Mutual funds’ ownership and firm performance: Evidence from China

Abstract

Mutual funds have emerged and rapidly developed since 2000 in China. This study tests empirically the impact of mutual funds’ ownership on firm performance in China, using a large sample for the period of 2001–2005. We find that equity ownership by mutual funds has a positive effect on firm performance. The result is robust to several measures of firm performance and various estimations. Our finding supports recent regulatory efforts in China to promote mutual funds as a corporate governance mechanism and suggests that pooling diffuse minority interests of individual shareholders who are prone to free-rider problems via mutual funds is beneficial.

Introduction

The role of institutional shareholders in monitoring corporate management and improving firm performance has been well recognized in the literature (e.g., Admati et al., 1994, Smith, 1996). One strand of the literature focuses on the governance role of financial institutions, particularly in economies where the market for corporate control is less effective, for example, Morck and Nakamura’s (1999) study of Japan’s Main Bank system and Edwards and Nibler’s (2000) examination of Germany’s Hausbank system. These studies generally find that banks as shareholders are important in solving agency problems in times of financial distress, but not when a portfolio firm is doing well (Allen, 2001). Another group of studies (e.g., Smith, 1996, Wahal, 1996, Woidtke, 2002, Cornett et al., 2007) have investigated the relation between shareholder activism of pension funds and firm performance in the United States (US), but reported mixed findings. Woidtke (2002), for example, examines a sample of Fortune 500 firms for the period 1989–1993 and reports that these firms’ Tobin’s Qs are positively related to shares held by private pension funds, but negatively related to the shares held by public pension funds. Cornett et al. (2007) investigate the effect of institutional ownership on corporate operating performance in the US and find that only pressure-insensitive institutional investors (e.g., mutual funds) that are less likely to have a business relationship with the invested firm have a positive impact on firm performance. An important implication of these two studies is that different financial institutions can have differing impacts on firm performance. In sum, these and other prior studies are largely based on developed economies (e.g., the US, Japan and Germany) and have generated mixed findings. However, research has not been undertaken in major emerging economies such as China, a large growing economy with increasing international influence. This paper investigates the effect of mutual funds’ ownership on the performance of Chinese publicly listed companies (PLCs). Our study is motivated in three principal regards.

First, the study is timely given that a great deal of regulatory effort has been made in China to develop mutual funds in recent years. For example, in year 2000, the Chinese government made a strategic decision to cultivate the ‘pillar role’ of mutual funds, among other financial institutions in domestic stock markets (China Securities Regulatory Commission (CSRC), 2000). Mutual funds are now encouraged to invest in listed companies in the expectation that they can monitor corporate decisions and counter speculative behaviors by individual investors (e.g., free-riding problems). According to the CSRC statistics, as of the end of 2005, there were 54 closed-end and 164 open-end mutual funds in China. The total net value of mutual funds was over 469 billion yuan (about US $ 58.6 billion). By the end of June 2007, the number of open-end mutual funds in China had grown to 343 and their total net value had soared to 1,796.9 billion yuan (about US $ 236.3billion).³ The mean mutual funds’ ownership in our sample firms represents about 7% of the total number of tradable A-shares in issue as of the end of 2005 and this figure is comparable to the reported level of mutual funds’ ownership in the US (see Section 4.1). Despite increased regulation and the explosive development of mutual funds in China, their governance role and impact on firm performance has not been empirically investigated. Several commentators (e.g., Tenev et al., 2002, Gen, 2002) have arbitrarily asserted that Chinese financial institutions (including mutual funds) are passive and short-term investors, and play no role in firm performance due to their small market presence. Our study thus attempts to validate these claims and fill the void in the lack of empirical evidence.

Second, compared with the US and the United Kingdom (UK) where there is a diffuse corporate ownership, China provides a different yet interesting environment within which to examine the effect of mutual funds’ ownership. In countries like the US and the UK, the role of institutional shareholders (e.g., mutual or pension funds) is mainly to monitor managerial inertia and thereby mitigate the owner–manager agency problem (e.g., Smith, 1996, Woidtke, 2002). In contrast, the concentrated and segmented ownership structure in China places mutual funds in a unique governance role in monitoring controlling shareholders (as well as their employed agents) and safeguarding the interest of minority shareholders. Specifically, shares in Chinese PLCs are officially classified into state shares, legal-person shares (i.e., shares held by state-owned company sponsors or non-state-owned legal persons), and tradable shares. Tradable shares are further divided into A-shares (exclusive to domestic investors – mainly individuals and mutual funds, but also available to qualified foreign institutional investors (QFIIs) with investment quota restriction since December 2002),⁴ B-shares (traded domestically but exclusive to foreign investors before February 2001), and H-shares (shares traded in Hong Kong and other overseas markets). The ownership structure is highly concentrated by international standards because Chinese PLCs are usually dominated by one large state or non-state shareholder, with over 70 millions of investors of tradable A-shares being minority shareholders (Bai et al., 2004).⁵ The ownership structure is also segmented in that state and legal-person shares are not publicly tradable and therefore large shareholders often have divergent interests from those of minority investors of tradable shares.⁶ The recent law and finance literature shows that a central agency problem in a setting like China with poor corporate governance and weak investor protection is the expropriation of minority shareholders by controlling shareholders (e.g., La Porta et al., 2000, Sun and Tong, 2003, Bai et al., 2004, Wei et al., 2005). By pooling funds from individuals and investing them in tradable A-shares, mutual funds may strengthen the bargaining power of minority shareholders (i.e., investors of tradable shares) and provide beneficial monitoring of a firm’s large shareholders as well as their employed agents (e.g., managers and directors) in the corporate decision process (Belev, 2003). Indeed, using a sample of Chinese PLCs in the period 1993–1995 and 1991–1996, respectively, Xu and Wang, 1999, Qi et al., 2000 report that the proportion of shares held by individuals (i.e., tradable A-shares) is negatively associated with firm value in China. They argue that the negligible fraction of shares owned by each individual coupled with the absence of a proxy voting procedure in China makes individual investors mainly free-riders and short-term speculators. Therefore, it should be interesting to examine whether mutual funds can help overcome the free-rider problem pronounced among diffuse individual investors and play a beneficial governance role in corporate monitoring and decision process.

Third, as the largest emerging economy in the world, China’s rapidly expanding corporate sector and securities market are increasingly integrated with the global economy through large amounts of foreign direct investment, its accession to the World Trade Organization (WTO), the introduction of the QFII scheme, and the increasing number of Chinese firms seeking listing status overseas. As a result, the Chinese corporate sector offers an improved opportunity for diversification by international investors. However, it is important for foreign investors to understand the different, if not unique, characteristics of ownership, governance, and market in this emerging economy. Our study thus contributes to the understanding of the effect of mutual funds’ ownership on firm performance in China.

Using a large sample of Chinese listed companies from the Shanghai Stock Exchange (SHSE) and Shenzhen Stock Exchange (SZSE) that spans the five years 2001–2005, we find that mutual funds’ ownership has a positive impact on firm performance, which is robust to several performance measures and various model estimations. This result shows that contrary to the conclusions of previous studies (e.g., Tenev et al., 2002), financial institutions (specifically mutual funds) have started to play an emerging and positive role in corporate governance in China. It also suggests that the effort of the Chinese securities regulators to develop mutual funds as one of the major types of institutional investors has in general been successful. Since prior studies (e.g., Xu and Wang, 1999, Qi et al., 2000) report that diffuse minority investors of tradable shares may lead to free- rider problems and a lower market valuation of the firm, our results indicate that mitigating such free-rider problems by pooling diffuse minority equity ownership (via mutual funds) can be beneficial.

The remainder of this study is organized as follows. We formulate our test hypothesis in Section 2. Section 3 describes the research design (including sample selection, model specification, and variable measurement). The empirical results are discussed in Section 4. Section 5 provides robustness checks and Section 6 concludes the paper.