What kind of trading drives return autocorrelation

Abstract

This paper proposes new tests for the prediction of Llorente, Michaely, Saar, and Wang (2002) that information trading drives positive autocorrelation. Daily data from the Taiwan Stock Exchange is used to exploit the differences in the trading motivations of three groups of institutional investors. Consistent with the predictions, we find that heavy trading by foreigners and mutual funds will increase the autocorrelation particularly for large firms, and that heavy trading by dealers will not. We also find that the sell volume of mutual funds - short sales are disallowed by regulation - has significantly smaller effect on the autocorrelation of returns than buy volume. A portfolio strategy that exploits the observed autocorrelation pattern can generate a significantly positive daily return. Key words: Institutional trading, information trading, return autocorrelation, short-sale constraints