POLICY RESEARCH WORKING PAPER 1578

# Summary findings

Institutional investors have become tremendously important in U.S. capital markets in recent years. But a study of 557 U.S. manufacturing firms (1985-90) shows the role of such investors to be mixed. Results show the following:

* Institutional ownership has a positive effect on capital spending but apparently a negative effect on research and development spending and no effect on advertising expenditures. So, institutional ownership might contribute to a firm's underinvestmcnt in intangible assets and hence exacerbate managerial myopia.

* Institutional investors are complex institutions, so the regulatory and investment environment in which they operate must be carefully designed. The institutionalization of the stock market (its domination by institutional investors rather than individuals) happened gradually in the United States and some other industrial countries and may happen gradually in developing countries as their financial markets are reformed and deepened.

There is a fundamental conflict between liquidity and control as objectives on institutional investment. In the United States, liquidity has been the dominant objective and "exit" rather than "voice" has been the preferred option of institutional investors on corporate governance issues. But recently "voice" has begun to be a more important objective.

* Institutional investors' monitoring and disciplinary activities may (through corporate governance) substitute for the disciplinary and signaling roles of debt. But there is no definite evidence that institutional ownership by itself improves firm performance. Still, activism by institutional investors has replaced takeovers as the central mechanism of corporate government in the United States in the 1990s.

The implication for developing countries: encourage institutional ownership of equity, and promote activism among institutional investors.

The U.S. experience cannot always be generalized to other countries, but it does demonstrate that such activism can be a viable alternative to takeovers as a vehicle for corporate governance. It is also important for curbing the excesses of managerial discretion and maximizing shareholder values.

This paper is a product of the Operations Policy Group, Operations Policy Department. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Cherian Samuel, room S 13-059, telephone 202-4730802, fax 202-477-6987, Internet address csamuel@worldbank.org. March 1996. (45 pages)

**_The_** _Policy_ **_Researche_** _Working Paper_ **_Series_** _disseminates_ **_the_** _findings of work in progress to encourage_ **_the_** _exchange of ideas about development issues. An_ **_objective_** _of_ **_the series_** _is to get the findings out quickly,_ **_even_** _if_ **_the_** _presentations_ **_are less_** _than fully polished._ **_The_** _papers carry_ **_the_** _names of_ **_the_** _autbors and should_ **_be_** _used and cited accordingly._ **_The_** _findings, interpretations, and conclusions_ **_are the_** _authors'_ **_oun_** _and should not_ **_be_** _attributed to_ **_the_** _World Bank, its Executive Board of Directors, or any of its_ **_member countries._**

Produced by the Policy Research Dissemination Center