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1 October 2014 CFA Institute Journal Review

Little Guys, Liquidity, and the Informational Efficiency of Price: Evidence from the Tokyo Stock Exchange on the Effects of Small Investor Participation (Digest Summary)

  1. Paul Lebo

Greater participation by individual investors in the stock market is widely viewed as contributing to less efficient prices. The authors examine minimum trade unit reduction events on the Tokyo Stock Exchange to test this notion. They conclude that greater participation by small investors attracts greater participation by large and better-informed investors rather than offsetting any expected deleterious effects on price efficiency.

What’s Inside?

Contrary to the popular belief that an increase in retail investors leads to less efficient market pricing, research reveals the opposite to be true. Intraday real-time trade and quote data from 1996 to 2005 in the context of falling minimum trade units (MTUs) show that prices became more efficient, adjusting faster to new information. This finding may seem counterintuitive given the increase in noninformed traders, but reducing MTUs increases both informed and noninformed traders. With the increase in liquidity, the rise in both types of traders actually helps improve price efficiency.

How Is This Article Useful to Practitioners?

A number of myths surround the effect of MTU reduction on the stock market. For example, a commonly held misperception is that the increase in noise traders following an MTU reduction is disadvantageous to the stock market. The reason most frequently cited is the increase in noninformed traders, who serve to decrease market price efficiency through their trading habits.

The authors provide statistically significant evidence to refute this myth by showing that the increase in informed traders offsets the increase in noninformed traders. In fact, MTU reduction decreases the bid–ask spread, thereby improving market efficiency. Furthermore, the effect of new informed traders in the market serves to reduce return volatility of stocks, outweighing the impact of more noninformed traders.

Given that Japan is the third-largest economy in the world, most global investors have some exposure to stocks on the Tokyo Stock Exchange. The presence of keiretsu (a group of companies with interlocking business relationships) in Japan and the impact of these cross-holdings on a particular stock is an area of great interest to research analysts with exposure to Japan. The authors’ work will help inform research analysts in selecting Japanese stocks.

How Did the Authors Conduct This Research?

The authors supply a number of tables and figures in support of their findings. Perhaps most foundational is a table that shows the increase in the number of shareholders after a reduction in MTUs. The number of shareholders increases the most when firms engage in a 10-to-1 MTU factor and naturally increases less with a 2-to-1 MTU factor. The data are statistically significant, which leads to the conclusion that the MTU reduction results in the increase in shareholders. The authors also provide evidence that although the reduction in MTUs leads to a substantial increase in the number of individual shareholders, the percentage of shares held by individuals increases only a small amount. This finding can be attributed to the fact that the individual shareholders are, for the most part, small investors.

The authors go on to illustrate the impact on quotes and trades of an MTU reduction. As would be expected, the number of quotes and trades increases significantly, and the increase is statistically significant. Finally, the size of the trades falls with the MTU change.

To demonstrate the increasing liquidity from MTU reduction, the authors report the effective spread changes. They show a falling bid–ask spread for most firms following an MTU reduction, thereby suggesting a more competitive and liquid market.

Finally, they examine return volatility to show that the increase in informed trading is more influential than the increase in noise trading. This result is proved by demonstrating that return volatility falls after an MTU reduction.

Abstractor’s Viewpoint

The authors provide an excellent evaluation of the impact of MTU reduction on the Tokyo Stock Exchange. When the MTU is reduced, there is a shift in order flow from large trades to small trades. The associated increase in liquidity and noise is then examined and common misperceptions clarified, leading to the summary that the impact of new informed traders is more influential than any negative impact from noninformed traders. This article is a must-read for any research analyst or investor who has exposure to the Japanese stock market.

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