Fundamental Analysis, Institutional Investment, and Limits to Arbitrage

56 Pages Posted: 19 Dec 2008

See all articles by Yanfeng Xue

Yanfeng Xue

George Washington University - Department of Accountancy

May H. Zhang

Fordham University - Graduate School of Business Administration

Multiple version iconThere are 2 versions of this paper

Date Written: August 1, 2008

Abstract

Previous research documents that financial ratios (fundamental signals) derived from publicly available financial statements can predict future abnormal stock returns. This paper examines whether institutional investors trade on these fundamental signals and the implications of institutional investors' trading for stock valuation. We provide evidence that transient institutional investors (institutions who actively trade securities for short-term returns) trade on fundamental signals. We also show that the abnormal returns associated with fundamental signals increase with transaction costs and arbitrage risk, indicating the existence of the limits to arbitrage for this investment strategy. We further document that transient institutions trade less aggressively to exploit the fundamental-signal-based trading strategy in firms with higher transaction costs and arbitrage risk, and their arbitrage trades help reduce the returns related to fundamental signals. This paper provides evidence helping to explain the abnormal returns associated with fundamental signals and contributes to our understanding of institutional investors' role in enhancing market efficiency.

Keywords: Fundamental analysis, stock valuation, institutional investment

JEL Classification: M41, G11, G20

Suggested Citation

Xue, Yanfeng and Zhang, May H., Fundamental Analysis, Institutional Investment, and Limits to Arbitrage (August 1, 2008). Available at SSRN: https://ssrn.com/abstract=788125 or http://dx.doi.org/10.2139/ssrn.788125

Yanfeng Xue (Contact Author)

George Washington University - Department of Accountancy ( email )

School of Business and Public Management
Washington, DC 20052
United States

May H. Zhang

Fordham University - Graduate School of Business Administration ( email )

1790 Broadway, 13th FL
New York, NY 10019
United States

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