Independent Directors and Favoritism: When Multiple Board Affiliations Prevail in Mutual Fund Families

• Author: Christine (Whuei‐wen) Lai
• Date: 01 August 2016
• DOI: http://doi.org/10.1111/fima.12131
• Published date: 01 August 2016

Independent Directors and Favoritism:

When Multiple Board Affiliations Prevail

in Mutual Fund Families

Christine (Whuei-wen) Lai∗

I examine whether independent directors with multiple board affiliations (IDMAs) trade off the

interestsof one fund relativeto another (fund favoritism) or whether they benefit fund shareholders

by increasing the level of the board’s expertise. Using a sample of mutual funds affiliated with the

top 55 fund sponsors from 2002 to 2008, I find that the presence of IDMAs is negatively related

to performance/resource shifting across funds within fund families. IDMAs appear to decrease

fund fees, increase the return gap associated with the unobserved actions of fund managers, and

facilitate the transfer of information acrossfunds in a fund family.

Fund families seek to maximize assets under management, as their profits are usually increasing

in assets under management. Therefore, it is unsurprising that the prior literature has examined

numerous fund family strategies to increase cash flows to fund families (Massa, 2003; Nanda,

Wang,and Zheng, 2004; Khorana and Ser vaes,2005; Gaspar, Massa, and Matos, 2006; Guedj and

Papastaikoudi, 2008; Evans, 2010; Nohel, Wang, and Zheng, 2010; Cici, Gibson, and Moussawi,

2010; Chen and Lai, 2010; Bhattacharya, Lee, and Pool, 2013). These strategies raise concerns

about potentially increasing cash flows at the sponsor level at the expense of member funds’

performance; that is, concerns about within-family “fund favoritism.” Consequently, one of

the governance responsibilities of mutual fund directors is to “monitor allocations of complex-

level opportunities and to protect their funds’ entitlement” (Tate and Jackson, 2000). However,

while previous studies have examined the effectiveness of fund boards from a large number of

perspectives, research on the relationship betweenfund governance and fund favoritism is scarce.1

In this study, I investigate the effect of independent directors with multiple board affiliations

(IDMAs) on fund favoritism. The Favoritism Hypothesis theorizes that independent directors

with multiple board appointments within a fund family might trade off the interests of one fund

I thank an anonymous refereeand Raghavendra Rau (Editor). Their insightful comments contributed enormously to this

paper. I am grateful for the valuable comments and suggestions from Hsuan-Chi Chen, Yanzhi(Andrew) Wang, seminar

participants at the National Cheng-chi University in Taiwan,and especially from Konan Chan and Hong-Yi Chen. I am

also grateful for the researchassistance of Pei Lan Su, Ya TingWu, Kate Valencia, Weng-Feng Wang,and Yi Hsun Lee. I

gratefully acknowledge the financial support fromthe Ministry of Science and Technology in Taiwan (100-2410-H-003-

019-MY3; 103-2410-H-003-031-; 104-2410-H-003-004-) and from the libraryof the National Taiwan Normal University

in Taiwan.

∗Christine (Whuei-wen) Lai is at Graduate Institute of Management in the College of Managementat National Taiwan

Normal University in Taiwan.

1These perspectives include fee setting (Tufanoand Sevick, 1997; Del Guercio, Dann, and Partch, 2003; Kuhnen, 2005;

Evans and Fahlenbrach,2012), fund perfor mance (Meschke,2007; Adams, Mansi, and Nishikawa, 2010), organizational

structure (Ferris and Yan,2009), fund mergers (Khorana, Tufano,and Wedge, 2007), fund scandals (Ferris and Yan,2007),

fund protection against market timing (Zitzewitz, 2003), and manager turnover (Dangl, Wu, and Zechner, 2008; Ding

and Wermers, 2009; Fu and Wedge, 2011). Ferris, Jagannathan, and Pritchard (2003) and Fich and Shivdasani (2006)

examine the issue of multiple board appointments in corporate firms.

Financial Management •Fall 2016 •pages 529 – 582

530 Financial Management rFall 2016

against those of another (e.g., fund favoritism)to maximize overall fund family profits. IDMAs are

expected to be positivelyassociated with resource shifting or performance shifting across the funds

within a fund family after controlling for endogeneity.However, multiple board appointments can

increase directors’ monitoring expertise thereby facilitating efficient information transfers and

reducing the hidden costs of fund managers’ unobserved actions, which increases the value of

investor claims. The Information Hypothesis argues that IDMAs are negatively associated with

resource shifting or performance shifting across funds within a fund family after controlling for

endogeneity.

Based on 63,055 independent director records from 55 fund sponsors from 2002 to 2008

collected from mutual funds’ Statement of Additional Information (SAI) filed with the Securities

Exchange Commission (SEC), I find that independent directors who are either academics or

retired executives from other firms are positively associated with IDMAs as proxied by Number

of Directorships, defined as the natural logarithm of the average number of funds overseen by a

fund’s independent directors. Since retired executives from other companies are effectivemonitors

(Brickley, Coles, and Terry, 1994), these results suggest that IDMAs may have the ability to play

an effective monitoring role.

Next, following Brown and Wu (2016), I estimate the Overlapping Rate, which is the average

independent director overlap rate betweena fund and the rest of the fund’s family. This fund-level

measure accounts for the fact that a director’s number of board affiliations will be affected by the

number of funds in a family.2I find that the average tenure of independent directors is positively

and significantly correlated with the Overlapping Rate indicating that independent directors with

longer tenure become members of more boards (as measured after taking the number of funds

offered by the family into account). To the extent that the tenure of independent directors can

serve as a proxy for a director’s expertise, this result indicates that independent directors with

expertise are shared by the funds in a family.

Finally, following Gaspar et al. (2006), I define high family value funds as funds that are high

past performers (or that charge high fees). I capture performance shifting using the performance

differential across high and low family valuefunds because of their family aff iliations. I compute

the Relative Number of Directorships, the natural logarithm of the ratio of the averagenumber of

funds overseen by independent directors who sit on the board of a low family value fund to the

average number of funds overseenby independent directors who sit on the board of a high family

value fund, and the Relative Overlapping Rate, the ratio of the overlapping rate of a low family

value fund to the overlapping rate of a high family value fund.

I use these variables to examine whether IDMAs exhibit fund favoritism, as reflected by per-

formance shifting. I find that performance shifting to enhance the perfor mance of high family

value funds at the expense of lowf amilyvalue funds decreases when independent directors in low

family value funds oversee an increased number of boards. However, I find some evidence that

the presence of IDMAs on the boards of high family value funds does not significantly decrease

performance shifting. Specifically, the Relative Number of Directorships and Relative Overlap-

ping Rate are significantly negatively related to performance shifting in both past performance

and total fee cases. In other words, performance shifting to high family value funds at the expense

of low family value funds decreases when the independent directors of low family value funds

have more board affiliations relative to the independent directors of high family value funds.

2Brown and Wu (2016) model a fund’s performance as a combination of a fund-specific component and a common

component shared by all of a family’s funds. They measure the common component using the average manager overlap

rate between the fund and the rest of its family.

Lai rIndependent Directors and Fund Favoritism 531

Phillips, Pukthuanthong, and Rau (2016) find that the fund size and performance relation is

endogenous. In my study, a concern is that IDMAs within a fund family could be endogenously

chosen. To control for the potential endogeneitybias, I identify a set of instruments that influence

the choice of IDMAs, but are unrelated to fund performance. One important instrument draws

on the 2004 amendment of the Investment Company Act that requires a 75% proportion of

independent directors on a mutual fund board. This legislative change, unlikely to be related to

individual fund performance, could have forced noncompliant funds to employa larger number of

independent directors after 2003, including employing more of the same IDMAs to accommodate

the regulatory shock. My results are robust to address the endogeneity of mutual fund board

composition.

Tofurther examine whether IDMAs display fund favoritism, I also examinewhether they engage

in the unequal allocation of underpriced initial public offerings (IPOs). Both Overlapping Rate

(for low performing funds) and Relative Overlapping Rate are significantly negativelyassociated

with the likelihood of preferential allocations of underpriced IPOs to high family value funds

at the expense of low family value funds suggesting that a low family value fund with more

IDMAs on its board is less likely to receive a lower allocation of underpriced IPOs. However, I

have limited evidence that the presence of IDMAs on the boards of high family value funds is

negatively associated with the preferential allocations of underpriced IPOs.

The asymmetric effect of IDMAs, that IDMAs for low family value funds are more effective

than IDMAs for high family value funds in reducing performance/resource shifting, is more

consistent with the Information Hypothesis than with the Favoritism Hypothesis. In particular,

multiple board affiliations enhance the information and bargaining power of IDMAs for low

family value funds, resulting in a decrease in strategic cross-fund subsidization. For IDMAs in

high family value funds, however, performance shifting to enhance the performance of those

funds does not conflict with the interests of the funds’ shareholders. However, it is also unlikely

that IDMAs for high family value funds will prompt unreserved intrafamily fund favoritism.

To some extent, multiple board affiliations help IDMAs for high performing funds to “break

the frame” and view their monitoring role from a perspective other than their own. As a result,

the negative relationship between multiple board affiliations and performance/resource shifting

might become weaker for independent directors in high family value funds.

Next, I investigate three possible channels through which IDMAs benefit funds. First, I revisit

Tufano and Sevick’s (1997) finding that fees are lower when the percentage of the sponsor’s

assets overseen by independent directors is higher. In addition, IDMAs reduce the hidden costs

associated with fund managers’ unobserved actions, such as cross-fund subsidization, window

dressing, or risk-taking in violation of stated investment objectives. To proxy for the unobserved

actions of fund managers, I use the return gap (Kacperczyk, Sialm, and Zheng, 2008). This is

the difference between actual fund performance and the performance of a hypothetical portfolio

that invests in previously disclosed fund holdings where the return gap is negatively related to

the hidden cost of a fund manager. I find that Number of Directorships and Overlapping Rate

are both statistically positively related to the return gap, suggesting that IDMAs increase value

by reducing the possible hidden costs of fund management. When I examine whether IDMAs

increase the return gap for funds with more opaque investment strategies, defined as funds whose

correlation between holdings and investor returns is among the bottom one-third of equity funds

in a given year, I find that IDMAs’ beneficial effect on the return gap is concentrated in funds

with less transparent investment strategies.

IDMAs may also benefit funds through efficient information exchange. Brown and Wu (2016)

find that when funds within a family rely on a shared source of information, such as stock

recommendations issued by the same pool of financial analysts, they are likely to movein similar