Recall that trading by arbitrageurs (smart investors) tend to make prices better reflect fundamental value. We know that institutional investors (funds) tend to trade stocks with large market capitalization because those stocks are more liquid (easier to trade). Does this imply that the prices of large capitalization stocks tend to be more efficient

Yes, the prices of large capitalization stocks tend to be more efficient.

Explanation:

Large capitalization stocks are much more liquid than small capitalization stocks since they belong to well established companies that are generally industry leaders. A lot of investors trade their stocks every single day, which results in thousands of them being sold every trading day. That also lowers the opportunity for arbitrage, since a large of investors must be wrong and a single (or a few) arbitrator must be right.

Large capitalization stocks generally have more stable prices and tend to pay consistent dividends. Their sustainable growth rate is lower than most small capitalization stocks but it is much more steady. This also results in lower potential returns when investing in large capitalization stocks since they pose a very low risk. On the other hand, small capitalization stocks pose a larger risk and one of them is that they are not valued correctly (which allows arbitrators to step in).

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