and Goodman () also find more informed trading for smaller firms.…”