Institutional investors with long-term horizons, referred to as dedicated institutional investors, have a positive impact on corporate innovation. Studies (e.g., Gormley and Matsa, 2016; Jiang and Yuan, 2018; Kim, et al. 2019; Kedia et al., 2020) have consistently documented that these investors are more inclined to engage in shareholder activism and advocate for corporate strategies that foster innovation. They also provide effective monitoring, improve governance quality, mitigate information asymmetry, and facilitate technology diffusion among their portfolio firms, thereby stimulating such innovation.
Nevertheless, the impact of institutional investors with short-term horizons, referred to as transient institutional investors, on corporate innovation remains unclear. In a new paper, we investigate that impact.
Prior research suggests that transient institutional investors can have a detrimental effect on corporate innovation by giving priority to immediate investment returns, exacerbating managerial myopia, and pressuring managers to sacrifice long-term investment for short-term earnings. For instance, Fang et al. (2014) reveal that higher stock liquidity attracts transient institutional investors and leads to a reduction in firm innovation. Additionally, He and Tian (2013) and Kim et al. (2019) emphasize that the investment horizons of institutions are positively related to innovation.
Contrary to the stereotype, a theoretical study by Edmans (2009) suggests that a higher level of active stock trading can discipline managers and potentially improve innovation. The study argues that transient institutional investors acquire information on a firm’s fundamental value and trade their shares on this information. With block equity holdings, these short-term investors’ trades help improve a firm’s information environment and facilitate price discovery. Consequently, a firm’s underlying fundamentals, including value appreciation resulting from innovation, are reflected in the stock price. Therefore, even without direct intervention in a firm’s operations, transient institutional investors can provide monitoring and governance. Theoretically, this helps alleviate managerial myopia and encourages value-enhancing investments such as innovation.
In our paper, we use a conventional approach to examine the impact of transient institutional investors on innovation. We construct a commonly used variable, the fraction of a firm’s shares that are held by transient institutional investors, to measure their influence. The results indicate a negative relationship between the proportion of shares owned by transient institutional investors and innovation output, measured by the number of patents and non-self-citations. These findings suggest that transient institutional investors may impede corporate innovation, which aligns with the stereotypical conclusions observed in previous empirical literature.
However, these results may be subject to bias due to the endogeneity issue arising from omitted variables. Unobservable characteristics of a firm could be simultaneously related to both transient institutional ownership and innovation. Our paper addresses this endogeneity concern and tests the theory proposed by Edmans (2009), which suggests that transient institutional investors provide monitoring to mitigate managerial myopia and hence foster innovation. We construct a novel variable to capture exogenous variations in the monitoring quality of transient institutional investors. We adopt the approach of Kempf et al. (2017) and generate a firm-level transient institutional investors’ distraction score at the annual frequency. As detailed later in our paper, we calculate the exogenous reductions in the monitoring quality of transient institutional shareholder in a particular firm, attributable to attention-grabbing events occurring in other industries. Our results show that an exogenously induced decrease in the monitoring quality of transient institutional shareholders, resulting from such distractions, is associated with a lower level of innovation. These findings support the notion that transient institutional investors provide monitoring that effectively alleviates managerial myopia and encourages innovation. Thus, our findings are in line with the conclusions drawn from the theoretical study by Edmans (2009).
To further explore the role of monitoring quality as the mechanism through which transient institutional investors enhance corporate innovation, we conduct a cross-sectional analysis. We investigate an alternative monitoring provider that serves as a potential substitute for institutional investors, namely financial analysts. We show that the negative effect of transient institutional investors on corporate innovation becomes more pronounced when the al firm has less financial-analyst coverage. Where the monitoring quality provided by financial analysts is lower, the monitoring offered by transient institutional investors becomes more important. As a result, an exogenous decrease in the monitoring quality of transient institutional shareholders has a stronger effect in impeding innovation. The results of our cross-sectional analysis provide further confirmation that transient institutional investors alleviate managerial myopia and improve innovation through monitoring.
Further analyses are conducted to validate our findings. First, we include additional control variables in the regressions, such as the CEO’s education background, which could affect innovation outcomes. Second, we exclude the observations from the period of the 2007-2009 financial crisis to address concerns about the influence of extreme events on our results of innovation decline. Third, we employ alternative measures of patent quality, such as originality and generality, to reevaluate the effect of transient institutional investors on innovation outcomes. Fourth, alternative definitions of innovation outcomes such as the raw number of patents and citations are applied. Fifth, we perform alternative estimation methods, including Poisson model and Tobit model. Across all these robustness checks, we consistently observe similar results to our main findings, reinforcing the robustness and reliability of our conclusions.
Our study provides compelling evidence that transient institutional shareholders play a positive role in enhancing corporate innovation through their monitoring. We find that an exogenous decline in the monitoring quality of transient institutional shareholders is associated with decreased innovation. This challenges the conventional perception that transient institutional investors, driven by short-term interests, worsen managerial focus and hinder corporate innovation. Our results confirm the theoretical argument by Edmans (2009) that transient institutional shareholders have incentives to monitor the firm. These findings have significant implications for policymakers, managers, and investors interested in promoting corporate innovation and firm growth.
Edmans, A., 2009. Blockholder Trading, Market Efficiency, and Managerial Myopia. The Journal of Finance 64, 2481-2513.
Fang, V. W., Tian, X., and Tice, S., 2014. Does stock liquidity enhance or impede firm innovation? The Journal of Finance, 69(5), 2085–2125.
Gormley, T.A. and Matsa, D.A., 2016. Playing it safe? Managerial preferences, risk, and agency conflicts. Journal of financial economics, 122(3), pp.431-455.
He, J. J., & Tian, X. (2013). The dark side of analyst coverage: The case of innovation. Journal of Financial Economics, 109(3), 856–878.
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Jiang, X., and Yuan, Q., 2018. Institutional investors’ corporate site visits and corporate innovation. Journal of Corporate Finance 48, 148-168.
Kedia, S., Starks, L.T. and Wang, X., 2021. Institutional investors and hedge fund activism. The Review of Corporate Finance Studies, 10(1), pp.1-43.
Kempf, E., Manconi, A., & Spalt, O., 2017. Distracted shareholders and corporate actions. The Review of Financial Studies, 30(5), 1660-1695.
Kim, H.D., Park, K. and Roy Song, K., 2019. Do long‐term institutional investors foster corporate innovation? Accounting & Finance, 59(2), pp.1163-1195.
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This post comes to us from professors Cheng Jiang at Boston College’s Carroll School of Management, Kose John at New York University’s Stern School of Business, Jun Wang at the University of Manitoba’s Asper School of Business, and Jingyu Zhang at Queen’s University’s Smith School of Business. It is based on their recent paper, “Do Transient Institutional Investors Really Impede Innovation? Evidence from Shareholder Distraction,” available here.