More Risk, More Information: How Passive Ownership Can Improve Informational Efficiency

Abstract

Abstract We identify a novel economic mechanism through which passive ownership positively affects informational efficiency in the cross-section of firms. Passive investors’ inelastic demand lowers a firm’s cost-of-capital, inducing it to take more risk. The higher cash flow variance, in turn, incentivizes active investors to acquire more precise private information, pushing up price informativeness for firms with high passive ownership. High passive ownership also implies higher stock prices and higher stock-return variances. An increase in the aggregate size of passive investors amplifies these cross-sectional differences. We also document complementarities in firms’ real investment and investors’ information choices that can cause information crashes. Received May 31, 2020; editorial decision January 4, 2023 by Editor Holger Mueller. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online