I had the pleasure of presenting findings from “Who Reacts to News,” a recent paper I co-authored, to Daniels faculty during the Winter Quarter Research Colloquium on Jan. 19. The paper builds on the well-accepted idea that investors react to unexpected information—or news—about a certain security and this reaction informs their trading activities, which, in turn, affects the prices of that security.
Considering that the value of a given security is the present value of its future cash flows discounted at the appropriate rate, relevant news about a firm either refers to that firm’s cash flows or its discount rates. Cash flow news is generally firm-specific and immediately affects prices. Discount rate news, on the other hand, is likely driven by systematic factors and, aside from an immediate effect on prices, also has implications for longer term expected returns. For example, bad cash flow news results in a price decrease, while future investment opportunities remain unchanged; bad discount rate news results in an immediate price decrease, but an improvement in future investment opportunities.
In our paper, we explore who reacts to different types of news and why. Specifically, we examine institutional investors’ reactions to both cash flow and discount rate news, conditional on their investment horizons. We argue that institutional trading patterns are driven by their objectives and are not necessarily homogeneous across all institutional investors. In particular, we argue that institutions with different trading horizons will have different trading patterns and will react differently to firm-specific cash flow and discount rate news.
We show that short-term institutions prefer to trade on cash flow news, while long-term institutions prefer to trade on discount rate news. This can potentially explain why the literature has shown that short- and long-term institutions have different preferences for certain stock characteristics (such as size, book-to-market, age, profitability, etc.) The reason these characteristics count can be traced back to identify stocks that are more likely to experience either cash flow or discount rate news. Additionally, this is consistent with the different economic roles of short- and long-term institutions. On one hand, short-term institutions are likely to rapidly trade on cash flow news, which quickly incorporates new information into stock prices and brings prices back to fundamentals. On the other hand, long-term institutions, which need time to take advantage of the changes in future investment opportunities, are more akin to relationship investors who monitor a firm’s behavior and try to influence its policies.
Our results also supports the notion that short- and long-term institutions likely trade with each other based on their opposing preferences. This is important, as it highlights how crucial it is to identify different institutional types rather than treat the whole group of institutional investors as homogeneous in their responses to news. Without making this distinction, institutional trading patterns would be masked in the aggregate. Going back to fundamentals, we show that well diversified, longer-term investors are more sensitive to discount rate news, and trade with shorter-term, informational return chasers who are more sensitive to cash flow news.
Each academic quarter, the Daniels College of Business hosts a Faculty Research Colloquium to showcase the scholarship of faculty throughout the College.