Institutional Monitoring: Evidence from the F‐Score

• DOI: http://doi.org/10.1111/jbfa.12123
• Published date: 01 September 2015
• Author: Kainan Wang,Blerina Bela Zykaj,Chune Young Chung,Chang Liu
• Date: 01 September 2015

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 42(7) & (8), 885–914, September/October 2015, 0306-686X

doi: 10.1111/jbfa.12123

Institutional Monitoring: Evidence from

the F-Score

CHUNE YOUNG CHUNG,CHANG LIU,KAINAN WANG AND BLERINA BELA ZYKAJ∗

Abstract: The extant literature shows that institutional investors engage in corporate gover-

nance to enhance a firm’s long-term value. Measuring firm performance using the F-Score,

we examine the persistent monitoring role of institutional investors and identify the financial

aspects of a firm that institutional monitoring improves. We find strong evidence that long-

term institutions with large shareholdings consistently improve a firm’s F-Score and that

such activity occurs primarily through the enhancement of the firm’s operating efficiency.

Other institutions reduce a firm’s F-Score. Moreover, we find evidence that, while monitoring

institutions improve a firm’s financial health, transient (followed by non-transient) institutions

trade on this information.

Keywords: institutional investor, F-Score, monitoring, financial strength

1. INTRODUCTION

Institutional investors’ stake in the equity market has significantly increased in the last

few decades, leading to many studies on the role of institutional investors in corporate

governance. This issue became even more important leading up to and during the

recent financial crisis, when institutional investors exerted an allegedly negative impact

on the market by pressuring management to increase risk-taking behavior for more

short-term profits (e.g., Della Croce et al., 2011; and Erkens et al., 2012).

The literature offers two opposing views on this subject: an institution could take

either a passive role (i.e., with a short-term focus and little incentive to influence firm

management) or an active monitoring role (i.e., with strong incentives to improve

firm management through monitoring). Bushee (1998, 2001) classifies institutional

investors based on their implied incentives and shows that transient institutional

owners (i.e., institutions with high portfolio turnovers and a reliance on momentum

trading) encourage myopic activities and, if present in large numbers, may cause

managers to focus on short-term investments. By contrast, non-transient institutional

∗The first author is from the School of Business Administration, College of Business and Economics, Chung-

Ang University, Seoul, Korea. The second author is from the Department of Financial Economics and

Information Systems, College of Business, Hawai’i Pacific University, Honolulu, HI. The third and fourth

authors are from the Department of Finance, College of Business and Innovation, University of Toledo,

OH. The authors gratefully acknowledge the helpful comments of Editor Peter F.Pope and one anonymous

referee that greatly improved the paper.

Address for correspondence: Kainan Wang, Department of Finance, College of Business and Innovation,

University of Toledo, OH 43606, USA.

e-mail: kainan.wang@utoledo.edu

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owners play a monitoring role in the firm by restraining managers’ myopic behaviors.

In the same spirit, Chen et al. (2007) use a cost–benefit framework to study the

attributes of institutions that are likely to be firm monitors, showing that not all

institutions have the incentives and means to monitor firm management. Rather,

independent and long-term institutions with large shareholdings are more likely to

engage in monitoring behaviors.1Yan and Zhang (2005) also argue that institutional

investors have different investment horizons due to differences in investment ob-

jectives, restrictions, and styles. They show that short-term institutions – institutions

with high portfolio turnovers and a short-term investment strategy (i.e., transient

institutions) – are more informed than other institutions and are thus more likely to

trade on information about firm value rather than monitor firm management because

the monitoring benefits would realize only in the long term, conflicting with their

short-term-focused investment strategy.

The ultimate goal of institutional monitoring is to improve a firm’s financial

strength, which in turn increases future stock returns.2Studies have captured the

monitoring effect of institutions by focusing on specific corporate events. For example,

research has examined institutional investors’ influence on executive compensation,

R&D investments, seasoned equity offerings, mergers and acquisitions, earnings

management, payout policy, and CEO turnover. Specifically, these studies gauge the

effectiveness of institutional monitoring by examining stock returns around a major

firm event.

These studies produce mixed evidence about whether institutional investors ef-

fectively monitor management and/or whether their governance actions increase

firm value. Some papers focus on ‘institutional activism’ and argue that institutional

investors actively monitor the firm and that such monitoring is effective. For example,

O’Barr and Conley (1992) find that institutional investors utilize proxy contests to

affect important firm decisions such as antitakeover amendments, R&D investments,

and CEO compensation. Karpoff (1999) and Gillan and Starks (2000) show that insti-

tutional investors actively influence corporate governance by presenting shareholder

proposals at shareholder meetings. Other more recent studies show that institutions

broadly influence managers’ value-maximizing decisions such as R&D investments

(Bushee, 1998), executive compensation (Almazan et al., 2005), privatization (Weir

et al., 2005), and capital structure (Chung and Wang, 2014). Thus, these studies find

empirical evidence that monitoring institutions (i.e., large shareholders with long-

term investment strategies) have incentives to monitor firm management and that

their monitoring is effective.

However, some papers find counter-evidence about active institutional monitoring.

For instance, Smith (1996) and Del Guercio and Hawkins (1999) show that active

institutional monitoring may not substantially influence firm performance, and Coffee

(1991) and Bhide (1994) find that the costs of active monitoring can be greater

than its benefits. Given the increased market liquidity of recent decades, it may

1 Other studies also find empirical evidence that institutions with large shareholdings reap greater benefits

than smaller investors with a short-term horizon from collecting information and improving corporate

governance, as vigorous monitoring consequently improves firm value. These investors tend to influence

firm management to ensure that they maintain the objective of maximizing the firm’s long-term value rather

than meeting short-term earnings goals (Shleifer and Vishny, 1986, 1997; Dobrzynski, 1993; Huddart, 1993;

Monks and Minow, 1995; Gillan and Starks, 2000).

2 The monitoring role of institutional investors does not contradict or substitute for their informational

advantage and may, in fact, even be enhanced by it.

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