It is widely accepted that given the right institutional conditions the quality of corporate governance can enhance firm performance in conventional firms (Duggal & Millar 1999; Hermalin & Weisbach 1991; Jackling & Johl 2009). Improving FMC performance is important for a transition economy as those financial institutions form an important aspect of a reforming economy’s path to financial development. It is therefore important to examine whether the quality of corporate governance could impact on firm performance in Chinese fund industry when there is an immature capital market, weak legal enforcement and poor external institutional conditions. The empirical analysis and evidence of this study may provide useful insights for instituting measures to better protect the interests of fund investors. The hypotheses are developed as follows.
Studies on the governance of U.S. mutual funds show that the quality of governance, as measured by governance ratings, plays a significant role in attracting fund investors. However, there is little empirical research on the role of corporate governance quality measured by those governance ratings in assessing fund performance (Chou et al. 2007; Ertugrul & Hegde 2009; Wellman & Zhou 2007).
If higher quality of corporate governance could lower fund expense ratio and enhance fund performance, then it is useful and valuable for fund investors to take governance rating into account when deciding on their investments. In the Chinese context, fund investors could
122
use this information to invest in FMC with good governance or avoiding FMC with poor governance. FMC are more likely to improve their corporate governance to attract more investors, which in return could enhance their performance. Therefore, examining the link between the quality of corporate governance and FMC performance will provide important evidence.
A series of studies in the literature have attempted to investigate the overall quality of a firm’s governance in conventional companies including La Porta, Lopez de Silanes et al. (1998), Gompers, Ishii et al. (2001), Gompers, Ishii et al. (2001) and Bebchuk et al. (2009). Most of them suggest that better corporate governance enhances firm performance.
There are relatively scant studies on how better governance quality may affect fund performance in the fund industry. Using Morningstar’s rating of board directors quality, Lai et al. (2010) examine 461 U.S. equity funds over 2001-2007 showing that good quality board are more responsive to adopt strategic change when performance is poor. Factors considered in measuring the board quality rating in the Morningstar include the nature of past board actions, board independence, director ownership stake, and the quality of board oversight. Wellman and Zhou (2007) document that the quality of fund governance is positively correlated to fund performance. Chou, Ng et al. (2007) show that a fund with better corporate governance ratings tends to invest in firms with strong corporate governance.
The literature on governance rating and fund performance suggests that fund investors ought to make their fund selection based not only on the fund’s past performance, but also fund governance. There has been no study on the Chinese fund industry to provide insight of the efficacy of FMC governance and its ramifications for FMC performance. This study fills a gap in the literature by examining how the overall quality of corporate governance as measured by governance ratings may affect FMC performance. Hypothesis 11 is formulated:
Hypothesis 11: Good governance enhances FMC performance.
The Corporate Governance Index (CGI) constructed by the China Centre for Institutional Investors (CCII at Nanjing University) is used as a proxy for overall quality of corporate governance and is applied to examine its impact on FMC performance in China. There are 7 provisions in the construction of the index including shareholders, board of directors, board independence, supervisory board, investment committee, superior officers and fund manager. For each category, it contains diversified variables underneath in terms of
123
age, sex, education background, position, years of experience, professional background. CGI aims to measure the overall quality of corporate governance in Chinese FMC.
In addition to investigating the link between the overall quality of governance and performance of FMC, this dissertation will also examine the relationship between identified governance mechanisms and FMC performance. It identifies for the Chinese context key internal governance mechanisms from various perspectives including shareholder identity and structure, board of directors, remuneration committee, and supervisory board.
Internal governance mechanisms
Most of the extant studies investigate what types of board composition and characteristics affect fund performance in the U.S. context (Adams et al. 2010; Ding & Wermers 2009; Ferris & Yan 2007; Khorana et al. 2007a; Khorana et al. 2007b; Kong & Tang 2008; Meschke 2007). This dissertation extends the conventional analytical approach by including an analysis of the potential performance impact of FMC ownership structure and concentration, presence of remuneration committee and Chinese supervisory board. It contributes to the studies of the corporate governance of the fund industry with new perspective and evidence.
Shareholder identity and concentration
It is often argued that state ownership harms firm performance in Chinese firms (Li et al. 2009; Nee et al. 2007; Yiu & Lu 2005). Most of the controlling shareholder for Chinese FMC is state-owned financial institutions. Accordingly, in this study we will examine whether the level of ownership stake by state-owned financial institutions in FMC affects FMC performance. Hypothesis 12 is formulated:
Hypothesis 12: Shareholding by state-owned financial institutions in FMC damages FMC performance.
As discussed in Chapter 3, with highly concentrated ownership, controlling shareholder can influence internal governance mechanisms such as the appointment of directors and supervisors’ choice(Hu et al. 2010). As already discussed in Section 4 of this Chapter, a controlling shareholder of Chinese FMC on average holds nearly 47% of total shareholding. And listed companies are usually subject to more rigorous corporate governance mandates and are generally expected to exhibit higher governance standards. It is therefore important to understand better how controlling shareholder affect firm performance. Hypothesis 13 is formulated:
124
Hypothesis 13: A listed company as the controlling shareholder of FMC enhances FMC performance.
A dummy variable will be used to test the effect of the presence of foreign equity ownership in FMC on FMC performance (See hypothesis 14). In the context that Chinese FMC shareholders are not fund investors, how concentrated ownership of FMC may affect performance deserves greater understanding and investigation. Hypothesis 14 and 15 are formulated:
Hypothesis 14: The presence of foreign shareholding in FMC enhances FMC performance. Hypothesis 15: Higher ownership concentration damages FMC performance.
Board characteristics and composition
Using Morningstar Stewardship Grades, both Wellman and Zhou (2007) and Lai, Tiwari et al. (2010) document that the quality of the board is the most important factor among all possible governance factors to explain mutual fund performance. The impact of board composition and characteristic on fund performance is the most researched area.
For instance, Ding and Wermers (2009) provide evidence that larger board composed of larger proportion of independent directors are related to better fund performance. Kong and Tang (2008) show however that none of the governance structures is significantly related to performance when continuous monthly returns (MPF) is used to measure performance, whereas fund with larger boards and boards with more than 75% independent directors actually underperform their peers when using objective-adjusted performance. By contrast, in a sample of 5957 U.S. mutual funds in 2002-2004, Meschke (2007) show that board independence affects fund performance negatively. Using 1406 U.S. equity and bond funds in 2005, Khorana, Servaes et al. (2007a) find that the size of the board, the degree of board independence, and board member compensation exhibit no statistical significance in explaining abnormal performance. Adams, Mansi et al. (2010) find an inverse relation between board size and fund performance but find no evidence that director time constraint such as retirement status, number of funds overseen with the fund family complex, outside directorships, and board of directors tenure are related to fund performance. Ferris and Yan (2007) find that neither chairman nor board independence is related to fund scandals nor fund
125
performance. However, existing studies provide ambiguous results regarding whether and how composition and profile of board of directors could enhance FMC performance.
Literature has shown that having diversity in the board and senior management could potentially impact positively on firm performance (Bantel & Jackson 1989; Carter et al. 2003; Murray 1989; Weippert 2002). This study examines how board size, independence, gender diversity affect FMC performance under China’s contractual form (see Hypotheses 16-19).
Hypothesis 16: Smaller FMC board size enhances FMC performance.
Hypothesis 17: Higher proportion of independent directors enhances FMC performance. Hypothesis 18: A female CEO/ board chair enhances FMC performance.
Hypothesis 19: Board with gender diversity enhances FMC performance.
Executive remuneration and supervisory board
Due to the acute shortage of qualified fund managers in China, fund managers turnover rate is therefore particularly important given managers turnover rate is on average 48% in 2000-2010 (Zou 2011). In 2011, the average tenure for fund managers in 62 FMC was only 2.56 years (Wind database). Song (2012) points out that high turnover rate of fund managers signals the importance for the introduction of performance-based compensation.
It could be argued that one desirable feature of good corporate governance for China's fund industry is to identify skilled managers, and set up the right incentives to motivate and encourage managers to retain their service so they would work longer and better than those FMC having poorer corporate governance practices. A remuneration committee can play an important role to align the interests of shareholders and those of senior managers and fund investors to better protect the interests of investors given fund investors are not shareholders and there is a conflict of interest between FMC shareholders and fund investors. Whether FMC with remuneration committee could enhance performance in contrast to those FMC without remuneration committee will be examined in this study (see Hypothesis 20). In China, supervisors of FMC are also required to play the same role as those in China’s public companies. Hypotheses 20 and 21are formulated:
Hypothesis 20: The presence of remuneration committee enhances FMC performance. Hypothesis 21: Increasing the number of supervisors does not enhance FMC performance.
126
Table 19: List of Hypothesis to test the relation between internal governance mechanisms and FMC performance.
Hypothesis 11: Good governance enhances FMC performance.
Hypothesis 12: Shareholding by state-owned financial institutions in FMC damages FMC performance. Hypothesis 13: A listed company as the controlling shareholder of FMC enhances FMC performance. Hypothesis 14: The presence of foreign shareholding in FMC enhances FMC performance.
Hypothesis 15: Higher ownership concentration damages FMC performance. Hypothesis 16: Smaller FMC board size enhances FMC performance.
Hypothesis 17: Higher proportion of independent directors enhances FMC performance. Hypothesis 18: A female CEO/ board chair enhances FMC performance.
Hypothesis 19: Board with gender diversity enhances FMC performance.
Hypothesis 20: The presence of remuneration committee enhances FMC performance. Hypothesis 21: Increasing the number of supervisors does not enhance FMC performance.