The Impact of Institutional Investor trading on income smoothing: Evidence from the Korean Stock Market

Abstract

Background: This study aims to examine whether the effectiveness of institutional monitoring differs depending on the economic conditions of emerging capital markets. Methods: We compute a proxy for total institutional ownership (the proportion of institutional trading volume) using trading volume data by investor type, which is uniquely provided in Korea. We then analyze the impact of the proportion of institutional trading volume on income smoothing. Results: We find evidence that the proportion of institutional trading is negatively correlated with income smoothing. This result indicates that, given the structural issues in the Korean market (high ownership concentration, large systematic risk, and a high proportion of individual investors), institutional investors on average reveal a strong preference for short-term investments, which implies an increase in opportunistic earnings reporting by management to meet the earnings expectations of institutional investors. Notably, our findings show that, in Korea, the diminished effectiveness of institutional monitoring is more pronounced in the post-financial crisis period with sluggish market growth. Therefore, in emerging capital markets during a period of low market growth, institutional investors’ long-term investment preferences and monitoring may be subdued because institutional monitoring costs may increase more than does the benefit from monitoring. Conclusion: This study contributes to an improved understanding of the differences in institutional monitoring in emerging capital markets depending on the structural properties of the market and market conditions.