Local Ownership and Private Information: Evidence of a Monitoring-Liquidity Trade-Off

Finance literature has demonstrated an increasing interest in local owners (investors geographically close to firms in which they invest), arguing that they exhibit superior returns due to private information. The authors use local ownership as a proxy for the amount of private information in a stock. Using data on mutual fund holdings, the authors construct a measure of local ownership for a broad panel of US firms. The authors show that, depending on the size of their stake, privately informed investors improve the quality of governance of the firm and induce value enhancing decisions (less over-investment and fewer acquisitions). At the same time, their presence in the firm increases the adverse selection discount required by the less informed investors to trade, reducing the firm's liquidity. The authors provide evidence that both effects are properly factored in by the investors and impounded in the firm's stock price. Their results contribute to the understanding of the liquidity-monitoring controversy and qualify the existing results of the emerging local ownership literature: the illiquidity borne out by the presence of local investors may play a role in the observed abnormal performance uncovered by these studies.