Spillover Effects of Mandatory Portfolio Disclosures on Corporate Investment

Jalal Sani is Assistant Professor of Accountancy at the University of Illinois Urbana-Champaign; Nemit Shroff is the School of Management Distinguished Professor of Accounting at the MIT Sloan School of Management; and Hal White is the Vincent and Rose Lizzadro Professor of Accountancy at the University of Notre Dame. This post is based on their recent article published in the Journal of Accounting and Economics. Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors (discussed on the Forum here) by Lucian A. Bebchuk, Alma Cohen, and Scott Hirst; and The Limits of Portfolio Primacy (discussed on the Forum here) by Roberto Tallarita.

U.S. mutual funds collectively managed assets worth $27 trillion, held about 32% of all U.S. corporate equity, and comprised 58% of U.S. household retirement accounts at the end of 2021 (Investment Company Institute, 2022). The Securities and Exchange Commission (SEC) requires mutual funds to provide the public with detailed information about their portfolio holdings and investment activities so mutual fund investors know how their money is being managed. Consistent with the SEC’s intent, prior studies find that mutual fund portfolio disclosures do indeed improve capital market transparency and liquidity. However, portfolio disclosures simultaneously impose significant costs on mutual funds, particularly actively managed (AM) mutual funds, by allowing others to front run and copy their trades without incurring the research cost, thereby hurting the performance of AM mutual funds.

In a paper published in the Journal of Accounting and Economics, we investigate whether the SEC’s portfolio disclosure requirements for mutual funds affect the investment decisions of the companies they invest in. We argue that portfolio disclosure requirements reveal proprietary information about AM mutual funds’ trading strategies, which curtails their incentive to engage in costly private information acquisition. Reduced private information acquisition lowers the informativeness of their portfolio companies’ stock prices and, consequently, the extent to which managers of these portfolio companies learn decision-relevant information from stock prices. We base our prediction on prior research that shows that stock prices aggregate information from several traders, which informs and improves the investment decisions made by companies. As such, we predict that portfolio disclosure requirements have a negative spillover effect on the investment decisions of portfolio companies by reducing investors’ incentives to collect private information about companies, and thereby curtailing corporate managers’ opportunities to learn from such investor efforts.

We exploit a 2004 SEC regulation that (i) increased the frequency of mutual funds’ portfolio disclosures from a semiannual basis to a quarterly basis, and (ii) streamlined their portfolio schedules to make them “more useful and understandable” to investors. We follow prior research and use the sensitivity of investment to stock price to proxy for the efficiency of the financial markets in guiding firm managers’ corporate investment decisions (managerial learning from price). The intuition for this measure is that, as the stock price reveals more new information to managers, they place more weight on their price when making investment decisions, increasing investment sensitivity to price.

Using a difference-in-differences design, we compare changes in investment-price sensitivity around the 2004 regulation for firms with high pre-regulation AM mutual fund ownership (treated firms) with changes in investment-price sensitivity over the same period for firms with low pre-regulation AM mutual fund ownership (control firms). We find that firms with high AM mutual fund ownership experience a significant decline in investment-price sensitivity after the regulatory change compared to firms with low AM mutual fund ownership. The economic magnitude is sizable. Treated firms experience a 36% drop in investment-price sensitivity relative to control firms after treatment.

In addition, we examine whether treated firms experience a decrease in their operating performance following the regulation. If the portfolio disclosure regulation reduces the amount of information that prices reveal to managers, it should diminish their ability to identify profitable investment projects, decreasing the firm’s future profitability. Consistent with reduced managerial learning, we find that treated firms experience a reduction in future profitability, relative to control firms, after the SEC regulation. Our results suggest a reduction in the opportunities for investee firms’ managers to learn decision-relevant information from their firms’ stock prices.

We conduct two sets of cross-sectional analyses to shed light on the mechanism underlying our results. The premise underlying our first set of analyses is that AM mutual funds are more likely to reduce effort in collecting private information post-regulation if they incur greater proprietary costs from disclosing their portfolio holdings. Indeed, we find that the negative effect of the 2004 SEC regulation on investment-price sensitivity occurs primarily when treated firms are owned by funds expected to incur high proprietary costs from disclosure (e.g., funds with concentrated holdings).

In the second set of cross-sectional analyses, we devise tests based on two predictions motivated by theoretical models of managerial learning from price. Learning from price models show that market participants collectively possess an information advantage over firm management with respect to growth opportunities rather than assets-in-place, and industry-level factors rather than idiosyncratic firm-level factors. Thus, if mandatory portfolio disclosures decrease investment-price sensitivity by reducing managerial learning, the effect should be stronger for managers of (i) high-growth firms and (ii) firms facing greater industry-level uncertainty. We find evidence consistent with both predictions, supporting the managerial learning channel.

We perform additional tests to validate our research design assumptions. First, our research design assumes that the 2004 SEC regulation reduces AM mutual funds’ incentives for private information acquisition. We provide evidence suggesting that affected AM mutual funds decrease their reliance on private information after the SEC regulation, supporting our research design assumption. Second, if AM mutual funds expend fewer resources on private information acquisition, we should observe a decrease in the stock price informativeness of their portfolio firms. We find evidence supporting this prediction.

Finally, we address a common criticism of papers that test whether managers learn decision-relevant information from price. Specifically, critics contend that studies on learning-from-price are silent on exactly how managers extract a trader’s private information by observing price movements. Our paper discusses that the communication between managers and equity market participants (analysts, investors, etc.) is a two-way street, where managers speak with market participants not only to provide them information relevant for valuing their company but also to get information from them. Interactions between corporate managers and market participants occur across many venues (conferences, phone calls, site visits, road shows, etc.) and managers explicitly ask investors/analysts to explain and opine on broader market movements as well as movements in their own firm’s stock price. Such conversations help managers unpack and understand the information aggregated in stock prices. It is important to note, however, that conversations with market participants alone would not be sufficient to help managers learn investors’ private information. Price serves as a mechanism for aggregating the collective views of different market participants with respect to perceptions of anticipated changes in firm value. Absent price, managers would not know if the opinion of an individual analyst or investor is representative of the consensus or is idiosyncratic.

Overall, our findings suggest that the 2004 SEC regulation, which was intended to help funds’ investors make more informed decisions by making mutual funds more transparent, may have harmed not only the performance of the AM mutual funds (as prior research finds), but also the performance of the portfolio firms – a double whammy for the investors in these funds.

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