The Role of Mutual Funds in Corporate Governance

Yawen Jiao is Assistant Professor of Finance at the University of California, Riverside. This post is based on an article authored by Professor Jiao and Ying Duan, Assistant Professor of Finance at the University of Alberta.

Mutual funds hold about a quarter to a third of outstanding shares of U.S. companies in the past decade and therefore have the potential to play a pivotal role in corporate governance. In our article, The Role of Mutual Funds in Corporate Governance: Evidence from Mutual Funds’ Proxy Voting and Trading Behavior, forthcoming in the Journal of Financial and Quantitative Analysis, we simultaneously consider two governance approaches of mutual funds in the proxy voting setting: First, they can follow the “Wall Street rule” when dissatisfied with firm management, that is, sell their shares and “exit” the firm. This approach is modeled by Admati and Pfleiderer (2009), Edmans (2009), and Edmans and Manso (2011). Second, they can attempt to directly intervene (“voice”) by voting against firm management, as suggested by theories of Shleifer and Vishny (1986), Maug (1998), and Kahn and Winton (1998).

We identify proxy proposals where firm management’s recommendation for a vote conflicts with that of Institutional Shareholder Services (ISS). These “oppose-management” proposals represent scenarios where mutual funds’ governance efforts are most likely to create value. Our main finding is, instead of supporting management, mutual funds are more likely to exit or vote against management on these proposals than for other proposals. Including both full and partial sales in funds’ exit decisions, as suggested by exit theories, the probability of mutual funds voting against management is 46.42% higher for oppose-management proposals than for other proposals, while their probability of exit is 3.12% higher. These findings suggest that both voice and exit are important governance mechanisms for mutual funds.

It is worth highlighting that the nature of our focus, proxy voting, is particularly conducive to governance through voice rather than exit because, compared to other forms of intervention (e.g., forcing out an incumbent CEO), voting against management is arguably the easiest form, as it is almost costless and can sometimes be as simple as following ISS’s recommendations. Thus, the fact that even in such a situation we find significant evidence of exits provides support for exit theories.

Our results are strongest among proposals with close voting outcomes. The percentage of supporting shares for these proposals is close to the number of votes required for passage of the proposal and mutual funds’ voting and exiting decisions are critical to the voting outcomes of such proposals. Thus, the fact that we find stronger evidence for such proposals underscores the informed role of mutual funds in corporate governance.

Mutual funds’ voting and exiting decisions depend on the benefits and costs of each choice, which vary across funds. For a mutual fund, a larger ownership block may be associated with greater liquidity constraints, leading to a smaller likelihood of exit (Maug (1998), Edmans (2009), and Edmans and Manso (2011)). On the other hand, a larger ownership stake can also provide a stronger incentive to engage in voice because it is of greater importance to the fund’s performance. Empirically, we find that a larger ownership stake is associated with a lower probability of exit relative to voting with or against management for a fund.

We also find funds with short investment horizons, measured by portfolio turnover rates, are more likely to exit than vote against management. These funds are particularly skilled at governance through exit because they are likely to be the fund group best able to trade on performance-related information, and they are not expected to be actively involved in direct intervention through proxy voting.

Kahn and Winton (1998) argue that exit should occur more often in firms whose investors are more likely to have information. Edmans (2009) and Edmans and Manso (2011) posit that investors should become more informed and engage in more exit when the cost of acquiring private information is low. Consistent with these predictions, we find that mutual funds are more likely to exit than vote against management in smaller firms, for which less public information is available and the cost for informed investors such as mutual funds to acquire private information is therefore lower.

Moreover, we find that mutual funds are more likely to exit than vote against management when insiders’ ownership stake in the firm is higher. A higher insider ownership stake makes the manager more aligned to the stock price, and thus the exit governance mechanism more powerful. Further, the greater voting power associated with a larger insider ownership stake increases the uncertainty about voting outcome, thereby lowering the potential gains from intervention. The finding above suggests that mutual funds are less inclined to intervene when the exit governance mechanism is more powerful and when the outcome of intervention is more uncertain.

Finally, we consider the impact of a portfolio firm’s stock liquidity on mutual funds’ decisions to vote or exit. Maug (1998), Edmans (2009), and Edmans and Manso (2011) contend that high liquidity encourages exit rather than intervention. Consistent with their prediction, we find that mutual funds are more likely to exit than vote with or against management for more liquid stocks.

The full article is available for download here.

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