It's a Small World: The Importance of Social Connections with Auditors to Mutual Fund Managers’ Portfolio Decisions

• Published date: 01 June 2022
• Author: YANGYANG CHEN,JUN HUANG,TING LI,JEFFREY PITTMAN
• Date: 01 June 2022
• DOI: http://doi.org/10.1111/1475-679X.12395

DOI: 10.1111/1475-679X.12395

Journal of Accounting Research

Vol. 60 No. 3 June 2022

Printed in U.S.A.

It’s a Small World: The Importance

of Social Connections with Auditors

to Mutual Fund Managers’ Portfolio

Decisions

YANGYANG CHEN,∗JUN HUANG,†TING LI,‡

AND JEFFREY PITTMAN§

Received 17 June 2020; accepted 9 July 2021

ABSTRACT

We find that mutual funds whose managers are socially connected with

firm auditors hold more shares of these firms and generate superior port-

folio returns. Cross-sectional results reveal that the relation between social

∗Department of Accountancy, City University of Hong Kong; †Institute of Accounting and

Finance, Shanghai University of Finance and Economics; ‡School of Accountancy, Shang-

hai University of International Business and Economics; §Faculty of Business Administration,

Memorial University, Pamplin College of Business, Virginia Tech

Accepted by Philip Berger. We appreciate an anonymous reviewer for providing valuable

insights throughout the review process. We have also benefited from the constructive com-

ments on an earlier version of this paper from conference and seminar participants at Shang-

hai Jiao Tong University, Fudan University, Nanjing University, Xiamen University, Virginia

Tech, the Xiamen-Osaka Joint Research Forum in Accounting, the 15th International Con-

ference on Asian Financial Markets and Economic Development, the 2020 Financial Man-

agement Association Annual Meeting, the 2020 Annual Meeting of the American Accounting

Association, and the 2021 European Financial Management Association Annual Conference.

Jun Huang acknowledges financial support from the National Natural Science Foundation of

China (Numbers 71632006, 72072107, and 72172081), the MOE Project of Key Research Insti-

tutes of Humanities and Social Science in Universities (Number 18JJD790011), the 111 Project

(Number B18033), and the Program for Innovative Research Team of Shanghai University of

Finance and Economics. Ting Li acknowledges financial support from the Shanghai Pujiang

Program (Number 18PJC064) and the Ministry of Education Youth Project of Humanities and

Social Science (Number 19YJC790066).

901

© 2021 The Chookaszian Accounting Research Center at the University of Chicago Booth School of

Business.

902 y. chen, j. huang, t. li, and j. pittman

connections and mutual fund stockholdings is more pronounced: when the

social connections are stronger, when the auditor is in a better position or has

stronger incentives to acquire private information, when the fund manager

exercises more power, for small audit firms, for auditors in areas with poor

investor protection, and for public firms with greater business opacity or pri-

vate information. Other results are consistent with fund managers electing

to schedule their corporate site visits to coincide with the fieldwork of their

connected auditors, as would be expected if fund managers time their visits

to meet with these auditors to facilitate information transfer. Additionally, we

observe associations between fund trading prior to earnings surprises and au-

dit opinions, and the presence of social connections between fund managers

and firm auditors. Finally, we show that mutual funds and firms in which they

invest tend to appoint connected auditors and pay them higher fees. Collec-

tively, we document empirical patterns that would arise if socially connected

auditors and mutual fund managers share information.

JEL codes: G11, G23, M42

Keywords: social connections; auditor incentives; mutual fund stockhold-

ing

1. Introduction

As human beings, financial market participants naturally belong to vari-

ous social networks. Prior research analyzes economic outcomes stemming

from social connections between corporate executives and related parties

such as board members (Hwang and Kim [2009], Fracassi and Tate [2012],

Bruynseels and Cardinaels [2014], Cao et al. [2015], Khanna, Kim, and

Lu [2015]), financial analysts (Cohen, Frazzini, and Malloy [2010]), bank

officers (Engelberg, Gao, and Parsons [2012]), and auditors (Guan et al.

[2016]). There are also studies that explore social links between execu-

tives and directors of the acquirer and the target (Ishii and Xuan [2014]),

as well as among CEOs of different firms (Engelberg, Gao, and Parsons

[2013]) and among different venture capitalists (Gompers, Mukharlyamov,

and Xuan [2016]). In this paper, we evaluate empirical associations consis-

tent with mutual fund managers eliciting private information about public

firms through their social connections with auditors of these firms and ex-

ploiting this information in making portfolio decisions.

Mutual fund managers have strong incentives to deliver high returns

to investors because their compensation and career trajectories hinge on

the performance of the fund. To generate superior returns, fund man-

agers need to secure an informational advantage over other investors. Ex-

tensive prior research implies that fund managers tend to invest in local

firms because it is easier to access private and sensitive information about

these firms (Coval and Moskowitz [2001, 1999], Lin, Tian, and Wu [2013]).

Fund managers also obtain private information from their peer networks

(Hong, Kubik, and Stein [2005], Pool, Stoffman, and Yonker [2015],

Rossi et al. [2018]), and through social connections with corporate board

mutual fund manager- auditor social connections 903

members (Cohen, Frazzini, and Malloy [2008]) and financial analysts (Gu

et al. [2019]). In monitoring the financial reporting process, auditors ac-

cumulate extensive private information about their clients (e.g., Reichelt

and Wang [2010], Dhaliwal et al. [2016]). Auditors also secure proprietary

information through informal discussions with top managers and board

members of the client firms. The private information auditors possess is

highly valuable to mutual funds in investing and may flow to fund managers

through their social connections, improving their portfolio decisions.

However, injecting tension into our analysis, socially connected audi-

tors eager to protect their valuable reputations and to avoid violating

professional standards may be reluctant to share private information on

their clients. Indeed, prior research implies that individual auditors in

China suffer severe negative consequences when their reputations are tar-

nished (e.g., He, Pittman, and Rui [2016]). Moreover, similar to other ju-

risdictions, regulators in China prohibit certified public accountants from

divulging confidential client information to third parties. Accordingly,

whether mutual fund portfolio decisions are sensitive to fund manager–

firm auditor social links distils to an empirical question.

We focus on the Chinese market in this study for several reasons. First, it

is well known that “guanxi” (i.e., social connections) dominates socioeco-

nomic activity in China (e.g., Xin and Pearce [1996], Park and Luo [2001]).

Social connections help cultivate trust among related parties in the Chinese

financial markets, which can be exploited to collude against the interests of

others or to arrange privileged access to resources, including private in-

formation. Given the major role that social ties play in China, this market

provides a high-power testing ground for our research questions. Second,

the mutual fund and auditing industries in China are relatively immature

compared to those in developed markets. In China, mutual fund managers

face intense competition from their peers, although governance structures

there remain relatively poor, implying that fund managers have strong in-

centives and wide scope to trade on private information stemming from

“grey” channels. Additionally, the audit market in China is highly compet-

itive and its legal institutions responsible for disciplining auditors against

misbehavior are lax (Chen et al. [2016]), which may make auditors more

willing to share proprietary information with related parties, including so-

cially connected fund managers. Third, we focus on the Chinese market to

capitalize on its unique data availability. For example, public firms in China

are required to disclose the identities of the signatory auditors, which en-

ables us to pinpoint social connections between fund managers and firm

signatory auditors using publicly available data on their educational histo-

ries. We also exploit the unique corporate site visit data in China in devel-

oping a validity test designed to improve identification.1

1Corporate site visits involve institutional investors traveling to firm headquarters and

other facilities to observe the firm’s production activities and operations, and to interview its