Institutional Investors and Equity Prices: Information, Behavioral Bias, and Arbitrage

This paper investigates how institutional investors matter for asset pricing by using daily institutional trading data and a natural experiment, the split–share structure reform in China. This reform required all listed companies to convert their non-tradable shares to tradable shares after paying a negotiated compensation. We find that: 1). Only passive institutions are privy to company-specific details: they buy (avoid) shares of companies that end up with high (low) compensation ratios on announcement day T0. 2). Trading halts after T0. On the first subsequent trading day T1, both passive domestic institutions and individuals are prone to the disposition effect: they sell a large and abnormal amount of shares in the reform companies with high unrealized gains accumulated during the non-trading period, and 3). The selling pressure drives stock prices significantly below fair values. Both active and foreign institutions take advantage of the stock undervaluation and earn significant abnormal return, which eliminate stock mispricing.