Evidence presented in Dasgupta et al. (2011) indicates that financial institutions can be net buyers or sellers of a stock over consecutive quarters, implying the existence of trends in a stock’s institutional ownership. I investigate the relation between institutional ownership and returns after controlling for trends by decomposing a stock’s institutional ownership into level, slope, and residual components. I find that the level, slope, and residual components have, respectively, positive but relatively weak, strongly positive, and strongly negative relations with returns. These relations are strongest within arbitrage-constrained stocks and are the result of financial institutions investing and actively managing their equity positions based on differences and changes in underlying firm fundamentals.

Keywords: Arbitrage constraints, Firm fundamentals, Institutional demand, Market efficiency

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