Yan Xiong, Liyan Yang
Based on: Review of Financial Studies, 2023, 36(9), 3643-3692 DOI: https://doi.org/10.1093/rfs/hhad018
In February 2020, Castlefield, a U.K.-based fund, made a public disclosure on its website regarding a site visit it conducted with Alumasc, a U.K.-based supplier of premium building products. Site visits are generally regarded as an important and expensive way for investors to gather information. Although the disclosure by Castlefield did not provide specific details about the fundamental aspects of Alumasc, it did indicate to the general public that the fund may have obtained valuable information about the corporation. However, the question arises as to why investors would willingly disclose the occurrence of their site visits.
In fact, the mandatory disclosure of corporate site visits, or more broadly, investors’ private meetings with firm management, has been an active topic of regulatory debate. Regulation Fair Disclosure (RegFD), enacted in 2000 in the United States, aimed to ensure a level playing field by requiring management to disclose material information to all investors at the same time. This emphasis on transparency regarding investors’ interactions with firm management is a common theme across various regulatory frameworks. In 2006, the Shenzhen Stock Exchange (SZSE) in China introduced its own version of RegFD, which prohibited SZSE-listed companies from selectively disclosing material nonpublic information to specific investors. Additionally, the SZSE mandated that listed firms disclose site visits in their annual reports. In 2012, the SZSE went a step further by requiring all listed companies to disclose site visits within two trading days through a dedicated web portal. These regulations, similar to the disclosure practices implemented by Castlefield, effectively increase the visibility of investors’ information-acquisition activities.
While many sophisticated investors often go to great lengths to conceal and erase their footprints in order to maintain the secrecy of their information acquisition, many other factors, in addition to the voluntary and mandatory disclosure described above, contribute to the increased observability of investors’ information-acquisition activities in financial markets. For instance, the Markets in Financial Instruments Directive II (MiFID II) in the European Union requires investment firms to unbundle investment research from other costs they charge to their clients. This separation increases the transparency and observability of investors’ information acquisition. Furthermore, alternative data such as corporate private jet data can also reveal investors’ footprints, adding to the overall visibility of their information-acquisition activities.
All of these observations raise an important question: How does the observability of information-acquisition activities impact investors’ research and trading, as well as the overall quality of financial markets? There is no short answer to this question. Rather, the answer depends on the interplay of two strategic forces, which we dub the “pricing effect” and the “competition effect.” These effects interact as information-acquisition activities become increasingly observable, changing from being secret to being overt.
The pricing effect arises from the interactions between investors and the market maker. While the former seek liquidity through trading on private information, the latter provides liquidity by facilitating market transactions. Consider a scenario with limited competition among informed investors. In this case, each investor trades conservatively to avoid alerting the wider market to an informational advantage. However, the market maker is less concerned about the adverse-selection risk, so secret investors always have incentives to acquire more information discreetly without prompting the market maker to adjust pricing. Overt information ends this subterfuge. Because an investor can no longer hide an information advantage, the value of gaining an informational advantage in the first place is lower, which leads to less information collection. That is, overt investors acquire less information than secret investors.
The competition effect works through interactions among investors trading on private information. Unlike the pricing effect, it consistently promotes information acquisition in the overt market rather than in the secret market. The intuition is as follows. Overt information acquisition by an investor reduces her peers’ incentives to trade aggressively on their own private information. Since the aggressive trading of others can harm the initial investor’s profits, the decrease in their trading aggressiveness gives the initial investor an additional incentive to acquire information. Consequently, the competition effect encourages more information production when information is acquired overtly rather than secretly.
The following figures summarize the interplay between the two strategic effects and their implications. When the cost of acquiring information is low, investors opt to acquire precise information, intensifying competition among them; hence, the competition effect dominates. This dominant competition effect leads to increased information under overt information acquisition, resulting in higher market efficiency (i.e., more information is incorporated into the price) but lower market liquidity (i.e., higher price impact of order flows). For example, when the cost of acquiring information is close to zero, overt investors acquire 25% more information than secret investors in the top figure, which results in a 1% decrease in market liquidity in the bottom left figure and a 7% increase in market efficiency in the bottom right figure.[1]
Conversely, when the cost of acquiring information is high, each investor acquires only coarse information and behaves as a local monopolist of her own information. Now the pricing effect prevails and works in the opposite direction to the competition effect. In such cases, overt information acquisition generates less information, leading to lower market efficiency but higher market liquidity. Continuing the numerical example, when the cost of acquiring information is at the upper end of the range shown in the top figure, overt investors gather 20% less information than secret investors. This difference in information acquisition results in a 10% improvement in market liquidity in the bottom left figure and a 2% decrease in market efficiency in the bottom right figure.
We can now use our theory to examine investors’ voluntary disclosure of site visits and regulations that impact the observability of their information-acquisition behavior.
According to the competition effect, an investor wants her competitors to perceive her information precision as high in order to discourage them from trading aggressively. As a result, this effect might incentivize an investor to conduct a site visit and disclose the event to inform her rivals. This rationale helps explain why certain investors, like the previously mentioned U.K. investment company, may choose to disclose their otherwise secretive site visits. Consistent with this mechanism, a recent study uses the timely SZSE disclosure as a setting and shows that when analysts can observe that a firm has been visited by other analysts, they allocate less attention to it.[2]
Moreover, regulations like RegFD that enhance the observability of investors’ information acquisition, transitioning from secretive to overt practices, are effective only in situations where the pricing effect works against and dominates the competition effect. In these situations, without the regulatory mandate, investors would not voluntarily disclose their information-acquisition activities. Once the regulatory mandate is effective, investors acquire less precise information; consequently, market liquidity improves but market efficiency worsens.
In summary, investors are more likely to disclose that they have acquired information when the competition effect is strong. By doing so, they deter rivals from trading aggressively on their own information. Conversely, mandatory disclosures concerning information acquisition are more likely to have an effect when the pricing effect is strong. Our analysis implies that mandatory disclosures, such as those required by RegFD, can decrease information production for firms with a limited number of investors or a high cost of information acquisition.
[1] In the figures, the difference between overt and secret markets might appear modest. This is because these figures aim to plot both possibilities: that overt investors can either over acquire or under acquire information relative to secret investors. Actually, when the cost of information acquisition is very small, the difference in information acquisition can be arbitrarily large.
[2] Ru, Yi, Ronghuo Zheng, and Yuan Zou. “Public Disclosure of Private Meetings: Does Observing Peers’ Information Acquisition Affect Analysts’ Attention Allocation?” Harvard Business School Working Paper, No. 22-064, July 2021.
Professor of Finance and Professor of Economics
Peter L. Mitchelson/SIT Investment Associates Foundation Chair in Investment Strategy
Bank of Canada Fellow
Rotman School of Management, University of Toronto
