Motivated monitoring by institutional investors and firm investment efficiency

AuthorYeqin Zeng, Charles Ward, Chao Yin
Publication Date01 Mar 2020
Eur Financ Manag. 2020;
© 2019 John Wiley & Sons Ltd.
DOI: 10.1111/eufm.12232
Motivated monitoring by institutional
investors and firm investment efficiency
Charles Ward
Chao Yin
Yeqin Zeng
ICMA Centre, Henley Business School,
University of Reading, Reading, RG6
Durham University Business School,
Durham University, Durham, DH1 3LB,
Yeqin Zeng, Durham University Business
School, Durham University, Durham
DH1 3LB, UK.
We find that motivated monitoring by institutional
investors mitigates firm investment inefficiency, esti-
mated by Richardsons (2006) approach. This relation is
robust when using the annual reconstitution of the
Russell indexes as exogenous shocks to institutional
ownership during the period 19952015 and after
classifying institutional ownership by institution type.
We also show that closer monitoring mitigates the
problem of both overinvesting free cash flows and
underinvestment due to managerscareer concerns.
Finally, we document that the effectiveness of the
monitoring by institutional investors appears to increase
monotonically with respect to the firms relative
importance in their portfolios.
agency problem, index switch, institutional investors, investment
efficiency, monitoring attention
G23; G30; G31; M4
We would like to thank the journal editor John Doukas, the two anonymous referees, Seth Armitage, Chris Brooks,
Rong Ding, Lynn Hodgkinson, Mohammad Irani, Scott Richardson, Alessio Ruzza, Ben Sila, Lei Zhao, and seminar
participants at the ICMA Centre, 2017 FEBS annual conference, 2017 EFMA annual conference, 2017 World Finance
conference, 2017 AAA annual conference, and 2017 FMA annual conference for their insightful and constructive
comments. The financial support from Durham University Business School and the ICMA Centre is gratefully
Successful investment by companies creates shareholder value and drives firm growth. However,
firms may fail to invest efficiently due to conflicts of interest between managers and shareholders.
Several managerial agency problems have been identified as leading to either overinvestment (e.g.,
Jensen & Meckling, 1976; Richardson, 2006; Shleifer & Vishny, 1997) or underinvestment (e.g.,
Aghion, Reenen, & Zingales, 2013; Bertrand & Mullainathan, 2003; Porter, 1991). As less efficient
investment is associated with lower firm future stock performance (Cai & Zhang, 2011; Titman,
Wei, & Xie, 2004), understanding the governance of firm investment efficiency in publicly traded
companies is of great importance to firmsshareholders.
In this paper we examine the role of motivated monitoring by institutional investors in
improving corporate investment efficiency. Given the tradeoff between the costs and benefits of
active monitoring, institutional investors will not have the same incentive to monitor the
activities of every firm in their portfolios. First, institutional investors are not homogeneous:
their monitoring roles are related to institution type, their investment horizon, and their
preference for trading (Bushee, 1998; Chen, Harford, & Li, 2007; Schmidt & Fahlenbrach, 2017).
Second, it is not optimal for institutional investors to equally monitor all the firms held in their
portfolios, because their capacity to monitor is not unlimited (Kempf, Manconi, & Spalt, 2017);
the motivation of institutional monitoring would rationally depend on the relative importance
of an individual stock in their portfolios (Fich, Harford, & Tran, 2015). Previous studies have
focused on the heterogeneity of institutional investors, and how their institutional
characteristics might affect firm performance. In contrast, we follow Fich et al. (2015) and
focus on the variety of monitoring attention that would be expected within institutions on firms
held in their portfolios, and how this divergence can affect managerial decisionmaking.
When economic agents have a limited capacity for processing information, it is rational for
them to vary the attention they give to different sources of information when making decisions
(Sims, 2003). Based on the assumption of limited attention, Kacperczyk, Van Nieuwerburgh,
and Veldkamp (2016) develop an attention allocation model to predict optimal information
choices for mutual funds. Kempf et al. (2017) find that an institutional investors monitoring
attention to the firms it holds may become distracted if an exogenous shock affects the stock
returns of unrelated firms in its portfolio. Fich et al. (2015) posit that when an institution has
only limited monitoring attention, a greater proportion of its portfolio that is represented by a
firm will be associated with greater benefits of monitoring that firm. They use the relative
importance of a firm in institutional investorsportfolios as a proxy for the motivation of
institutional monitoring in mergers and acquisitions (M&As) and find that targets with more
motivated monitoring institutional ownership (IO) have higher deal premiums and deal
completion probabilities.
Motivated by these studies, we measure an institutional investors
motivation to monitor a firm by the fraction of the institutions portfolio represented by the
firm. If the optimal level of monitoring attention is determined by the tradeoff between
monitoring benefits and costs, an institutional investor will be more motivated to monitor firms
which are relatively more important in its portfolio.
We extend Fich et al.s (2015) study to
In practice, it is costly for investors to collect firmspecific information, analyze the information with professional expertise, monitor firm activities, and
intervene through shareholder activism.
Motivated monitoring IO is the ownership of institutional investors with high motivation to monitor the firm. Masulis and Mobbs (2014) also find that
directors who have multiple directorships are motivated to monitor firms in which their directorships are relatively more prestigious.
The opportunity costs of monitoring may not be ignored in the tradeoff given the limited investorsattention.
TABLE 1 Summary statistics
Panel A. This table reports time series of institutional holdings. This panel presents the number of reported institutional positions, the number of institutional investors,
the total market value of institutional holdings (in billions of dollars), the stock market value (billion dollars), the percentage of stock market share held by institutions,
and the average number of stocks in institutional investor portfolios. We report these summary statistics in every September from 1995 to 2015.
Number of
Market value
of institutional holdings
Stock market
value Percentage
Average number
of stocks per institution
Sept. 1995 343,187 1,212 3,303 6,570 50.0% 283
Sept. 2000 514,160 1,740 9,699 18,102 54.3% 295
Sept. 2005 605,990 2,224 11,002 17,694 64.5% 272
Sept. 2010 664,732 2,705 11,101 17,092 65.2% 246
Sept. 2015 649,619 2,732 13,686 23,274 59.6% 238
Panel B. This tablereports institutional stock holdings by decile portfolios.This panel reports the summary statistics of stock holdings in institutional investor portfolios.
We sort all stocks of an institutional investor into decile groups by the market value of holdings. Decile group 1 is the top decile that includes the stocks with the top 10%
holding value ranks. For each decile group, we report the average holding value (in thousands of dollars) of individual stocks, and the mean, median, 25th percentile,
and75thpercentileoftheratioofthedecilegroupholdingvaluetothetotal institutional portfolio value. The sample period is from March 1995 to December 2015.
Individual stock Decile portfolio value to total portfolio value
Average holding
value Mean Median 25th percentile 75th percentile
Decile 1 105,443.7 41.5% 38.1% 27.2% 53.0%
Decile 2 23,676.6 18.8% 18.9% 15.9% 21.7%
Decile 3 11,977.7 12.5% 13.1% 9.9% 15.3%
Decile 4 6,999.6 8.6% 9.0% 5.9% 11.3%
Decile 5 4,339.2 6.1% 6.1% 3.5% 8.6%
Decile 6 2,790.4 4.7% 4.3% 2.2% 6.8%
Decile 7 1,745.8 3.3% 2.8% 1.3% 4.7%

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