Institutional Investors’ Stock Picking Ability and Idiosyncratic Risk

Focusing on trades of institutional investors from 1980 to 2012, this study examines the stock-picking ability of institutional investors. We find that stocks bought by institution investors outperform stocks sold by institutional investors in the pre-1995 period. Consistent with a costly arbitrage equilibrium in which arbitrage costs insulate mispricing, the outperformance is larger for stocks with higher idiosyncratic volatility. The stock picking ability of institutional investors declines in the post-1995 period. We also find that investment firms have stronger stock-picking ability than banks and insurance companies. Overall, Banks and insurance companies show negative stock-picking ability, especially for stocks with high idiosyncratic risk. Alternatively, overall, investment firms show strong stock-picking ability for stocks with higher idiosyncratic volatility, and the ability declines in the post-1995 period.