Passive Institutional Ownership, R2 Trends, and Price Informativeness

• Author: R. Jared DeLisle,Dan W. French,Maria Gabriela Schutte
• Published date: 01 November 2017
• Date: 01 November 2017
• DOI: http://doi.org/10.1111/fire.12132

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

Abstract

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; E-mail:mschutte2@udayton.edu.

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.

C2017 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

proxy.

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 (http://acct.wharton.upenn.edu/faculty/bushee/IIclass.html). All other financial institutions

are classified as active (e.g., nonpassive).

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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).