This paper uses social networks to identify information transfer in security markets. We focus on connections between mutual fund managers and corporate board members via shared education networks. We find that portfolio managers place larger bets on firms they are connected to through their network, and perform significantly better on these holdings relative to their non-connected holdings. A replicating portfolio of connected stocks outperforms a replicating portfolio of non-connected stocks by up to 7.8% per year. Returns are concentrated around corporate news announcements, consistent with mutual fund managers gaining an informational advantage through the education networks. Our results suggest that social networks may be an important mechanism for information flow into asset prices. Key words: Social networks, private information, connections, portfolio managers, boards The Small World of Investing -Page 1 Information moves security prices. How information disseminates through agents in financial markets and into security prices, though, is not as well understood. We study a particular type of this dissemination in the form of social networks. Social networks are network structures composed of nodes (usually people or institutions) that are connected through various social relationships ranging from casual to close bonds. In the context of information flow, social networks allow a piece of information to flow, often in predictable paths, along the network. Thus, one can test the importance of the social network in disseminating information by testing its predictions on the flow of information. One convenient aspect of social networks is that they have often been formed ex-ante, sometimes years in the past, and their formation is frequently independent of the information to be transferred. In this paper we explore a specific type of social network that possesses exactly this feature: connections based on shared educational backgrounds. The nodes of our social networks are mutual fund portfolio managers and senior officers of publicly traded companies. We believe these two agents provide a useful setting because one side likely possesses private information, while the other side has a large incentive to access this private information. Further, the stock market is an ideal laboratory to examine private information flow through a social network because of the information's eventual revelation into prices, and so easy relation to stock return predictability. Our tests focus on educational institutions providing a basis for social networks. We use academic institutions attended for both undergraduate and graduate degrees as our network measure, and test the hypothesis that mutual fund managers are more likely to place larger bets in firms run by individuals in their network, and to earn higher average returns on these investments. We motivate the use of educational institutions in three ways. First, people often select into undergraduate and graduate programs made up of social groups having aligned interests to their own, generating both a higher level of interaction and a longer relationship length from relationships built. (2001)) and that communication between parties is more effective when the two parties are more alike (Bhowmik and Rogers (1971)). There are a number of potential ways information could be moving through networks. First, there could be a direct transfer from senior firm officers to portfolio managers. Second, the networks could simply lower the cost of gathering information for portfolio managers. So, for instance, it may take fewer calls, or people may be more forthcoming with information if they are inside the network. This explanation would be a case where agents have comparative advantages in collecting certain types of information. Third, it could be that networks may make it cheaper to access information on managers, and so assess managerial quality (for similar reasons as above). We are not able to completely rule out any of these mechanisms, although our results are generally less consistent with a story based on superior assessments of managerial quality. To test whether information is disseminated through education networks, we use the trading decisions of mutual fund portfolio managers in firms that have senior officials in their social network (connected firms) and firms that do not (non-connected firms). Grossman and Stiglitz (1976) offer a simple intuition that when agents have comparative advantages in collecting certain types of information, we should observe them earning abnormal returns to this information. We attempt to identify precisely those situations where portfolio managers are expected to have a comparative advantage from their respective social networks. We then examine both their portfolio allocation decisions, and ability to predict returns, in both the connected and non-connected classes of stocks. Our results reveal a systematic pattern, in both holdings and returns, across 2 Data from The Giving Institute. In 2005, 15% of charitable donations ($38.6 billion) were given to educational institutions. The largest recipient, religious organizations, received 36% ($93.2 billion) (Giving USA (2006)). The Small World of Investing -Page 3 the entire universe of US mutual fund portfolio managers: fund managers place larger concentrated bets on companies to which they are connected through an education network, and perform significantly better on these connected positions than on non-connected positions. We create calendar time portfolios that mimic the aggregate portfolio allocations of the mutual fund sector in connected and non-connected securities and show that portfolio managers earn higher returns on their connected holdings. A strategy of buying a mimicking portfolio of connected holdings and selling short a mimicking portfolio of non-connected holdings yields returns up to 7.84% per year. Furthermore, the portfolio of connected stocks held by portfolio managers outperforms the portfolio of connected stocks that managers choose not to hold by 6.84% per year. Both the portfolio allocation and return predictability results are increasing with the strength of the connection. We also examine the returns of connected and non-connected stocks around news events. If the higher return on connected securities is due to information flow through the network, we would expect to see the bulk of the return premium when the news is eventually released to the investing public. Consistent with this hypothesis, we find that nearly the entire difference in returns between holdings within and outside a manager's network is concentrated around corporate news announcements. We then look at changes in a fund's portfolio manager, and focus on the specific case where the previous manager and the new manager share no educational connection. We find that incoming managers unload securities within the old manager's network, and at the same time purchase securities within their own network. We test a number of alternative hypotheses. We include firm characteristics, fund characteristics, and industry dummies, none of which can explain managers' large bets on connected stocks or the abnormal returns managers earn on these connected positions. We also show that our results are not driven by the geographical effects documented in Coval and Moskowitz (2001), by the "SAT effect" document in Chevalier and Ellison (1999) and described below, by small The Small World of Investing -Page 4 managers, by a few top schools (ex. Ivy League), by a certain type of firm, or by a certain part of our sample period. Our work links a large literature on the portfolio choices and investment performance of mutual fund managers with a growing literature on the role of social networks in economics. The strand of the mutual fund literature most closely related to our paper is the body of work exploring whether mutual fund managers possess stock-picking ability. The evidence on this question is decidedly mixed.
Similar preferential behaviour is found in other areas, for example reference REF reports on American fund managers investing more money in firms run by people who were known via shared education networks.
2008): “The Small World of Investing: Board Connections and Mutual Fund Returns
691] DUBEY,P.,J.GEANAKOPLOS, AND S. SHUBIK
Business Economics