Motivated monitoring by institutional investors and firm investment efficiency

• DOI: http://doi.org/10.1111/eufm.12232
• Author: Yeqin Zeng,Charles Ward,Chao Yin
• Date: 01 March 2020
• Published date: 01 March 2020

Eur Financ Manag. 2020;26:348–385.wileyonlinelibrary.com/journal/eufm348

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© 2019 John Wiley & Sons Ltd.

DOI: 10.1111/eufm.12232

ORIGINAL ARTICLE

Motivated monitoring by institutional

investors and firm investment efficiency

Charles Ward

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Chao Yin

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Yeqin Zeng

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1

ICMA Centre, Henley Business School,

University of Reading, Reading, RG6

6BA, UK

2

Durham University Business School,

Durham University, Durham, DH1 3LB,

UK

Correspondence

Yeqin Zeng, Durham University Business

School, Durham University, Durham

DH1 3LB, UK.

Email: yeqin.zeng@durham.ac.uk

Abstract

We find that motivated monitoring by institutional

investors mitigates firm investment inefficiency, esti-

mated by Richardson’s (2006) approach. This relation is

robust when using the annual reconstitution of the

Russell indexes as exogenous shocks to institutional

ownership during the period 1995–2015 and after

classifying institutional ownership by institution type.

We also show that closer monitoring mitigates the

problem of both over‐investing free cash flows and

under‐investment due to managers’career concerns.

Finally, we document that the effectiveness of the

monitoring by institutional investors appears to increase

monotonically with respect to the firm’s relative

importance in their portfolios.

KEYWORDS

agency problem, index switch, institutional investors, investment

efficiency, monitoring attention

JEL CLASSIFICATION

G23; G30; G31; M4

EUROPEAN

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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

acknowledged.

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INTRODUCTION

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 over‐investment (e.g.,

Jensen & Meckling, 1976; Richardson, 2006; Shleifer & Vishny, 1997) or under‐investment (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 firms’shareholders.

In this paper we examine the role of motivated monitoring by institutional investors in

improving corporate investment efficiency. Given the trade‐off 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);

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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 decision‐making.

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 investor’s 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 investors’portfolios 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.

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Motivated by these studies, we measure an institutional investor’s

motivation to monitor a firm by the fraction of the institution’s portfolio represented by the

firm. If the optimal level of monitoring attention is determined by the trade‐off between

monitoring benefits and costs, an institutional investor will be more motivated to monitor firms

which are relatively more important in its portfolio.

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We extend Fich et al.’s (2015) study to

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In practice, it is costly for investors to collect firm‐specific information, analyze the information with professional expertise, monitor firm activities, and

intervene through shareholder activism.

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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.

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The opportunity costs of monitoring may not be ignored in the trade‐off given the limited investors’attention.

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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.

Time

Reported

positions

Number of

institutions

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

Group

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%

(Continues)

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