Brent Kitchens, Robert Parham, Chris Yung
Review of Finance, Volume 28, Issue 6, November 2024, Pages 1991–2015, https://doi.org/10.1093/rof/rfae030
Selective disclosure allows a subset of privileged investors to gain access to material information before it is released to the public. This early access enables investors to trade on this information, so that market prices incorporate significant information even on days without public news announcements. This explains Roll’s (1988) puzzling finding that stocks have almost exactly the same return R2 – equivalently, the same idiosyncratic return variance — on days with and without public news release. In his 1988 address to the AFA, he finds his result “not very gratifying” and poses it as a significant challenge to the market efficiency.
We show that Roll’s result disappears with the introduction of Selective Disclosure Regulations (SDRs), which occurred in the US in 2001 with Regulation FD, and in the EU when analogous regulations went into force at 2005. Specifically, these regulations induce a widening of the R2 gap (non-news days minus news) by a factor of five. These changes occur nearly exactly at the time of SDR introduction. We show similar effects using volume and turnover. That is, SDRs reduce abnormal trading volume on non-news days, consistent with a large reduction in selective disclosure-based trades.
SDRs thus accomplish their intended goal of “leveling the playing field” and in turn shift price discovery from non-news days to news days. After SDRs, on non-news days, stocks tend to fluctuate with overall market movements, and typically do not have large idiosyncratic price movements.
No such effects are observed in Japan and Australia, neither of which implemented SDRs during our sample period. Importantly, these highly staggered regulation enactment dates (2001; 2005; never) allow us to rule out explanations driven by an omitted time-dependent factor affecting all developed markets simultaneously. Such ruled-out explanations include (i) the dot-com crash; (ii) the migration of news from print to online; and (iii) the rise of passive index investing. These and other global phenomena occurred contemporaneously in the US, EU, Japan and Australia.