Sophisticated Investors and Market Efficiency: Evidence from a Natural Experiment

We study how sophisticated investors, when faced with shocks to information environment, change their information acquisition and trading behavior, and how these changes in turn affect market efficiency. We find that, after exogenous reductions of analyst coverage due to closures and mergers of brokerage firms, hedge funds scale up information acquisition, trade more aggressively, and earn higher abnormal returns on the affected stocks. The hedge fund participation also mitigates the impairment of market efficiency caused by coverage reductions. Overall, in a causal framework, our findings suggest a substitution effect between sophisticated investors and public information providers in facilitating market efficiency.

Keywords: Hedge funds, information environment, market efficiency, information acquisition, analyst coverage

JEL Classification: G12, G14, G23

Suggested Citation: Suggested Citation

Chen, Yong and Kelly, Bryan T. and Wu, Wei, Sophisticated Investors and Market Efficiency: Evidence from a Natural Experiment (November 22, 2019). Journal of Financial Economics (JFE), Vol. 138, 2020, pp. 316–341, 29th Annual Conference on Financial Economics & Accounting 2018, Mays Business School Research Paper No. 3117188, Yale ICF Working Paper No. 2018-05, Available at SSRN: https://ssrn.com/abstract=3117188 or http://dx.doi.org/10.2139/ssrn.3117188