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!
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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