Mutual Funds and Information Diffusion: The Role of Country-Level Governance

The following post comes to us from Chunmei Lin of the Department of Business and Economics at Erasmus University Rotterdam; Massimo Massa, Professor of Finance at INSEAD; and Hong Zhang of the PBC School of Finance, Tsinghua University.

If the institutions of a country (e.g., property rights and contracting institutions) jeopardize the quality of its financial market, can the market by itself put in force corrective mechanisms that counterbalance and offset such negative impact? This question is at the core of modern financial economics because it essentially asks whether the market plays a more fundamental role than institutions in shaping modern financial activities, or the other way around. While the role of institutions has many facets and is subtle in nature, in our paper, Mutual Funds and Information Diffusion: The Role of Country-Level Governance, forthcoming in the November issue of the Review of Financial Studies, we focus on one unique element of the market—the global mutual fund industry—to provide some new insights.

The challenge we focus on is about information: weak institutions at the country level are known to lower the quality of public information. Given that financial market efficiency is predicated on abundant information, poor institutions complicate, if not distort, the trading and contracting activities of the financial markets. The market, on the other hand, is not short of potential corrective mechanisms: weak institutions, for instance, would incentivize savvy investors or financial intermediaries to collect and disseminate non-public information. Indeed, in many countries fund managers are known to be able to process information above and beyond what the general public can do, and generate what we call as semipublic information. Hence the question becomes: could the problem of low-quality information induced by weak institutions—as well as its associated negative impacts—be solved by the market-based corrective mechanism of introducing savvy mutual funds that can process semipublic information?

In our paper, we first confirm that savvy mutual funds do use more semipublic information in countries with weaker institution. Empirically, semipublic information-related mutual fund trading is five times higher in countries with the worst quality of governance than in countries with the best. Moreover, the use of semipublic information not only allows savvy mutual funds to generate performance for their investors, but also incorporates new information, through fund trading, into the market, which increases the (otherwise low) informativeness of stock prices. On such evidence, it may appear that financial intermediaries such as mutual funds offer a perfect market-based solution to offset the negative impact that weak institutions may have in terms of information.

Unfortunately, this picture is incomplete. Indeed, when savvy fund managers process information above and beyond what the general public can do, the informational asymmetry between savvy fund managers and the general public gets increased. This will discourage the market participation of less informed investors, and greatly reduce market liquidity. The cost of increased information asymmetry/illiquidity outweighs the benefit of more information in stock evaluation during ordinary days, and becomes especially devastating during financial crisis, leading to price drops and liquidity crunches that far exceed those experienced by stocks in countries with strong institutions—our estimation, for instance, shows that the liquidity crunch could be 30% deeper. Through this channel, markets with weaker institutions are essentially more vulnerable to crises.

Our study, therefore, documents a pivotal yet delicate role played by savvy fund managers who can generate semipublic information when public information is less reliable. Weak country-level institutions propose a fundamental challenge to the financial market even in the presence of informed managers: the low-information problem of weak institutions can be solved only by creating other problems, such as information asymmetry and illiquidity, which may outweigh the positive effects of more information and destabilize the market during crises.

Our results suggest that, for countries with poor governance, advances in institutions in either property rights or contracting quality are a necessary condition to further improve their financial markets. Without proper progress in institutions, policies focusing solely on the development of financial intermediaries such as mutual funds may adversely affect the market. Overall, country-level governance seems to shape the market in a more profound way than traditionally understood by affecting the creation and transfer of semipublic information.

The full paper is available for download here.

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