Financial Reporting Quality, Investment Horizon, and Institutional Investor Trading Strategies

• In Event: Valuation consequences of reporting quality
  In Paper Session: Valuation Consequences of Reporting Quality

Abstract

This paper provides evidence on whether financial reporting quality influences the holding costs of trading strategies, and hence the degree to which they are employed by short-term investors. While prior research has focused on the benefits of poor financial reporting quality (i.e., larger returns due to a greater amount of private information), we examine whether poor financial reporting quality imposes greater holding costs by requiring a longer holding period for strategies that require future earnings realizations for price corrections. We predict that poor financial reporting quality will motivate sophisticated investors with short-term horizons to tilt their portfolios away from value strategies, whose returns are contingent on future earnings realizations, and toward momentum strategies that are less dependent on future earnings realizations. We find that short-term institutions are less (more) likely to create large portfolio positions in a value (momentum) strategy among firms with poor financial reporting quality. In addition, we find that poor financial reporting quality increases the length of time that institutions maintain these large positions for value-strategy firms. Our results imply that mis-valuations resulting from poor financial quality can be persistent as arbitrageurs perceive risk-adjusted returns being poor enough to not justify their investments even when they can see through the opaque financial disclosures.

Authors

• Theodore H Goodman, Purdue University

• Brian J Bushee, University of Pennsylvania

• Shyam V Sunder, The University of Arizona