Passive Institutional Ownership, R2 Trends, and Price Informativeness

Published date01 November 2017
Date01 November 2017
The Financial Review 52 (2017) 627–659
Passive Institutional Ownership, R2Trends,
and Price Informativeness
R. Jared DeLisle
Utah State University
Dan W. French
University of Missouri
Maria Gabriela Schutte
University of Dayton
A distinctive trend in the capital markets over the past two decades is the rise in equity
ownership of passive financial institutions. We propose that this rise has a negative effect on
price informativeness. By not trading around firm-specific news, passive investors reduce the
firm-specific component of total volatility and increase stock correlations. Consistent with this
hypothesis, we findthat the growth in passive institutional ownership is robustly associated with
the growth in marketmodel R2s of individual stocks since the early 1990s. Additionally, we find
Corresponding author: Department of Economics and Finance, School of Business Administration,
University of Dayton, 502 Miriam Hall, 300 College Avenue,Dayton, OH 45469; Phone: (937) 229-3458;
Fax: (937) 229-2477;
The authors thank Douglas Blackburn, Paul Brockman, George Comer, Joe Dancy and LSGI Investment
Partners, Gustavo Grullon, Manuel Gonzalez-Astudillo, Campbell Harvey, Jean Helwege, G. Andrew
Karolyi, Ivonne Liebenberg, Jim Northeyand LaSalle Technology Partners LLC, Rodney Sullivan, Jeffrey
Wurgler, and seminar participants at Michigan Technological University, the Federal Reserve Bank of
Chicago, the University of Dayton, the University of Texas at Arlington, Washington State University,
the 19th Annual Conference of the Multinational Finance Society in Krakow, Poland, the 2012 Financial
Management Association Conference in Atlanta, the First Paris Financial Management Conference (2013),
and the 2015 Eastern Finance Association Conference. Special thanks to Jason Fink for providing data on
vintage firm age and to Brian Bushee for making his institutional classification data available for public
download. Any errors and omissions are the responsibility of the authors.
C2017 The Eastern Finance Association 627
628 R. J. DeLisle et al./The Financial Review 52 (2017) 627–659
a negative relation between passive ownershipand earnings predictability, an informativeness
Keywords: comovement, volatility, informed trading, correlated trading, passive investing,
institutional ownership, price informativeness
JEL Classifications: G14, G15, G18
1. Introduction
One of the most distinctive trends in capital markets over the past two decades is
the rise in the equity ownership of passive financial institutions since the mid 1990s.
The cause for this increase has been primarily attributed to changes in tax legislation
that make defined contribution (i.e., 401k) plans attractive to retail investors and
technological change that make rebalancing large indexed portfolios feasible at a
very low cost.1Low transaction and monitoring costs have given passive investors
the ability to charge lower fees and grow at the expense of actively managed funds.
Figure 1 illustrates this spectacular rise. As of 1992, passive investors owned about
30% of the total market capitalization of the NYSE, Amex, and NASDAQ.2By
December 2010, their ownership had risen to about 50% or 72% of all institutionally
owned shares.
There is an ongoing debate among academics regarding the implications of
this rise in capital market efficiency. Although retail investors clearly benefit from
the diversification provided by certain passively managed portfolios (i.e., indexed
funds), some scholars have started to question whether this benefit has not been
overshadowed by passive investors’ lack of fundamental-based trading that could
increase stock return correlations and make prices less informative. Other studies
contend that is not necessarily the case as passive investors have a positive effect on
1Portfolio rebalancing costs dropped dramatically with the introduction of online communications between
buy-side managers and traders, which also facilitated basket trading or the execution of multiple orders
at once. Just one year after the creation of the Hyper Text Markup Language (HTML) in 1991, the
financial sector developedthe Financial Information eXchange (FIX) Protocol. FIX is a standard language
for transmitting messages from buy-side managers to traders, designed to match and execute institutional
block orders through their own internal books (Securities and Exchange Commission [SEC], 1997). Basket
trading intensified with the introduction of the new SEC regulations in 1997 (Order Handling Rules) and
1998 (Regulation ATS),which permitted electronic trading platforms to operate, the switch from tick-by-
tick to decimal pricing in 2001, and the proliferation of hedge funds that provided the necessary computing
resources to increase trading volumes (Northey,2011).
2Weidentify passive institutional investors as those that meet the quasi-indexer definitionin Bushee (1998,
2001) and Bushee and Noe (2000). Quasi-indexers are passiveinvestors that use indexing or buy-and-hold
strategies. Their portfolios are characterized as being well diversified and having low turnover. A list of
quasi-indexers current to December 2010 was obtained from Brian Bushee’sInstitutional Investor classifi-
cation website ( All other financial institutions
are classified as active (e.g., nonpassive).
R. J. DeLisle et al./The Financial Review 52 (2017) 627–659 629
1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
Passive Inst. Ownership Acve Inst. Ownership Total Instuonal Ownership
Figure 1
Stock ownership by institution type
Figure 1 shows the stock ownership of all financial institutions, passive financial institutions (quasi-
indexers), and active financial institutions (transient and dedicated) from 1983 to 2010. Institutions are
classified into passive or active categories using Brian Bushee’s classification of financial institutions
(available on his website). Institutional ownership is obtained from the SEC 13f reports.
the transparency and managerial disclosure of the firmswhose stock they own, thereby
reducing information asymmetries, improving liquidity,and keeping transaction costs
down (e.g., Carleton, Nelson and Weisbach, 1998; Del Guercio and Hawkins, 1999;
Boone and White, 2015; Appel, Gormley and Keim, 2016). Thus, eventhough passive
investors cannot engage in arbitrage directly, the improved information environment
they promote could allow others to effectively do so.
Despite this evidence, whether passive investing erodes market efficiency re-
mains an empirical question. In their seminal paper, Grossman and Stiglitz (1980)
suggest that the equilibrium number of informed investors needed for informational
efficiency depends endogenously on structural factors that determine the size of the
arbitrage profit. Structural factors that reduce information acquisition costs, such as
transparency and information production, make detecting mispriced assets easier, but
also reduce the size of the reward. Given that the risk-adjusted margins of passive
investors currently exceed those of active investors, the reward needed to induce
investors to acquire costly information might not be achievable. In addition, even if
market inefficiencies were to reach a threshold that would induce active investing,
one active manager’soverperformance is often offset by another’s underperformance
causing the expected value of cheap passive funds to still dominate that of active
management (Blitz, 2014).

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