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E-MailPedro Matos is Associate Professor of Business Administration at the University of Virginia Darden School of Business. This post is based on a recent paper by Professor Matos; Jan Bena, Assistant Professor at the University of British Columbia Sauder School of Business; Miguel Ferreira, Banco BPI Chair in Finance at Nova School of Business and Economics; and Pedro Pires, Nova School of Business and Economics.
In an era of increasing financial globalization, many analysts have expressed fears that a dispersed and globalized shareholder structure may be harmful to corporate investment, undermining firms’ future growth and performance. In fact, many policy makers have voiced protectionist sentiments with regard to foreign capital flows which might represent “hot money” in search of short-term profits, with little regard for firms’ long-term prospects. These views were famously vocalized over a decade ago by Franz Müntefering, the then chairman of the German Social Democratic Party (SPD), when he compared foreign investors to an invasion of “locusts” stripping companies bare. At SPD’s convention he stated that “(…) we support those companies, who act in interest of their future and in interest of their employees against irresponsible locust swarms, who measure success in quarterly intervals, suck off substance and let companies die once they have eaten them away.” The concern regarding “locust” foreign capital is that it might lead to asset stripping to boost short-term profits, delocalization of production, and adoption of unfriendly labor policies.
We ask whether these concerns are warranted using a comprehensive data set of portfolio equity holdings by institutional investors covering over 30,000 publicly listed firms in 30 countries over the 2001-2010 period. We first show that greater foreign institutional ownership fosters long-term investment (both in terms of capital and R&D expenditures) and innovation output (proxied by patents). Next, we show that these larger investments in tangible and intangible capital are not accompanied by unfriendly labor policies. On the contrary, we show that higher foreign institutional ownership leads to increases in employment and measures of human and organization capital. We also show that higher foreign institutional ownership leads to increases in total factor productivity, internationalization of firms’ operations, and shareholder value. When we ask what mechanism underpins these effects, we find that they can be explained the important monitoring role of foreign institutions. Compared to domestic institutional investors, who are more likely to have business ties with local companies, foreign institutions have more of an arm’s-length relation with the firms they invest in. Thus, foreign institutions are in better position to exert a disciplinary role on entrenched corporate insiders. Our findings help to dismiss popular fears that portray foreign investors as predominantly interested in short-term gains while ignoring long-term firms’ prospects.
It is important to establish that we identify causal effects of foreign institutional ownership on corporate outcomes. For example, it could be that foreign institutions choose to invest in firms with better long-term growth prospects or in firms for which they anticipate a surge in innovation. To provide causal evidence, we exploit the exogenous variation in foreign institutional ownership that follows the addition of firms’ stock to the Morgan Stanley Capital International (MSCI) indices. Our results indeed suggest that the presence of foreign institutions leads to increases in long-term investment, employment, and innovation output. This evidence also suggests that indexed money managers play an active governance role by influencing firm policies, which is consistent with growing evidence that passive investors do not mean passive owners. For example, in 2015, Larry Fink, the Chairman of Blackrock, the world’s largest (and mostly indexed) asset manager, sent a high-profile letter to chairmen/CEOs of S&P500 firms asking them to “(…) understand that corporate leaders’ duty of care and loyalty is not to every investor or trader who owns their companies’ shares at any moment in time, but to the company and its long-term owners.”
We conclude that the globalization of firms’ shareholder base is a positive force for capital formation and make firms more productive and competitive in the global economy. There are also wider policy implications, as the use of scarce corporate resources in long-term investment and innovation activities has important benefits on local economies. Our results do not support economic nationalism aimed at protecting “national champions” from predatory foreign capital. Rather, our findings suggest that openness to international portfolio investment can generate positive externalities for the real economy by helping to create jobs, as well as facilitating the development of new technologies, products, and services.
The complete paper is available for download here.
