”Do Institutional Investors Demand Public Disclosure?” by Stephen A. Karolyi and Andrew Bird

”Do institutional investors demand corporate disclosure? A central question in finance and accounting is whether corporate transparency benefits or hurts investors. This issue is complicated by the fact that information provision could affect groups of investors differentially. Public information may crowd out the private information advantage of some institutional investors; alternatively, investors, particularly those following more passive trading strategies, may not be information sensitive. However, even passive institutional investors may benefit from an increase in monitoring by other stakeholders following improved disclosure. Further, regardless of the preferences of institutional investors, whether or not they are able to affect corporate policy on this margin is unclear. This tradeoff is reflected in mixed empirical evidence on the relationship between institutional ownership and corporate disclosure.

To address this tradeoff faced by institutional investors, we analyze the revealed preference for corporate disclosure by institutional investors and the associated impact on the information content of corporate disclosure. Empirically, identifying a causal effect of institutional ownership on corporate disclosure policy is difficult because experimental settings and direct measures of corporate disclosure quantity and characteristics are scarce. We propose a two-part solution to these problems. First, we utilize exogenous changes in institutional ownership around Russell 2000 index reconstitutions in a regression discontinuity design to identify the effect of institutional ownership on corporate disclosure policy. Second, we directly measure the characteristics of corporate disclosure using a novel data set composed of all 8-K filings between 1996 and 2006.

Russell index membership satisfies the key aspects of a regression discontinuity design because membership is based on the end of May closing-price implied market capitalization rank. While these market capitalization rank cutoffs are public knowledge and consistent through time, the underlying market capitalization cutoffs are time-varying and depend on the cross-sectional distribution of market capitalization at the end of the last trading day in May. Firms in the top 1,000 ranked market capitalization on that day become members of the Russell 1000, and the subsequent 2,000, those ranked between 1,001 and 3,000, compose the Russell 2000. Therefore, especially close to these market capitalization rank thresholds, Russell index reconstitutions are quasi-random with respect to corporate policies. Because the indexes are value-weighted, the largest firms in the Russell 2000 receive weights that are ten to fifteen times larger than do the smallest firms in the Russell 1000, even though they are similar in size. Since these indexes are widely used as performance and portfolio benchmarks by institutional investors, this difference in weights leads to significant differences in institutional ownership between firms at the bottom of the Russell 1000 relative to those at the top of the Russell 2000.

This experimental setting and novel data provide a platform to contribute to our knowledge about institutional investor demand for corporate disclosure along the dimensions of quantity, form, and quality. We find that Russell 2000 inclusion has a positive impact on the quantity of disclosure. Relative to firms just excluded from the Russell 2000 index, firms just included disclose more 8-K filings and more items per 8-K filing. These results suggest that institutional investors demand more corporate disclosure and that this preference is successfully reflected in incremental disclosure by firms.

Not only do corporations disseminate more content per disclosure, but the information content of disclosures, as measured by the absolute market reaction to announcements, increase as well. Furthermore, this increase in market reaction is directly related to the increase in length, embedded graphics, and exhibits per 8-K filing. Indeed, our findings suggest that the increase in the information content of 8-K filings is explained by the change in disclosure characteristics. From these results, we infer that the increase in the information content of 8-K announcements is a result of changes in disclosure quantity and form, rather than index-membership-induced changes in investor attention.

Disclosure is a unique component of governance both because it has important feedback effects on other components of governance, by empowering all shareholders with decision-relevant information, and because it affects allocative efficiency. Our results demonstrate that institutional investors demand and affect the public dissemination of decision-relevant information. That is, we observe both that governance affects disclosure policy, and that disclosure policy then affects investment decisions. Because the investment decisions in response to the disclosure are not likely being made by the same investors that benchmark to the Russell indexes, we can infer that the incremental information has reached its target audience and that the institutional investors that enacted the change in disclosure policy must benefit indirectly from this incremental disclosure.

Trading in response to Russell index reconstitutions is a result of benchmarking behavior, so our inferences about the governance and disclosure preferences of institutional investors necessarily relate to institutional investors that benchmark to the Russell indexes. Because both active and passive investors may use the Russell indexes as portfolio benchmarks, the Russell index reconstitution setting identifies the governance and disclosure preferences of a mix of active and passive investors. However, because investors that are close to the pure indexing extreme of the benchmarking continuum are the most likely to respond to Russell index reconstitutions, we view our results as reflecting the disclosure preferences of relatively passive investors…….”

Read full paper here.

Source: Havard Law School Forum on Corporate Governance and Finanacial Regulation

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