Institutional trading and information processing: Evidence from complicated firms and easy‐to‐analyze firms

• Published date: 01 June 2023
• Author: Dallin M. Alldredge
• Date: 01 June 2023
• DOI: http://doi.org/10.1111/jfir.12320

Received: 11 March 2021

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Accepted: 11 January 2023

DOI: 10.1111/jfir.12320

ORIGINAL ARTICLE

Institutional trading and information processing:

Evidence from complicated firms and

easy‐to‐analyze firms

Dallin M. Alldredge

Department of Finance, Florida International

University, Miami, Florida, USA

Correspondence

Dallin M. Alldredge, Department of Finance,

College of Business, Florida International

University, Miami, FL 33174, USA.

Email: dalldred@fiu.edu

Abstract

In this article, I examine institutional trading within two

groups of firms with different demands on investor

information processing: conglomerate firms and stand‐

alone firms. On average, institutional trading in conglomer-

ate firm stocks yields significantly lower returns than

institutional trading in stand‐alone firm stocks. Inferior

returns following institutional trading in conglomerate firm

stocks persist across small and large firms. Moreover,

financial institutions with a low concentration of conglom-

erate firms in their portfolios are more profitable in their

trading. This study provides evidence that skilled institu-

tional investors intentionally focus their information‐

processing efforts on easy‐to‐analyze firms.

JEL CLASSIFICATION

G11, G14, G23, G41

1|INTRODUCTION

It is costly to acquire and process information materially relevant to the value of a stock. Hence, some investors

inadvertently fail to process all relevant information, whereas others intentionally ignore somewhat relevant

information to focus on information most closely related to the prospects of firm fundamentals. However,

information‐processing costs vary across stocks. Some stocks require high levels of information‐processing

effort (i.e., complicated firms) whereas other stocks demand lower levels of information‐processing effort

(i.e., easy‐to‐analyze firms). Investors might approach easy‐to‐analyze stocks with the intention of attaining low‐

cost trading profits. However, these stocks could be more efficiently priced and therefore unrewarding to investors

J Financ Res. 2023;46:411–435. wileyonlinelibrary.com/journal/JFIR

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searching for profitable trading opportunities. On the other hand, investors might view complicated stocks as

difficult to value and thus subject to greater mispricing. Furthermore, investors with access to high levels of

information processing might attempt to gain from potential mispricing in complicated stocks. The purpose of this

study is to explore whether differences in demand for information processing affect institutional trading profits in

complicated firms and easy‐to‐analyze firms.

Throughout this article, I use “conglomerate firms”as a proxy for complicated firms and “stand‐alone firms”

as a proxy for easy‐to‐analyze firms. According to Cohen and Lou (2012), conglomerate firms are inherently

complicated, and information about such firms is challenging to analyze. Corporations that maintain business

operations in multiple industries (i.e., conglomerate firms) are more difficult to analyze than corporations that

operate in a single industry (i.e., stand‐alone firms). Cohen and Lou (2012) find a significant delay in the

impounding of information into conglomerate firm prices in comparison to their stand‐alone firm counterparts.

According to Barinov et al. (2022), the delay in information processing also increases post‐earnings‐

announcement drift for conglomerate firm stock prices. The potential opportunities to profit from mispricing

could be attractive to sophisticated financial institutions; however, these gains might not be worth the high

costs of processing information on conglomerate firms. Do financial institutions exert the effort necessary to

rapidly process complex information about conglomerate firms and profitably trade in conglomerate stocks, or

do institutions prefer to focus their information‐processing efforts on stand‐alone firms to attain lower cost

trading profits?

Financial institutions are the focus of this study because they are widely regarded as skilled investors and found

to exhibit superior abilities in analyzing and processing information.

1

For example, financial institutions quickly

process and trade on data provided by financial intermediaries such as Institutional Brokers’Estimate System and

financial news provided by Bloomberg terminals (Akbas et al., 2018; Ben‐Rephael et al., 2017). Cohen and Lou

(2012) suggest that difficulties in information processing reduce the ability of market participants to arbitrage

mispricing in conglomerate firms; therefore, the conglomerate firm environment presents a unique setting in which

to test whether institutional investors quickly process and profitably trade on value‐relevant information.

It is reasonable for investors to use their finite processing capacity to analyze information that best maximizes

their return. Rational inattention models suggest that skilled investment managers recognize the scarcity of their

information‐processing efforts and are rationally inattentive to maximize profit (Veldkamp, 2011). Kacperczyk et al.

(2016) find that mutual fund managers intentionally shift their attention from aggregate information to idiosyncratic

information during different states of the business cycle. According to Gupta‐Mukherjee and Pareek (2020), mutual

fund managers allocate greater information‐processing effort to stocks in which they have larger active positions.

Huang and Liu (2007) find that information‐processing costs induce rational investors to ignore important economic

news, even if it affects their investment performance.

It is also possible that investors use information‐processing resources in a biased manner. Peng and Xiong

(2006) show that overconfident investors ignore firm‐specific information and focus on market‐and sector‐wide

information. Schmidt (2019) finds that active portfolio managers distracted by multiple earnings announcements are

less profitable in their trading and absorb higher transaction costs, and Kempf et al. (2017) show that distracted

institutional shareholders are poor monitors of corporate behavior. Frederickson and Zolotoy (2016) find that

investors presented with contemporaneous earnings announcements respond to the most visible earnings

announcement first, instead of prioritizing firms based on information‐processing costs.

Sophisticated investors, such as institutional investors, could identify complicated firms as stocks that are more

costly to analyze and therefore more difficult to value, leading to greater opportunities to arbitrage away mispricing.

With the view that institutional investors maintain trading skill and considerable information‐processing resources,

they could view complicated firms as an opportunity to skillfully and quickly process complicated information and

1

Recent studies documenting institutional investor skill include Alldredge et al. (2022), Gao et al. (2021), Grinblatt et al. (2020),

Henry and Koski (2017), Hoberg et al. (2018), Jiang and Verardo (2018), Pan et al. (2019), and Pástor et al. (2017).

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