Are institutional investors and analysts informed traders? An empirical examination

Date of Completion

January 1997


Economics, Finance




The adverse selection problem in finance is well documented. More precisely, a dealer widens the bid-ask spread when trading with someone who likely possesses superior knowledge. A higher cost of trading discourages uninformed traders from market participation. This motivates the dealer to widen the bid-ask spread even further, since disproportionately more informed traders remain. Knowing whether analysts and institutional owners help to mitigate the "adverse selection problem" is important to practitioners and scholars alike. If true that analysts and institutions are effective monitors of a firm, then private information is less available to traders and the adverse selection cost is kept low. Investors and financial managers benefit accordingly.^ The purpose of this dissertation is to test whether the adverse selection component is lower for firms which are widely followed by analysts and heavily owned by institutions (institutional favorites) and higher for firms which are virtually ignored by analysts and institutions (neglected firms). This research extends previous work in the areas of both firm monitoring and market microstructure and offers the unique contribution of concurrently evaluating the adverse selection problem for both institutional favorites and neglected firms.^ Findings for institutional favorites confirm prior research that attention paid to a firm by analysts and institutions helps to reduce the adverse selection cost of trading. No evidence is found that the adverse selection cost of trading is higher for neglected firms vis-a-vis control group firms, similar in size and SIC Code. This result is compatible with the research which suggests that the stringent listing requirements of the New York Stock Exchange enhance a firm's visibility, even in the absence of attention from analysts and institutions.^ Results for firms, regardless of visibility level, reveal a higher adverse selection cost of trading around the opening of the market. This is consistent with extant literature that suggests that informed trading occurs early in the day as people are anxious to take advantage of news which accumulates throughout the night.^ Future research might examine institutional favorites and neglected firms trading in markets other than the New York Stock Exchange or for a different period of time. ^