The Role of Mutual Funds in Deterring Corporate Fraud in China

Abstract

Since the 1990s there has been a surge in the mutual fund industry across the world. Mutual funds offer individual investors both the diversification of investment risk and the expertise to monitor corporate decisions. We find the effect of mutual fund ownership in reducing corporate fraud activities among listed firms in China. This confirms that fund managers utilize share prices to discipline firms for misdemeanors. Additional tests reveal that open-end funds reduce their ownership after firms are penalized by the regulatory authorities for corporate fraud. We also observe that this effect is more pronounced among non-state-owned enterprises (NSOEs) than state-owned enterprises (SOEs). This implies the negative side of the government support to SOEs. Since state-controlled listed firms receive government financial support, they are less dependent on the capital market and therefore more insulated from monitoring by external stakeholders. Thus, although managerial political connections could benefit firms in a transitional economy, they incur agency costs for minority shareholders.