Investor heterogeneity and trading

Date01 September 2018
Published date01 September 2018
DOI: 10.1111/eufm.12169
Investor heterogeneity and trading
Anzhela Knyazeva
Diana Knyazeva
Leonard Kostovetsky
Securities and Exchange Commission,
Washington, District of Columbia
Boston College, Carroll School of
Management, Chestnut Hill,
Institutional investors play a crucial role in the information
environment of firms. We argue that heterogeneity in the
information ability of institutional investors has a signifi-
cant impact on trading around information releases. We
propose novel measures of within-firm investor heteroge-
neity and find that investor heterogeneity increases
abnormal trading volume around news, holding constant
the average levels of investor sophistication. We also find
larger spread reductions around announcements for firms
with greater investor heterogeneity. The effect of investor
heterogeneity on trading continues to hold after accounting
for total institutional ownership, the presence of certain
types of institutional investors, and analyst coverage.
information, institutional investors, investor heterogeneity, spreads,
trading volume
G10, G12, G14
The authors are grateful to the Editor (Lu Zhang), an anonymous referee, and seminar participants at George Washington
University, New York University PhD Alumni Conference, Hui Guo, Jeffrey Harris, and Jonathan Kalodimos for helpful
input, and to Brian Bushee for providing the institutional investor classification information on his website. All errors and
omissions are our own. The Securities and Exchange Commission disclaims responsibility for any private publication or
statement of any SEC employee or Commissioner. This article expresses the authorsviews and does not necessarily reflect
those of the Commission, the Commissioners, or other members of the staff.
© 2018 John Wiley & Sons, Ltd. Eur Financ Manag. 2018;24:680718.
Institutional ownership has been linked to the information environment of firms, trading patterns, and
corporate decisions. Institutions are traditionally regarded as sophisticated investors with superior
information. However, viewing institutional investors as a single group of sophisticated investors
overlooks crucial differences in their ability to gather and analyze information and their incentives for
doing so. This paper examines the effects of differences in information capabilities of institutional
investors of a given firm on trading of a firm's shares around news releases.
We argue that heterogeneity in the information gathering and processing ability of institutional
investors has a first-order effect on a firm's information environment that is not explained by existing
metrics. Our measures focus on within-firm heterogeneity in the characteristics of institutional
investors that proxy their ability to gather and analyze information.
We empirically test the relation
between investor heterogeneity and trading around earnings surprises. Our measures have additional
power to predict trading around news releases after accounting for commonly used information
environment proxies.
We hypothesize that heterogeneity in the information ability within a firm's investor base results in
differences in the precision of investor information about firm performance. As an example, the
precision of a trader's ex ante private information may be a function of the trader's overall or company-
specific investment experience, local knowledge, or the extent of resources that the trader can allocate
to information gathering. The arrival of a corporate announcement causes updating of beliefs about
firm performance among differentially informed investors. Kim and Verrecchia (1991b) show that
differential precision of pre-announcement investor information results in a greater volume reaction to
the announcement. The information contained in the news announcement is more important to traders
with less precise prior information, who revise their beliefs more. In contrast, ex ante better informed
traders place less weight on the public announcement, revising their beliefs less. Thus, even if
the announcement is interpreted identically by all traders, differences in the precision of pre-
announcement information lead to higher trading volume on the announcement. The greater the
informational differences between investors, the larger the abnormal trading volume reaction to
the announcement. In the absence of differences in precision, there is no trading volume on the
Kim and Verrecchia (1997) and Wang (1994) extend and generalize the Kim and Verrecchia
(1991b) framework. Kim and Verrecchia (1997) incorporate differences both in the precision of pre-
announcement information and in the interpretation of information in the public announcement. When
news about current earnings is released, heterogeneously informed investors may differ in how well
they interpret the information that is released. For instance, an earnings release may not only lead
investors to revise their beliefs about the previous quarter's performance but also to update their beliefs
about future firm performance. Wang (1994) extends the Kim and Verrecchia prediction to a setting
with both noninformational and information-driven trading.
Investor pre-announcement information can stem from acquiring private information and processing public information
about firms prior to the announcement. Thus, precision of an investor's pre-announcement information depends on the
ability to both gather and process information prior to the announcement. Conceptually and empirically, our main
hypothesis does not distinguish between the two aspects, collectively referred to as the information ability or pre-
announcement informedness of investors.
A number of papers explore other theoretical settings in which trading volume arises from disagreement and differences
among investors in a broader context. See Bamber et al. (2011) for an in-depth discussion of prior work.
Empirically, all else equal, these effects predict a positive relation between heterogeneity in
investor informedness and trading volume around earnings releases. Moreover, heterogeneity in
investor informedness may affect the behavior of bidask spreads around the announcement.
Heterogeneity in investor informedness prior to the announcement can result in an adverse selection
problem (e.g., less informed investors recognizing that they are less informed and being unwilling to
trade against better informed investors), leading to larger bidask spreads prior to the announcement.
The arrival of information in the form of a public announcement makes less informed investors
relatively more informed. The resulting convergence in the level of informedness of investors can
reduce information asymmetries between investors. By reducing information asymmetries between
investors and mitigating the adverse selection problem, the public release of earnings information can
reduce bidask spreads. Thus, our empirical prediction is that the reduction in bidask spreads after the
announcement would be more pronounced if there were greater differences in investor informedness
prior to the announcement.
While our main hypothesis has re ceived more support in prior th eoretical work, a competing
effect may emerge. If differen ces in the information ability of investors translate into di fferences in
investor ability to interpret th e announcement information, th e announcement may in some cases
increase the information asy mmetry between less informed and better informed inves tors and result
in adverse selection. In Kim and Verrec chia (1994), heterogeneity in inv estor ability to interpret the
announcement information in creases information asymmetr y and widens bidask spreads after the
announcement. Notably, t heir model predicts higher bidask spreads as well as higher tr ading
volume for such firms. At the sam e time, George, Kaul, and Nimalen dran (1994) show that under
some conditions heterogene ity in the information ability of i nvestors can increase spread s and
decrease trading volume.
In their model, differences in the informatio n ability of investors imply
differential ability to interpr et announcement information, whi ch results in adverse selection and
increases transaction costs . Thus, the relationship between d ifferential precision and volu me
becomes both indirect and amb iguousonce transaction co sts are endogenized. Heter ogeneity in
the information ability of investors has two competing eff ects: increased information-driven trading
and reduced liquidity trading (caused by increased transaction cos ts as a result of adverse selection).
Whether the two effects offset e ach other depends on the impact of in creased transaction costs on
liquidity trading. General ly, public announcements of inf ormation tend to reduce informa tion
asymmetries between investo rs. However, if heterogeneit y in information ability affects th e
processing of announcement infor mation in a manner that increases adverse s election, investor
heterogeneity could incr ease abnormal spreads around the announcement and reduc e abnormal
Ultimately, the effect of differences in the information ability of investors on volume and spreads
around earnings announcements is an empirical question. We are able to disentangle our main
hypothesis (investor heterogeneity increases the volume of trading and reduces spreads around
announcements) from competing effects (investor heterogeneity reduces volume and increases spread)
as they have contrasting empirical predictions.
Our empirical setting relies on earnings announcements for two reasons. First, the release of
earnings news is a well-documented source of new information carefully watched by the market,
so it is relevant for investors. Second, unlike other disclosures, the content of an earnings release
Adverse selection caused by the presence of less informed and better informed investors has also been modeled in the
context of share repurchases in Brennan and Thakor (1990) and Lucas and McDonald (1998). More generally, the argument
that uninformed liquidity traders that have discretion with respect to the timing of their trades may trade less when
information asymmetry is high is presented in Admati and Pfleiderer (1988) and Foster and Viswanathan (1990).

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