Fundamental Analysis, Institutional Investment, and Limits to Arbitrage

Previous research documents that financial ratios (fundamental signals) derived from publicly available financial statements can predict future abnormal stock returns. This paper examines whether institutional investors trade on these fundamental signals and the implications of institutional investors' trading for stock valuation. We provide evidence that transient institutional investors (institutions who actively trade securities for short-term returns) trade on fundamental signals. We also show that the abnormal returns associated with fundamental signals increase with transaction costs and arbitrage risk, indicating the existence of the limits to arbitrage for this investment strategy. We further document that transient institutions trade less aggressively to exploit the fundamental-signal-based trading strategy in firms with higher transaction costs and arbitrage risk, and their arbitrage trades help reduce the returns related to fundamental signals. This paper provides evidence helping to explain the abnormal returns associated with fundamental signals and contributes to our understanding of institutional investors' role in enhancing market efficiency.