Transient Institutional Ownership and the Contracting Use of Returns and Earnings*
Shane S. Dikolli
University of Texas at Austin
Susan L. Kulp
Harvard Business School
Karen L. Sedatole
University of Texas at Austin
Data Availability: Data used for this study are derived from publicly available sources
* We thank Brian Bushee for providing access to the institutional investor classifications used throughout this paper,
Frank Moers for assistance on the estimation techniques used, and Jane Zhang for valuable research assistance. We
appreciate the helpful comments of Ramji Balakrishnan, Rebecca Hann, Bruce Johnson, D.J. Nanda, Tatiana
Sandino, Jae Yong Shin, Wim Van der Stede and seminar participants at the Management Accounting Section Mid-
Year Meeting, the University of Arizona, the University of Iowa, the University of Southern California, and the
University of Utah. Kulp gratefully acknowledges the financial support of the Harvard Business School.
Transient Institutional Ownership and the Contracting Use of Returns and Earnings
Prior work suggests that, on average, institutional ownership is associated with increased pay-
for-performance sensitivity of CEO compensation. However, other studies find that transient
institutional ownership is positively associated with myopic managerial actions (Bushee 1998),
stock price volatility, and stock mispricing (Bushee 2001). Consequently, the type of institutional
ownership may affect the performance measure properties and undermine their usefulness for
CEO contracting purposes. In this paper, we posit that transient institutional ownership is
negatively associated with the congruence and noise properties of both returns and earnings and,
hence, the use of these measures for incentive compensation. Consistent with this conjecture, we
find that transient institutional ownership is negatively associated with the sensitivity of CEO
cash compensation to both of these measures. Our findings indicate that given a 10% increase in
return on equity, the cash compensation of a CEO of a firm with low transient ownership will
increase by approximately 3%, while that of a firm with high transient ownership will only
increase by approximately 1%.
Institutional investors provide an important role in the governance of firms via
monitoring activities (e.g., voting on proposals), stock trading (e.g., by "voting with their feet,"
Parrino et al. 2003) (Gillan and Starks 2003; O’Brien and Bhushan 1990; Walther 1997), and
their influence on compensation contracts (Almazan et al. 2004; Hartzell and Starks 2003).
However, institutional investors are not all alike. Among other things (e.g., the ability and
incentive to monitor, Brickley et al. 1988), they differ in their investment horizon; while
“dedicated” institutional investors have a long-term investment horizon, “transient” investors
have a short-term horizon (Bushee 1998).
Moreover, there has been increasing concern regarding the influence of transient
institutional investors, not only on market prices, but also on management decision-making
(Porter 1992). For example, Barbara Franklin, Chairman of National Association of Corporate
Directors Blue Ribbon Commission on Director Compensation and former U.S. Commerce
Secretary (under President George H.W. Bush), states:
There is confusion because of the apparent assumption that all shareholders are
alike and have the same objectives. We all know that is not so. Relationship
investors - who buy for the long haul and are not overly sensitive to short-term
ups and downs in the stock price - are one group and are ideal from the
perspective of a director. But many investors are not of this type. There are many,
termed "financial intermediaries" by Donald Perkins in a recent speech, who buy
and sell the stock for short-term profit only and who have no interest in the health
of the enterprise in the longer term. (Franklin 1996, p. 37)
The investment horizon of transient institutional investors – the “financial intermediaries”
to which Former Secretary Franklin refers – is of particular interest because of the potential
effect that a short-term investment horizon has on the key performance measure properties (i.e.,
sensitivity, precision, and congruence) of returns and earnings. In theory, these properties help
determine the usefulness of performance measures for incentive contracting purposes. Thus,
incentive contracts should vary depending on the composition of a firm’s institutional investor
In this paper, we investigate whether the concentration of transient institutional
ownership is associated with the use of returns and earnings in incentive contracting. Prior
research documents that overall pay-for-performance sensitivity in executive contracts increases,
on average, with institutional investor concentration (Hartzell and Starks 2003). However, this
result appears to be driven by long-term institutional investors with the ability and incentive to
engage in monitoring activities (Almazan et al. 2004).
By contrast, transient institutional investors have a short-term (i.e., myopic) horizon as
indicated by their high portfolio turnover, extensive use of momentum trading strategies, and
relatively high diversification ( Bushee 1998). These types of institutional investors have little
incentive and likely little opportunity to engage in monitoring. They may, however, affect
contracting decisions, not necessarily because of their influence on firms’ contracting choices,
but because of their effect on the performance measure properties of returns and earnings, two
metrics frequently used as a basis of incentive compensation.
We assert that transient institutional ownership is associated with decreases in both the
congruity of stock returns and earnings with firm value and with the precision of stock returns.
Thus, we expect the concentration of transient institutional investors to be negatively related to
the use of stock returns and earnings in cash-based incentive compensation. We focus on cash-
based incentive compensation because stock and stock option grants are often not tied explicitly
to current measures of returns and earnings (Hall 1999). That is, stock and stock option
compensation are designed to induce managers to take actions that affect the firm’s long-term
performance, rather than as a reward for current levels of performance. Therefore, these types of
compensation are less dependent on the properties (e.g., precision and congruence) of current
returns and earnings.
Prior research shows (i) that the trading behaviors of transient investors are associated
with stock price volatility (Bushee and Noe 2000), and (ii) that transient investors myopically
price securities by over-weighting current earnings (Bushee 2001). Agency theory suggests that
the contracting usefulness of a performance measure decreases with the measure’s precision
(Banker and Datar 1989) and with the degree of congruity between the measure and firm value
(Datar et al. 2001; Feltham and Xie 1994). Taken together, we argue that the trading and pricing
behaviors of transient investors diminishes the congruence and the precision of returns. We
accordingly predict and find that the implicit contracting weight on returns is negatively
associated with the concentration of transient institutional investors. Furthermore, we test the
incremental effect of transient ownership on the implicit weight on returns after controlling for
stock return volatility. The results support the argument that lower congruence, in addition to
increased noise, is associated with a decreased weight on returns in cash compensation. These
results hold after controlling for the effects of CEO age, the use of stock and option pay, and
other economic determinants of pay-for-performance sensitivity, suggesting an incremental
effect of investor composition over variables used in prior research on pay-for-performance
Additionally, we test whether the concentration of transient investors is also related to
diminished usefulness of earnings as a basis of incentive compensation. Bushee (1998) shows
that managers of firms with high concentrations of transient investors are likely to make myopic
investment decisions (e.g., cut R&D) to increase current earnings and support stock prices.
Additionally, Matsumoto (2002) finds that firms with higher transient institutional ownership are
more likely to meet or exceed expectations at the earnings announcement. However, myopic
actions to increase current earnings may not be congruent with actions to maximize long-term
firm value. If so, current earnings are less useful for contracting. Consistent with this conjecture,
we predict and find that the relationship between CEO cash compensation and earnings is
decreasing in the transient institutional ownership. Again, this result holds after controlling for
the effect of earnings volatility and for the effects of other constructs previously shown to
influence pay-for-performance sensitivity.
This research improves our understanding of transient institutional investors’ impact on
managerial control and the structure of incentive compensation. Prior research tends to treat all
institutional investors alike. On average, institutional investors appear to strengthen corporate
control through, for example, monitoring and increased pay-for-performance sensitivities. Our
research illustrates that the presence of transient institutional owners differs from this average
effect and, in fact, may diminish the cash-based incentive compensation usefulness of both stock
returns and earnings.
This study has three important implications. First, the findings of this study suggest that
firms with high levels of transient institutional investors may invest in increased managerial
monitoring in order to preserve the congruence of earnings with firm value. Doing so would
offset a diminution in the contracting usefulness of earnings. Second, firms may identify
alternative metrics to use as the basis of cash-based incentive compensation. That is, they may
invest in the identification and collection of other performance metrics less likely to be adversely
affected by the presence of transient institutional investors. Finally, firms with high levels of
transient ownership may utilize non-cash-based forms of compensation (e.g., stocks and options)
that are not dependent on the performance measure properties of returns and earnings. All of
these actions represent rational responses to the decline in the contracting usefulness of returns
and earnings documented in this paper.
This paper is organized as follows. The following section develops the hypotheses, and
Section 3 details the sample selection, empirical variables, and descriptive statistics. Section 4
presents the empirical methodology and analysis of results. Section 5 concludes the paper.
2. Hypothesis Development
Prior research suggests that institutional owners play an important role in managerial
control in at least two ways. First, institutional investors directly influence firms via their
monitoring activities (Gillan and Starks 2000, 2003; Schipper 1989; Shleifer and Vishny 1997).
That is, because these investors have superior information gathering and processing abilities
(O’Brien and Bhushan 1990; Walther 1997), increased incentives to monitor management (i.e.,
large shareholdings), and the ability to affect change (i.e., large voting blocks) (Shleifer and
Vishny 1997), institutional investors influence management and the board of director with their
proposals and votes (Brickley et al. 1988; Gillan and Starks 1998). Second, institutional owners
exhibit influence indirectly by selling their shares (Parrino et al. 2003). Because large turnover
affects price, management may try to minimize this turnover by catering to large investors.
Importantly, prior research also documents that not all institutional investors are alike.
Institutional investors vary in their direct monitoring efforts; some institutional investors actively
monitor a firm’s activities while others play a more passive role (Almazan et al. 2004).1
Additionally, Bushee (1998) empirically classifies institutional investors into transient and long-
1 Institutional investors play a more passive monitoring role when they have incentives to retain currently held
business with the firm (e.g., debt and insurance contracts) and a more active monitoring when they have no such
conflicts of interest. Indeed, Almazan et al. (2004) find that pay-for-performance sensitivity is higher and level of
pay is lower for firms with high levels of active institutional ownership (defined as investment advisory firms such
as mutual funds), relative to passive institutional ownership (defined as banks and insurance companies).
term based on their past trading behaviors. The long-term investors (including both dedicated
and quasi-indexers as defined in Bushee 1998; hereafter, long-term investors) make highly
concentrated investments, have low turnover, and exhibit little trading sensitivity to current
earnings. Prior research that documents a positive association between total institutional
ownership, governance, and incentive compensation (e.g., Hartzell and Starks 2003) likely
reflects this dominant group of long-term institutional investors.2
Transient institutional investors (Bushee 1998), on the other hand, exhibit high portfolio
turnover, extensive use of momentum trading strategies, and relatively high diversification.
Importantly, due to their trading behavior and their influence on management short-term actions,
the presence of transient investors is likely associated with altered performance measure
properties of returns and earnings and consequently, the weight of these measures in incentive
contracts. It is therefore unclear whether pay-for-performance sensitivity to these metrics will be
increasing in the concentration of transient institutional investors.
The following hypotheses detail the relationship between the type of institutional investor
base, specifically the concentration of transient institutional ownership, and the use of
performance measures (i.e., stock returns and earnings) in CEO cash compensation. We focus on
cash compensation to increase the power of our empirical tests. Often, firms design employee
stock and stock option plans as either a fixed number or a fixed dollar value of grants at each
grant date (Hall 1999). Thus, these types of compensation are less dependent on the properties
(e.g., precision and congruence) of current returns and earnings. As we are interested in studying
the interaction between the characteristics of the performance measures and the firm’s use of the
performance measures given the investor base, we concentrate on the effect of transient
2 In Bushee (1998) 74 percent of the sample was classified as long-term (i.e., dedicated or quasi-indexer) and 26
percent was classified as transient.
institutional ownership on the use of returns and earnings in cash compensation (an approach
similar to Lambert and Larcker 1987). In the following sections we describe our hypotheses.
2.1 CASH COMPENSATION SENSITIVITY TO STOCK RETURNS
We predict a negative association between the concentration of transient institutional
investors and the implicit contracting weight placed on stock returns for two reasons. First, prior
research suggests that the optimal contracting weight on a performance measure decreases with
the noise (i.e., increases with the precision) of the measure (Aggarwal and Samwick 1999;
Banker and Datar 1989; Lambert and Larcker 1987). Transient institutional investors engage in
frequent trading and extensively use momentum trading strategies, which increase the noise in
stock prices relative to firms without such trading activity (Bushee and Noe 2000). This, in turn,
makes stock returns less effective and/or more costly for use in incentive contracting. It follows
that firms will reduce the implicit contracting weight placed on returns in the presence of high
concentrations of transient institutional investors.
Second, in addition to changes in volatility, the presence of transient institutional
investors also impacts the congruence between stock returns and long-term firm value. Congruity
(or congruence) refers to the correlation between a performance measure, or a group of weighted
performance measures, and firm value. Feltham and Xie (1994) find that the optimal contracting
weight of a performance measure increases as the congruence between that performance measure
and firm value (i.e., the firm’s objective function) increases. As the “match” between the
performance measure and firm objectives increases, the performance measure better motivates
the manager to take actions consistent with the firm’s goals and is thus weighted more heavily.
Bushee (2001) documents that the concentration of transient investors is positively
(negatively) associated with the amount of expected short-term (long-term) earnings impounded
in stock price, consistent with myopic pricing by transient institutional investors. Furthermore,
Bushee (2001) finds that transient investors over-weight current expected earnings in their
pricing of securities; a trading strategy based on this pricing myopia generates significant
abnormal returns. These results imply that stock returns are a weaker reflection of long-term
value creation in the presence of high concentrations of transient institutional investors. Since the
optimal contracting weight of a performance measure decreases (ceteris paribus) as the degree of
congruity between the measure and firm value declines, returns become less useful valuable for
contracting purposes with increased pricing myopia induced by transient investors. We,
H1: The concentration of transient institutional ownership is negatively associated with
the sensitivity of CEO cash compensation to stock returns.
Almazan et al. (2004) show that pay-for-performance sensitivity is positively associated
with the concentration of active institutional ownership (defined as investment advisory firms
such as mutual funds), but unrelated to the concentration of passive institutional ownership
(defined as banks and insurance companies). The classification of transient ownership used in
this paper is separate and distinct from the passive institutional ownership used in Almazan et al.
(2004). Additionally, Hypothesis H1 predicts not just a weaker positive (or no) relation between
the concentration of transient investors and pay-for-performance sensitivity, but a negative
2.2 CASH COMPENSATION SENSITIVITY TO ACCOUNTING EARNINGS
Managers have an incentive to increase earnings for many reasons including their cash
compensation being tied to earnings. For example, reputation and career concerns provide
incentives to maintain earnings persistence to support the firm’s stock price. The myopic pricing
pressures exerted by transient investors described above may induce managers to engage in
myopic decision-making at the expense of long-term firm value (Bushee 2001). Indeed, Bushee
(1998) documents that managers are more likely to make income-increasing cuts in R&D when
there is a high concentration of transient investors. Additionally, Matsumoto (2002) finds that
firms with high transient institutional ownership are more likely to meet or beat earnings
The evidence suggests that transient institutional investors can provide incentives for
managers to make myopic decisions that positively affect current earnings but adversely affect
long-term firm value. Managerial myopia arising from transient investor influence thus causes
earnings to less congruent with long-term value maximization and thus, less useful for
contracting. Accordingly, we hypothesize:
H2: The concentration of transient institutional ownership is negatively associated with
the sensitivity of CEO cash compensation to accounting earnings (ROE).
Note that in the above hypotheses, we predict declines in the implicit contracting weights
placed on both stock returns and earnings. We make no predictions about changes in the relative
weights placed on these measures in CEO cash compensation. As earlier noted, an important
implication of this study is that firms may look for alternative sources of pay-for-performance
sensitivity (e.g., stock or options) since results supporting our hypotheses would suggest an
overall decline in the pay-for-performance sensitivity that can be achieved with cash
compensation based only on returns and earnings.
Research Setting and Data Description
Our initial sample consists of the universe of ExecuComp firms during the years 1992 to
2000. From this database, we collect components of CEO cash compensation including salary,
bonus, and other annual payments as well as information regarding the CEO’s total wealth in the
company. From the Center for Research in Security Prices (CRSP), Compustat, and
CDA/Spectrum, we collect stock returns, accounting information, and institutional investor
holdings (i.e., from SEC Form 13f filings), respectively. Finally, we hand-collect the CEO’s age
and information regarding board characteristics (e.g., size and percent of outside directors) from
the firm’s proxy statements.3
We exclude firm-year observations with missing data. In addition, because mergers,
acquisitions, and bankruptcies affect the composition of the investor base and the firm’s
incentive plan, we drop from the sample all years in which one of these events occurs. Finally,
because we analyze the change in compensation for the pay-for-performance tests, firms must
have the pertinent information for at least two consecutive years to be retained for analysis. The
final sample consists of 1,897 firm-year observations. Table 1, Panel A describes the reasons for
data loss. Panel B classifies the sample by industry.
/Insert Table 1/
3.2.1 Dependent Variable
Change in Cash Compensation. The dependent variable used to test the hypotheses is
the change in the natural log of the CEO’s cash compensation defined as salary, bonus, and other
annual compensation (∆LnSBOA). Similar to prior studies (e.g., Lambert and Larcker 1987;
Sloan 1993), we measure the contracting use of accounting (return on common equity, ROE) and
non-accounting (returns, RET) performance measures as the implicit incentive weights (i.e.,
coefficients) in a regression of changes in cash compensation on those performance measures.
3 For a random-sample of observations, we verify the compensation information in ExecuComp with the proxy data.
3.2.2 Independent Variables
Performance Measures. We investigate the sensitivity of CEO cash compensation to two
performance measures, annual stock returns, RET, and accounting earnings. Earnings is measured
as the change in return-on-equity, ∆ROE, where ROE defined as net income before extraordinary
items and discontinued operations divided by average book value of common equity.
Institutional Investor Classifications. Bushee (1998; 2001) classifies institutional
investors based on the average size of the institution’s stake in the firm, the degree of portfolio
turnover, and the trading sensitivity to current earnings news (i.e., momentum trading). Cluster
analysis by Bushee (1998) indicates three groups of institutional investors defined as “transient,”
“dedicated,” and “quasi-indexers.” Transient institutions are characterized by the highest
turnover, the highest use of momentum trading strategies, and relatively high diversification.
Dedicated institutions have highly concentrated investments, low turnover, and almost no trading
sensitivity to current earnings. The quasi-indexers are highly diversified and typically follow a
Bushee (1998, 2001) suggests that transient institutional investors have systematic
preferences for short-term managerial actions not evident for dedicated and quasi-indexers. Thus,
we use Bushee’s (1998) classification methodology to compute the percentage of transient
institutional investors (%TRA). We combine the Bushee (1998) categories of dedicated and
quasi-indexers into one subsample of “long-term” institutional investors (i.e., %LT). The
variable, %LT, is used as a control in the tests of H1 and H2.
All institutional investor concentrations are measured as of the beginning of the fiscal
4 The classification of transient ownership by Bushee (1998) and used in this paper is separate and distinct from the
passive/active institutional ownership classifications used in Almazan et al. (2004). Importantly, the correlation
between the concentration of passive and transient ownership is only 0.15 (p < .01) in our sample. For more
evidence on differences between these classifications see Bushee (2001).
year. Note that, although institutional investors frequently fall out of the transient classification
(Bushee 1998), the total concentration of transient ownership for a given firm is relatively stable
through time as indicated by a high correlation (0.89) between %TRA and one-quarter-lags in
Control variables. We control for other variables that may affect the level of CEO cash
compensation CEO cash compensation (e.g., firm size, SIZE, measured as the log of the market
value of equity) and/or the sensitivity of CEO cash compensation to performance (e.g., logged
level of annual restricted stock grants, LnSTOCK, and of option grants, LnOPTION). In
particular, we control for the level CEO ownership which is calculated as the sum of the
executive’s stock option value, restricted stock value, and common stock holdings. We scale this
sum by the firm’s total market value and take the log (LnOWNERSHIP). We include CEO age
(CEOAGE) to control for CEO horizon effects on contracting as documented in prior research
(Dikolli 2001; Dikolli et al. 2004). We also include controls for the board size (BOARDSIZE)
and an indicator variable for when the CEO is the chairman of the Board of Directors
(CEOCHAIR). Prior work demonstrates that firms with the CEO as chairman or with larger
boards pay their CEO a higher compensation (Core et al. 1999; Yermack 1996). Finally, year
indicators and 2-digit industry indicators are included in all regressions to control for pay
similarities within industries and trends over time.
Descriptive statistics for the sample of 1,897 firm-year observations are presented in
Table 2, Panel A (variable definitions in Panel C). On average (median), institutional investors
make up 50% (51%) of the investor base. The average (median) level of transient institutional
ownership is 11% (8%); the average (median) level of long-term institutional ownership is 38%
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(38%). Table 2, Panel B presents the correlation table.
/Insert Table 2/
We test hypotheses H1 and H2 using the following empirical model.
∆LnSBOAit = β0 + β1RETit + β2RETit*%TRAit + β3RETit*%LTit
+ β4∆ROE it + β5∆ROEit*%TRAit + β6∆ROEit*%LTit
+ controls + εit
where ∆LnSBOA is the change in the log of annual cash compensation and %TRA
(%LT) is the percentage of outstanding shares held by transient (long-term) institutional
investors as defined by Bushee (1998). We use a changes specification to control for unidentified
correlated omitted variables. As in prior studies (e.g., Lambert and Larcker 1987; Sloan 1993),
we interpret the weights on the financial performance variables, returns (RET) and return on
equity (∆ROE), as the sensitivity of the CEO’s cash pay to firm performance. We control for the
effect of CEO horizon on pay-for-performance sensitivity to returns and earnings (Cheng 2004;
Dikolli et al. 2004) by including as controls terms interacting RET and ∆ROE with CEO_AGE.
We further examine how pay-for-performance sensitivity varies with the concentrations of
transient and long-term institutional investors by interacting the performance variables with
%TRA and %LT. We mean-center the independent variables (other than indicator variables) to
simplify the interpretation of the intercept and interaction and to reduce multi-collinearity arising
from the introduction of interactions among continuous variables (Aiken and West 1991).5
We allow for the possibility that the concentrations of transient and long-term
5 Indeed, there is no indication of multicollinearity in any of the empirical results reported (i.e., variance inflation
factors are less than ten, Kennedy 1997). We also run the analyses using uncentered variables. Although the results
and implications are qualitatively the same, the variance inflation factors are high, indicating multicollinearity.