Do Passive Investors Demand High Earnings Quality? Evidence from Natural Experiment

Abstract

In this paper, we examine the effect of passive institutional holdings on firms’ earnings quality by exploiting the variation in passive ownership around Russell 1000/2000 index cutoff. Using three sets of earnings quality proxies (properties of earnings, investor responsiveness to earnings, and external indicators of earnings misstatements), we find that passive ownership improves earnings quality. Furthermore, this effect is more pronounced in firms with low active institutional ownership. Finally, we find firms with higher passive ownership undertake more long-term investments. The last two results provide consistent evidence that passive investors improve earnings quality because they have long-term investment horizon and they only have the option of monitoring (as opposed to threat to exit) for good portfolio performance due to their buy-and-hold strategy.

Keywords: Passive investors, earnings quality, earnings management

JEL Classification: G23, M41