Mutual Fund Governance and Performance: A Quantile Regression Analysis of Morningstar's Stewardship Grade

Abstract

Manuscript Tytpe: Empirical Research Question/Issue: We study the relation between mutual fund performance and Morningstar's fiduciary grades using quantile regression models. This research is important because we shed new light on the principal-agent issue in the mutual fund industry, and investors and professional managers often use Morningstar's rating system to guide their investment decisions. Quantile regressions allow us to examine the differential impact of mutual fund governance variables such as manager incentives and board quality on fund performance across the entire performance distribution. Research Findings/Insights: Quantile regressions find a strong contemporaneous association between Stewardship Grade and Sharpe Ratio. Manager incentives, though not significant in the OLS regression, are positively related to the fund performance for better performing funds, and negatively correlated with portfolio turnover. However, manager incentives are shown to have little predictive power for funds' future performance. In contrast, board quality, which is in the center stage of the proposed SEC mutual fund regulation, bears little relationship with contemporaneous fund performance, yet is strongly related to funds' future performance. Theoretical/Academic Implications: Our analyses and results have two important implications for the principal-agent theory. Our finding that board quality has a more profound impact on fund performance than manager incentives suggests that incentive alignment through compensation contracts is less effective in mitigating agency problems than quality board monitoring. Our quantile regression results also provide new insights to the analysis of corporate governance research. The major advantage of using quantile regression is that it reveals the whole spectrum of heterogeneous mutual fund performance responses to their governance efforts, especially the behavior of funds at the tails of the distribution; hence better corporate governance policies can be drawn up and instituted. This methodology is useful for other governance research as well and entails meaningful regulatory implications when firms/industries are heterogeneous and the conditional means of traditional regression analysis does not provide much information and guidance for corporate decision making. Practitioner/Policy Implications: This study shows that fund performance is associated with manager incentives contemporaneously, while board quality predicts fund performance in the long haul. This finding has important regulatory implications, as the efficacy of SEC's proposal on board and chairman independence is under great debate. Our results also provide useful information for investors who use Morningstar's Stewardship grades to guide their investments.