Social Capital in Mutual Funds: The Implications for Agency Problem, Governance, and Synergy

Cheng-Min Chuang, National Taiwan University Chih-Pin Lin, Aletheia University, Taiwan ABSTRACT Although agency problem, governance, and synergy in mutual fund industry have been studied in financial literature, the implications of social capital for these issues have not been studied. Using 12,809 investments in open-ended mutual funds collected from Taiwan, this study finds that social capital between mutual funds and their investors results in agency problems. The reciprocal relationships between mutual funds and certain investors may damage other investors, causing agency problems. This study also finds that because formal governance infrastructures are weak in mutual fund industry, investors seek informal social mechanisms to govern agency problems and protect their own interests. Finally, this study finds that social capital is crucial for investment companies, which issue and manage multiple mutual funds, to create synergies with regard to transferring and sharing customer-specific information across mutual funds. INTRODUCTION Investor investment in mutual funds is just like investment in corporate stocks, facing agency problems. Investors invest in mutual funds in the hope that the professional knowledge of fund managers will increase returns and control risk, but in reality this does not necessarily occur. Fund managers may use the proceeds that investors invested to increase their own interests at the expense of investors. When facing agency problems, investors seek corporate governance mechanisms to protect their own interests. In public corporations, investors organize boards of directors, align managerial incentives, and introduce market for corporate control to govern the agency problems (Sundaram and Inkpen, 2004). However, in mutual fund industry, the governance mechanisms are not well-designed (Radin and Stevenson, 2006); namely, investors investing in mutual funds are less protected. Additionally, investment companies, which issue and manage multiple mutual funds, prevail in mutual fund industry in order to create synergies by combining several mutual funds within an investment company. However, the synergies are not empirically significant in literature (Chen, Hong, Huang, and Kubik, 2002). Although agency problem, governance, and synergy in mutual fund industry have been studied in financial literature, the manner in which social capital between mutual funds and investors affects these phenomena is unknown. Social capital describes the goodwill available to individuals or groups from the network of relationships in which they are embedded (Adler and Kwon, 2002). Social capital has proved effective in governing interorganizational relationships and hazardous transactions (Coleman, 1988; Uzzi, 1996; 1997; 1999; DiMaggio and Louch, 1998; Dyer, 1997; Dyer and Singh; 1998; Dyer and Chu, 2003; Gulati, 1995; Chung, Singh, and Lee, 2000; Inkpen and Tsang, 2005; McEvily and Marcus, 2005; Kotabe, Martin, and Domoto, 2003; Peng and Heath, 1996; Subramani and Venkatraman, 2003; Reuer and Arino, 2007; Westphal, Boivie, and Chng, 2006). Additionally, scholars have shown that social capital is important to corporate governance within business groups in emerging economies (Khanna and Palepu, 1997, 2000; Luo and Chung, 2005; Peng, Lee, and Wang, 2005). Nevertheless, the manner in which social capital functions as a corporate governance mechanism for external investors is unknown. However, as argued by Granovetter (1985; 1992), social capital itself may cause malfeasance. This study will investigate the agency problems incurred by social capital. Social capital may bring reciprocal relationships between an investment company and certain investors that damage other investors, causing agency problems. Finally, social capital may create synergies for investment companies. Social capital transfers customer-specific information and knowledge to investment companies though fund-customer ties, which can be used by other mutual