Institutional Investors and Equity Returns:
Are Short-term Institutions Better Informed?
Xuemin (Sterling) Yan
University of Missouri – Columbia
Zhe Zhang
Singapore Management University

We show that the positive relation between institutional ownership and future stock returns documented in Gompers and Metrick (2001) is driven by shortterm institutions. Furthermore, short-term institutions’ trading forecasts future stock returns. This predictability does not reverse in the long run and is stronger for small and growth stocks. Short-term institutions’ trading is also positively related to future earnings surprises. By contrast, long-term institutions’ trading does not forecast future returns, nor is it related to future earnings news. Our results are consistent with the view that short-term institutions are better informed and they trade actively to exploit their informational advantage. (JEL G12, G14, G20)

This article examines the relation between institutions’ investment horizons and their informational roles in the stock market. Although a large body of literature has studied the behavior of institutional trading and its impact on asset prices and returns,1 the informational role of institutional investors remains an open question. Gompers and Metrick (2001) document a positive relation between institutional ownership and future stock returns. However, they attribute this relation to temporal demand shocks rather than institutions’ informational advantage. Nofsinger and Sias (1999) find that changes in institutional ownership forecast next year’s returns, suggesting that institutional trading contains information about future returns. In contrast, Cai and Zheng (2004) find that institutional trading has negative predictive ability for next quarter’s returns. Bennett, Sias, and Starks (2003) show that the evidence of institutions’ ability to forecast returns is sensitive to how institutional trading is measured.

One potential reason for the mixed results regarding institutional investors’ informational role is that most studies in this literature focus on all institutional investors as a group. While institutional investors share some important commonalities, they are far from homogeneous. An important dimension of heterogeneity is the investment horizon. Institutions may have different investment horizons because of differences in investment objectives and styles, legal restrictions, and competitive pressures; in addition, their investment horizons may differ because of their different informational roles.

There are several reasons why one might expect institutions with different investment horizons to be differentially informed. First, if some institutional investors possess superior information and can regularly identify undervalued or overvalued stocks, we would expect these institutions to trade frequently to exploit their informational advantage or skill [e.g., Grinblatt and Titman (1989) and Wermers (2000)]. On the other hand, institutional investors possessing limited information would trade more cautiously. Therefore, institutions that trade more actively (short-term institutions) would be better informed than those that trade less actively (long-term institutions).2 Second, one might argue that longterm institutions trade infrequently because they trade only on the basis of information.On the other hand, short-term institutions might also trade on the basis of noise, perhaps owing to overconfidence [e.g.,Odean (1998) and Barber and Odean (2000)]. In this case, it would appear on average that long-term institutions are better informed than short-term institutions. Third, it is also possible that both short- and long-term institutions are informed. However, short-term institutions are better at collecting and processing short-term information, while long-term institutions are better at collecting and processing long-term information. As a result, short-term institutions would be better informed in the short run while long-term institutions would be better informed in the long run.

The purpose of this article is to empirically examine the informational roles of short- and long-term institutions. Specifically, using quarterly institutional holdings for the period from 1980 to 2003, we construct an investment horizon measure based on institutions’ portfolio turnover, which is similar to that of Gaspar, Massa, and Matos (2005). We then classify institutions into short- and long-term based on this measure. In our empirical analyses, we first examine whether short- and long-term institutions have different preferences for stock characteristics. We then examine the extent to which the investment horizon affects the relation between institutional ownership and future stock returns. More importantly, we investigate whether short- and long-term institutional trading contains information about future stock returns and future earnings.

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