In the new study “The Small World of Investing: Board Connections and Mutual Fund returns,” University of Chicago Graduate School of Business professor Andrea Frazzini and coauthors Lauren Cohen and Christopher Malloy of Harvard Business School study social networks on Wall Street.
Frazzini, Cohen, and Malloy found that mutual fund managers invest more money in companies that are run by people with whom they went to college or graduate school than in companies where they have no such connections. The investments involving school ties, on average, also perform significantly better than other investments.
These associations between firms’ officials and mutual fund managers are worth probing for two reasons. First, the senior officer is likely to possess private information, while the portfolio manager is highly motivated to obtain that information. Second, these associations are especially interesting within the context of the stock market, where the exchange of private information can impact stock prices.
“This topic interested us because, particularly on Wall Street, a lot of people place emphasis on where they went to school,” says Frazzini. “We wanted to see if it was true that being connected to a particular firm through this shared educational network has an impact on whether a stock is purchased and how it is traded.”
Levels of Connections
Frazzini, Cohen, and Malloy began with the hypothesis that
mutual fund managers are likely to place larger bets on
firms run by those they know through a collegiate connection,
and that they earn higher average returns on these
investments.
To test that hypothesis, the authors focused on the willingness of mutual fund portfolio managers to trade with firms headed by senior officials with a college connection versus firms with no connection.
The authors identified different types of educational connections. In the weakest kind of connection, a fund manager and one of a company’s top three executives attended the same university. They could have attended different schools within the university and have been on the campus decades apart. The benefits of these connections might flow from merely participating in the same alumni network. In the strongest connection, a fund manager and one of the top three executives attended the same school at the same university, and their time on campus overlapped.
Based on their study of 1,648 actively managed U.S. equity funds and 2,501 portfolio managers between January 1990 and December 2006, the authors found fund managers nvested considerably more in securities of firms headed by senior officials who attended the same college as the fund manager. Allocations to such securities increased with the strength of the connection between the two individuals.
Profiting from a Connection
Having determined fund managers do invest more heavily
in “connected stocks,” the authors next studied whether
those choices earn higher than average returns. In examining
all available stocks and funds during the period studied,
and focusing on the highest degree of connection, the
authors found that the funds’ investments in connected
firms outperform their nonconnected counterparts by 8.4
percent each year.
“The clear conclusion is that educational networks matter,” says Frazzini. “Mutual funds tied to an educational network outperform on those specific investments, and do so significantly.”
Recognizing that information provided by education connections led fund managers to make investment decisions, the authors researched whether most of the managers’ gains came when “news” was incorporated into prices. They found disproportionately larger returns in connected versus nonconnected portfolios in months when information was released to the investing public in the form of public announcements.
“That finding is consistent with fund managers having accessed information prior to a public announcement,” says Frazzini. “We have no proof of that, of course. One hypothesis is that insider trading was involved. An alternative hypothesis is that the fund manager knows the CEO is a talented and bright individual from having attended school with him, and places his bet in that company. We can’t distinguish the difference.”
Finally, Frazzini, Cohen, and Malloy tested whether changes in managers of funds influenced those funds’ portfolio allocations. Consistent with their school connections findings, their results showed incoming managers substantially reduced holdings in firms connected to the former manager, while simultaneously allocating more to holdings in firms to which they are connected.
“For example, when a fund manager from Stanford is replaced by a manager from Yale, she sells all the stocks of the Stanford manager unconditionally,” says Frazzini. “Then she immediately buys new stocks of companies in her own education network.”
These findings suggest that social networks are an important source of information flow between firms and investors. The evidence is consistent with the hypothesis that the social network formed through education links allows portfolio managers to gather information on firms, and use it to make better investment decisions.
A Systematic Effect
The authors note that what they documented through
their examination of education networks is not an isolated
situation or constrained to a few portfolio managers or
firms. Rather, it is a systematic effect across the entire
universe of U.S. firms and portfolio managers.
Frazzini, Cohen, and Malloy’s study suggests that future research should examine different forms of social networks and to what extent different types of information are delivered across different networks. Understanding these issues can provide a better idea of how information flows and how investors receive information in security markets, allowing researchers to better predict how and when prices will respond to new information.
“The Small World of Investing: Board Connections and Mutual Fund
Returns.”
Lauren Cohen, Andrea Frazzini, and Christopher Malloy.