Academic journal article Quarterly Journal of Finance and Accounting

Mutual Fund Governance, Returns, Expenses, and Cash Flows

Academic journal article Quarterly Journal of Finance and Accounting

Mutual Fund Governance, Returns, Expenses, and Cash Flows

Article excerpt

Introduction

Are good governance grades for a mutual fund positively related to returns for investors? Does good governance as indicated by those grades lead to reduction of expenses for a mutual fund? If improved returns result from good governance, is this noticed by investors who in turn increase their investment in the mutual fund? These are the questions we attempt to answer in this study.

We investigate these topics because mutual fund governance has been controversial, as shown by popular press articles and academic studies in recent years. Boards of directors have become more independent of mutual fund management. Morningstar has created governance measures for mutual funds. We want to know if these changes have benefited investors.

Previous academic research indicates that it is almost a certainty that if a mutual fund reduces its expenses, it will improve returns and these returns will in turn attract increased investment. For example, studies by Chance and Ferris (1991) and by Malhotra and McLeod (1997) link reduced expenses to improved returns. More recently, the link between reduction of expenses and increased cash flow into a mutual fund has been established in studies by Ivkovie (2002); Sirri and Tufano (1998); Siggelkow (1998 and 2003); Nanda, Wang, and Zheng (2000); Barber, Odean, and Zheng (2005); and Khorana and Servaes (2004). But, it is not a certainty whether good governance as indicated by Morningstar governance grades leads to reduction of expenses and whether expense reduction from this source will cause investment to increase. Hence, we are investigating these linkages.

Aside from direct benefits to investors, our findings may be of interest to the Securities Exchange Commission and other regulatory agencies. These agencies operate for the benefit of investors. If they find that improved governance grades are associated with improved returns, they may want to promote good governance through regulation.

Previous Studies

Studies on corporate governance focus on the impact of effective governance on shareholder wealth. Studies that find a positive relation between improved performance and better governance typically hold that good governance results from the presence of more independent directors on the corporate board. This group of studies includes those by Weisbach (1988); Byrd and Hickman (1992); Cotter, Shivdasani, and Zenner (1997); and Brickley, Coles, and Terry (1994). However, other studies such as those by Baysinger and Butler (1985), Hermalin and Weisbach (1991), and Klein (1998) find no evidence of an impact of board composition on firm performance and shareholder value.

As to mutual fund governance, researchers have taken a variety of approaches in investigating the benefits of good governance. One of the earliest works is by Tufano and Sevick (1997). They report that fees charged by mutual funds are lower when fund boards have characteristics that are consistent with effective governance. Del Guercio, Dann, and Partch (2003) report that effective fund governance is associated with lower expense ratios. Cremers, Driessen, Maenhout, and Weinbaum (2005) report that governance plays a role in fund performance and funds with higher director ownership perform better. Wellman and Zhou (2007) report that funds that have good governance will also have superior performance. They also find evidence of cash outflows for funds with poor governance ratings. Kong and Tang (2008) find that unitary boards are a better mechanism for mutual fund governance because those funds have lower expenses and rank better on stewardship measures.

Method of Investigation

A. REGRESSION MODELS

We investigate the effect of governance on mutual funds by using ordinary least squares (OLS) regression to find whether Morningstar's measures of governance effectiveness can predict a mutual fund's total return, magnitude of expense ratio, and level of cash flow into or out of the fund. …

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