Institutional Ownership and Stock Liquidity

Abstract

The study examines the relationship between institutional ownership and liquidity of stocks, focusing on the effect of institutions' information advantage on liquidity. The information advantage of institutions can affect liquidity through two channels: adverse selection and information efficiency. The adverse selection effect results from an increase in information asymmetry. The information efficiency effect, however, results from an increase in competition among institutions. Competition promotes the rate at which private information is incorporated into prices, reducing uncertainty about future payoffs. I find evidence of a nonmonotonic (U-shaped) relationship between the fraction of shares of a firm held by institutions and various measures of stock liquidity. This evidence of a nonmonotonic relationship strongly suggests that the two effects coexist and interact with each other. The effect of information advantage of institutions on liquidity also varies with the amount of publicly available information and asset risk. My evidence indicates that institutional ownership (Granger) causes liquidity, allaying, to an extent, concerns that findings are a result of institutions' preference for liquid stocks. Lastly, I document that institutional investor characteristics, such as investment horizon and risk aversion, also affect liquidity. Liquidity decreases with both increases in fraction of equity held by long-term investors and risk aversion of institutional investor.

Keywords: Microstructure, Ownership, Liquidity, Spreads, Institution, Adverse selection, Information efficiency

JEL Classification: G14, G20, D82, D83