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Questions raised (again) about measuring both fund and corporate performance based on quarterly market pricing of stock

 

 

Source: The Harvard Law School Forum on Corporate Governance and Financial Regulation, July 11, 2018 posting

Mutual Fund Transparency and Corporate Myopia

Posted by Vikas Agarwal (Georgia State University), Rahul Vashishtha (Duke University), and Mohan Venkatachalam (Duke University), on Wednesday, July 11, 2018

Editor’s Note: Vikas Agarwal is H. Talmage Dobbs, Jr. Chair and Professor of Finance at Georgia State University J. Mack Robinson College of Business; Rahul Vashishtha is Associate Professor of Accounting at Duke University Fuqua School of Business; and Mohan Venkatachalam  is R.J. Reynolds Professor of Accounting at Duke University Fuqua School of Business; This post is based on their recent article, forthcoming in the Review of Financial Studies.

Related research from the Program on Corporate Governance includes The Agency Problems of Institutional Investors by Lucian Bebchuk, Alma Cohen, and Scott Hirst (discussed on the Forum here).

Much anecdotal and large-sample evidence suggests that pressure from institutional investors to report good short-run financial performance can hinder investment in innovative projects that hurt short-term profits but generate value in the long run. But what incentivizes institutional investors to put excessive focus on short-run results? In Mutual Fund Transparency and Corporate Myopia (Review of Financial Studies, 2018, 31(5), pp. 1966-2003), we explore the role of mandated frequent disclosures of portfolio holdings by mutual fund managers in shaping their emphasis on short-term corporate performance and the concomitant myopic underinvestment in innovative activities by investee firms’ managers.

Our focus on the mutual fund portfolio disclosures is motivated by prior work that argues that fund managers’ short-term focus stems from their career concerns (e.g., Shleifer and Vishny, 1990) [1] and greater transparency about their actions (i.e., portfolio choices) can amplify these concerns (e.g., Prat, 2005). [2] Intuitively, the idea is that fund managers are concerned about their own performance measurement, which is used by fund investors to make inferences about fund managers’ stock picking abilities. Suppose a fund manager invests in a firm that is making significant R&D investments that will only payoff in the long run and has so far shown poor short-term earnings and stock price performance. Such a fund manager runs the risk that fund investors may attribute poor short-term performance of the investee firm to poor stock selection ability, resulting in fund outflows and job termination. Thus, career concerns reduce fund managers’ willingness to “ride-out” the declines in short-term performance of investee firms.

Prat (2005) shows that tighter monitoring of fund managers’ portfolio choices can amplify career concerns and their short-term focus. The intuition is that the agents (fund managers) are aware that the principals (fund investors) are closely scrutinizing their actions. This incentivizes the agents to take actions that are perceived as high-ability actions even if the agent’s private information suggests that some other action is optimal. Thus, as fund investors gain access to more frequent and reliable information on fund managers’ stock picks, fund managers may excessively focus on holding stocks that appear as “winners” in these short-term disclosures. Consequently, frequent portfolio disclosures can reduce the fund manager’s tolerance for having investee firms in the portfolio that pursue policies that will generate value in the long run, but can appear as “poor” stock picks in short-term portfolio disclosures. This increased short-term focus of fund managers can create pressure on managers of investee firms to behave myopically.

Considerable anecdotal evidence exists in support of the above arguments. The following quote from a money manager in Lakonishok et al. (1991) directly highlights how the intense pressure to show winning stocks in their quarterly portfolio disclosures can cause money managers to myopically ignore the future potential of some stocks: “Nobody wants to be caught showing last quarter’s disasters. … You throw out the duds because you don’t want to have to apologize for and defend a stock’s presence to clients even though your investment judgment may be to hold.” [3]

We use the securities market regulation in 2004 that altered the disclosure frequency of portfolio holdings by mutual fund managers from semi-annual to quarterly reporting to investigate whether institutional investors can pressurize the corporate managers to behave myopically. Using a difference-in-differences design, we find strong evidence of a decline in corporate innovation (as measured by citation-weighted patent counts) following the regulation, for firms with high ownership by mutual funds that were forced to increase the frequency of portfolio disclosures subsequent to the regulation. The innovation decline is much greater when bulk of the ownership comes from more career concerned younger fund managers who would have greater incentives to signal their ability by appearing to make smart portfolio choices. We also uncover direct evidence of increased short-term focus in fund managers’ trading behavior, which exhibits shorter holding periods, increased sensitivity of holdings to short-term investee firm performance, and reduced portfolio allocation toward innovative firms following the regulation.

These results highlight the role of mandated quarterly portfolio disclosures in shaping short-term incentives and lend support to the argument in Shleifer and Vishny (1990) that it is the money managers’ own career concerns and performance evaluation pressures that lie at the root of their short-term focus that promotes corporate myopic behavior. This study also adds to our understanding of the consequences of increased mandated information disclosure by establishing how it can create adverse real effects by distorting the incentives of career-concerned agents. Finally, the study portrays a dark side of the consequences of the agency relation between money managers and fund investors on the real economy, a phenomenon that has become increasingly important to understand because of the astounding growth in delegated money management over the last three decades.

The complete paper is available for download here.

Endnotes

1 Shleifer, A., and R. W. Vishny, 1990, Equilibrium short horizons of investors and firms, American Economic Review 80, 148‒153.(go back)

2 Prat, A., 2005, The wrong kind of transparency, American Economic Review, 95(3), 862‒877.(go back)

3 Lakonishok, J., A. Shleifer, R. Thaler, and R. Vishny, 1991, Window dressing by pension fund managers, American Economic Review 81, 227‒231.(go back)

 

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