Abstract
In contrast to US companies, Chinese firms have concentrated ownership with the effect that the central agency problem emanates from controlling shareholders expropriating minority shareholders, a phenomenon referred to as ‘tunneling’. This study examines the monitoring effect of mutual funds on the tunneling behavior of controlling shareholders. Due to the distinctive institutional settings in China, including a high level of ownership concentration, underdeveloped legal system in the stock markets and weak governance mechanisms in the mutual fund industry, we find that an increase in mutual fund ownership effectively mitigates the tunneling behavior of controlling shareholders thus improving firm performance. Nonetheless, after the mutual fund ownership reaches a certain threshold, an increase in concentrated mutual fund ownership is associated with heavier tunneling and lower firm performance. This may suggest that concentrated mutual funds collude with controlling shareholders in order to preserve their private interests. Moreover, the above effects are found to be more pronounced for firms with heavier tunneling activities. Our finding of the non-monotonic monitoring role of mutual funds brings attention to the private interest theory for mutual funds, an aspect that has been largely ignored in previous studies on mutual funds.
Highlights
The governance role of institutional investors, mutual funds, in monitoring managerial actions and improving firm performance has been well documented in the literature that covers developed countries (e.g., Cornett et al 2007; Del Guercio and Hawkins 1999; McConnell and Servaes 1990; Nesbitt 1994; Smith 1996), limited work has been devoted to major emerging economies such as China
The dependent variables are the proxies of firm performance, which are represented by return on assets (ROA), return on equities (ROE), returns on sales (ROS), TOBIN_Q and OPNIC, respectively
We further examine the causal relationship between the tunneling behavior and mutual fund ownership over our whole sample period using panel vector autoregression with GMM estimation, we already control for the impact of stock returns or tunneling at t − 1 in the previous regressions
Summary
The governance role of institutional investors, mutual funds, in monitoring managerial actions and improving firm performance has been well documented in the literature that covers developed countries (e.g., Cornett et al 2007; Del Guercio and Hawkins 1999; McConnell and Servaes 1990; Nesbitt 1994; Smith 1996), limited work has been devoted to major emerging economies such as China. Beyond a certain level of mutual fund ownership, where mutual funds are more likely to collude with the controlling shareholders of their invested firms in order to preserve their private interests, mutual fund ownership is positively associated with tunneling and negatively associated with firm performance These are consistent with our expectation and may result from the distinctive institutional features in China, including a high level of ownership concentration, underdeveloped legal system, and weak governance mechanisms in the mutual fund industry. We conclude that mutual funds are an effective guardian of minority investors to mitigate tunneling behavior and enhance firm value, as long as their ownership does not exceed a certain threshold, while concentrated mutual fund ownership may increase agency costs and weaken firm performance in the emerging market context. The study can lend empirical evidence to other emerging markets where the agency issue of tunneling arises from similar market features to those of China.
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