Flight to Quality in International Markets: Political Uncertainty and Investorss Demand for Financial Reporting Quality

Abstract

We examine whether international equity mutual-fund managers shift their portfolios toward stocks with higher financial reporting quality during periods of high political uncertainty. Our study is motivated by two primary factors. First, prior research shows evidence of fund managers’ “flight to quality” (e.g., to less risky securities) during periods of uncertainty. Second, recent theoretical research concludes that stocks with higher financial reporting quality are assessed as less sensitive to systematic risk (such as political uncertainty). We employ national elections as exogenous increases in systematic risk in the local markets and accordingly use an international sample of mutual funds that focus on local markets. We find that mutual-fund managers shift their equity holdings to stocks with higher financial reporting quality during election periods when political uncertainty is higher. Such a flight-to-quality effect is less pronounced for elections with larger expected electoral margins in the pre-election period (i.e., when the incumbent is more likely to win the election) and for countries with higher transactions costs. In contrast, the effect is more pronounced when governments have greater involvement in the local economy. Our inferences are robust to alternative proxies for political uncertainty and financial reporting quality and to numerous other sensitivity analyses.