By |Published On: July 14th, 2015|Categories: Research Insights|

Through the traditional lens of the efficient market hypothesis, market prices stick close to their fundamental values because professional investors with large amounts of capital counteract mispricings created by “dumb” or “retail” investors. For example, if Dan the DayTrader enters sell orders on stock ABC at $8, when it is worth $10, Peter the Professional swoops in and purchases all the sell orders until stock ABC moves back up to $10. In the end, market prices are efficient, Dan the DayTrader loses money, and Peter the Professional has served his role as the “smart” money.

All a great story. But what does Peter the Professional really do in practice?

A while ago we mentioned a recent research piece that spotlighted an interesting phenomenon: institutional investors don’t correct anomalous contribute to stock return anomalies!

A more recent paper highlights that some professionals do serve as agents of market efficiency, but others actually create mispricings!

Institutional Investor Type and Misvaluation

We find that institutional investor types have distinct effects on the perceived value of the firm. Dedicated long-term institutional investors decrease future firm misvaluation relative to fundamentals, as well as the volatility of firm returns. Transient short-term institutional investors, in contrast, increase future firm misvaluation and volatility of firm returns. This result implies a more nuanced relationship of institutional ownership with firm value and corporate governance.

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About the Author: Wesley Gray, PhD

Wesley Gray, PhD
After serving as a Captain in the United States Marine Corps, Dr. Gray earned an MBA and a PhD in finance from the University of Chicago where he studied under Nobel Prize Winner Eugene Fama. Next, Wes took an academic job in his wife’s hometown of Philadelphia and worked as a finance professor at Drexel University. Dr. Gray’s interest in bridging the research gap between academia and industry led him to found Alpha Architect, an asset management firm dedicated to an impact mission of empowering investors through education. He is a contributor to multiple industry publications and regularly speaks to professional investor groups across the country. Wes has published multiple academic papers and four books, including Embedded (Naval Institute Press, 2009), Quantitative Value (Wiley, 2012), DIY Financial Advisor (Wiley, 2015), and Quantitative Momentum (Wiley, 2016). Dr. Gray currently resides in Palmas Del Mar Puerto Rico with his wife and three children. He recently finished the Leadville 100 ultramarathon race and promises to make better life decisions in the future.

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Important Disclosures

For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Third party information may become outdated or otherwise superseded without notice.  Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency has approved, determined the accuracy, or confirmed the adequacy of this article.

The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. Our full disclosures are available here. Definitions of common statistics used in our analysis are available here (towards the bottom).

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