Director Connections in the Mutual Fund Industry

Paul Calluzzo is assistant professor of finance at Queen’s University Smith School of Business. This post is based on his recent paper.

Over the past two decades, there has been a push by the Securities and Exchanges Commission towards more independent mutual fund boards with the intent of improving fund governance. This movement is supported by research that associates independent mutual fund boards with fewer scandals and lower shareholder fees. The industry has heeded the call: from 1996 to 2008, the percentage of fund boards with more than 75% of their seats held by independent directors increased from 46% to 88%.

At the same time, little attention has been paid to the identity of these independent directors and what impact their backgrounds may have on the funds they monitor. In our study, we manually collect the employment history of independent mutual fund directors and find that these directors often hold high-ranking positions at publicly-traded firms. As mutual funds often invest in the stock of director-connected firms, the presence of these directors thus raises the possibility that the influence they exert on the fund extends beyond their fiduciary monitoring responsibilities.

Our research shows that this concern is justified. When independent directors simultaneously hold high-ranking positions in publicly-traded firms, they hold larger stakes in the stocks of connected firms—driven by an increase in both the probability that funds hold connected firms and the aggressiveness of their stake.

We consider two explanations for why funds bias holdings toward connected firms. The first motivation is to provide price support for the connected firm around negative shocks. Director connections may help the firm access management-friendly shareholders who can mitigate undesirable market effects during turbulent periods. Indeed, we find that funds are more likely to purchase connected stocks when other mutual funds sell that stock.

The second motivation is to capitalize on superior information in the connected firm. As independent directors are likely to possess expertise about publicly-traded firms through their outside employment, the mutual fund boardroom represents an ideal setting for fund managers to form communication networks with fund directors. Our research bears this out. We find that trading in the connected stock predicts returns. Relative to trades in unconnected stocks, a purchase of average size in a connected stock is associated with a 1.58% abnormal return over the following quarter, and a sale of average size in a connected stock is associated with a negative 0.94% abnormal return over the following quarter. Furthermore, we find that funds do not trade informatively in the firm outside the connection period. This finding suggests that the director’s presence on the board, rather than factors related to the director’s selection, is the source of the information advantage.

The breadth of information transfers extends beyond the connected firm. We find evidence that funds also trade profitably in stocks in the same industry segment as the connected firm, suggesting a wider channel through which the director can influence fund performance. To quantify broader effects, we examine total fund returns and find that funds with director connections outperform funds without director connections by an economically significant 0.77% per year. Considering that 13.6% of fund-years in our sample have director connections, this result suggests that the director-connection channel is an important driver of returns in the mutual fund industry.

What are the underlying mechanisms that drive these information transfers? One possibility is that firm executives, in their capacities as directors, provide nuanced views on public information that help managers develop more effective investment strategies. Consistent with this mechanism, we also find that connected trading returns are strongest in informationally opaque environments and among executives who are likely to possess more information.

There is, however, another possibility. Investors have a strong incentive to access information, and firm executives are likely to possess inside information about their firms. Thus, there can be incentives for fund managers to use communication networks with directors to access the directors’ inside information. Ultimately, our results cannot rule out this mechanism. The finding that connected trading returns are largest during times of information asymmetry—when the dispersion of analyst forecasts is high—is just as consistent with insider information acquisition as it is with the idea that fund managers piece together public information from their connection to generate unique market insights.

These findings have wide implications for the mutual fund industry. A greater number of independent directors means that there are more directors who are simultaneously employees of publicly-traded firms. That means more potential for directors to influence the fund beyond their formal monitoring responsibilities. Overall, this paper suggests that legislation requiring the presence of independent mutual fund directors has led to unanticipated information spillover effects at the funds.

The full paper is available for download here.

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