The real effects of local mutual funds: Evidence from corporate innovation

• Published date: 01 June 2023
• Author: Hyoseok (David) Hwang
• Date: 01 June 2023
• DOI: http://doi.org/10.1111/irfi.12398

ORIGINAL ARTICLE

The real effects of local mutual funds: Evidence

from corporate innovation

Hyoseok (David) Hwang

College of Business, University of Wisconsin

at Eau Claire, Eau Claire, United States

Correspondence

Hyoseok (David) Hwang, College of Business,

University of Wisconsin at Eau Claire, Eau

Claire, WI, United States.

Email: hwangh@uwec.edu

Funding information

University of Wisconsin-Eau Claire Small

Research Grants Program

Abstract

This paper investigates whether the proximity between

mutual funds and firms could explain corporate innovation.

I find that local mutual funds tend to increase firms' R&D

expenditures and productivity. Firms with greater local

ownership produce more patents and patents with bigger

impact. The positive relations are more pronounced for

firms with low information quality and poor corporate gov-

ernance. Further, local funds with more innovative firms

outperform the ones with less innovative firms. Finally,

firms with higher local ownership are less likely to fire CEOs

who engage in innovation, which incentivizes CEOs for

risky investments.

KEYWORDS

corporate innovation, information advantage, local mutual fund,

monitoring effectiveness

JEL CLASSIFICATION

D82, G23, G32, O30

1|INTRODUCTION

One of the key factors that drive economic growth is corporate innovation. How to spur innovations and what pro-

motes inventive activities in corporations have been important questions for firms and policy makers as well as aca-

demics. Among the investigations into the forces behind innovation, this study focuses on local institutional

investors, that is, local mutual funds. Whether mutual funds (or overall institutional investors) encourage corporate

innovations is in debate. While some argue that the frequent trading and short-term focus of institutional investors

encourage managers to engage in myopic investment behavior (e.g., Porter, 1992), others suggest that institutional

investors are long-term investors and look for economic gains from firm innovation (e.g., Aghion et al., 2013).

Received: 6 July 2021 Revised: 14 June 2022 Accepted: 30 September 2022

DOI: 10.1111/irfi.12398

© 2022 International Review of Finance Ltd.

272 International Review of Finance. 2023;23:272–300.

wileyonlinelibrary.com/journal/irfi

In addition, Bushee (1998) finds that high-turnover and momentum investors lead to myopic investment behavior,

otherwise institutional ownership serves for long-term investment, indicating that the type and the objective of insti-

tutional investors influence firm investment policy. While the literature emphasizes types, objectives, size, or the

investment-horizon of institutional ownership with respect to corporate innovation, this study investigates the

effects of the proximity between institutional investors and their portfolio firms on corporate innovation.

The geographical proximity between financial institutions and their investments has been studied in the areas of

mutual fund performance (Coval & Moskowitz, 2001), proprietary trading profits (Hau, 2001), hedge fund perfor-

mance (Teo, 2009), and equity analysis (Malloy, 2005). Asset proximity provides information advantages to close

investors over distant investors, suggesting geographical distance as a proxy for informational costs. As informational

costs are relatively lower for near firms, investors could monitor the firms effectively and obtain a better understand-

ing of their local investments (Chhaochharia et al., 2012). Consequently, this would help firms to engage in inventive

activities as the contracting and monitoring costs associated with innovations otherwise tend to be large relative to

routine investments (Francis & Smith, 1995).

Corporate innovations require long-term commitments along with a significant amount of resources.

1

Further-

more, a high probability of failure in producing outcomes (e.g., patents, related products, and eventual cash flows)

creates enormous uncertainty and information asymmetry between investors and innovative firms, which results in a

higher cost of capital for the firms. Therefore, corporate innovation often faces serious financing constraints

(Cornaggia et al., 2015; Hsu et al., 2014). In addition, agency conflicts arising from managers' career concerns and

their preference for the quiet life hinder corporate innovation (Aghion et al., 2013; Atanassov, 2013). Manso (2011)

argues that firms need an innovation-motivating incentive contract that would require substantial tolerance for early

failure and reward for long-term success. Without such an optimal incentive contract—the sub-optimal contract

problem, managers are discouraged to engage in innovation.

My conjecture is that distinctive features of local mutual funds over distant funds could help address those con-

cerns and motivate firms to innovate better. The important characteristics of local funds include that they are better

informed, more effective in monitoring, and thus likely tolerate for short-term failure.

2

Having information asymme-

try and agency problems of innovative firms, investors may want to put their money toward nearby and easy-to-

access firms (Coval & Moskowitz, 1999),

3

and they are willing to visit corporate sites more often (Cheng et al., 2018;

Jiang & Yuan, 2018).

4

Investors close to firms can easily talk to their employees, managers, and suppliers (key chan-

nels for private information). They may be able to obtain important information from the local media and may have

close personal ties with local executives. The lower cost for obtaining information and better understanding of cor-

porate projects provide local investors with an incentive to hold and support otherwise risky investments. This even-

tually allows local funds to monitor firms more effectively and likely to keep managers who engage in inventive

activities, thereby spurring corporate innovation.

Using mutual fund average holdings and innovation measures, I find that local mutual funds lead firms to greater

corporate innovation. Mutual funds investing in local firms tend to increase the firms' research and development

(R&D) expenditures as well as R&D productivity. The results show that a 1% increase in local ownership in firms, on

average, boosts R&D expenses by around 4%.

5

Following innovation literature such as He and Tian (2013), I control

for several variables that are associated with corporate R&D expenses.

6

Although R&D expenses largely represent a firm's endeavor for innovation, it only captures innovation input. As

literature suggests, patent-related variables are better for measuring innovation because they reflect the successful

output of the firm's effort. Therefore, I include patent counts and citation-weighted patent counts for empirical anal-

ysis (Aghion et al., 2013; Fang et al., 2014; He & Tian, 2013). In addition, I employ a measure developed by Kogan

et al. (2017), calculating the economic value of innovations based on stock market reactions to patent grants.

7

The

advantage of using financial data is that asset prices are forward-looking and, hence, provide us with an estimate of

the economic value to the patent holder based on ex ante information. This economic value, however, need not coin-

cide with the scientific value of the patent—typically assessed using forward patent citations (i.e., citation-weighted

patent counts). Using the patent-related variables, I find that firms with higher local fund ownership tend to produce

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