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Active fund managers and earnings management at portfolio companies

Active fund managers and earnings management at portfolio companies
Active fund managers and earnings management at portfolio companies

Purpose: This paper aims to examine the association between the types of mutual funds, i.e. active versus passive, and the level of earnings manipulation in companies that comprise their stock portfolios. Design/methodology/approach: The authors use Cremers and Petajisto’s (2009) classification of mutual funds by active share and tracking error volatility to differentiate between active and passive mutual funds. To assess the extent of earnings quality at portfolio companies, the authors measure accruals earnings management and real earnings management. Findings: The authors find that the portfolio firms held by active fund managers exhibit lower levels of earnings manipulation. The inverse relationship between earnings management and fund holdings is more pronounced at higher levels of active share selection among concentrated active fund managers. Practical implications: The degree to which earnings management influences mutual funds’ investment behavior has significant implications for the stability of the US stock market. Based on the findings that earnings management at portfolio companies serves as a potential instrument to guide funds’ investment decisions, future research would examine how these investment preferences exert price pressure (if any) on the stock of the portfolio companies. It would also help to ascertain whether the investment preferences of fund managers with respect to earnings management help to render the stock market more or less efficient. Originality/value: This paper contributes to the understanding of how actively managed funds perform stock selection. Earnings manipulation leads to negative earnings quality that would inhibit stock performance over time. Active fund managers, who dynamically manage their exposures to systematic and stock-specific risks (in their attempt to outperform their benchmark index), target firms that manage earnings less to form part of their investment portfolios.

Accruals management, Active versus passive funds, Earnings management, Mutual funds, Real activities manipulations
1475-7702
Farooqi, Javeria
89427a1b-b742-4c3e-b978-b8c57de2b774
Jory, Surendranath
2624eb24-850a-48f6-b3c6-c96749b87322
Ngo, Thanh
852ea7b9-fd74-4a39-9281-87626e50886b
Farooqi, Javeria
89427a1b-b742-4c3e-b978-b8c57de2b774
Jory, Surendranath
2624eb24-850a-48f6-b3c6-c96749b87322
Ngo, Thanh
852ea7b9-fd74-4a39-9281-87626e50886b

Farooqi, Javeria, Jory, Surendranath and Ngo, Thanh (2019) Active fund managers and earnings management at portfolio companies. Review of Accounting and Finance. (doi:10.1108/RAF-11-2017-0209).

Record type: Article

Abstract

Purpose: This paper aims to examine the association between the types of mutual funds, i.e. active versus passive, and the level of earnings manipulation in companies that comprise their stock portfolios. Design/methodology/approach: The authors use Cremers and Petajisto’s (2009) classification of mutual funds by active share and tracking error volatility to differentiate between active and passive mutual funds. To assess the extent of earnings quality at portfolio companies, the authors measure accruals earnings management and real earnings management. Findings: The authors find that the portfolio firms held by active fund managers exhibit lower levels of earnings manipulation. The inverse relationship between earnings management and fund holdings is more pronounced at higher levels of active share selection among concentrated active fund managers. Practical implications: The degree to which earnings management influences mutual funds’ investment behavior has significant implications for the stability of the US stock market. Based on the findings that earnings management at portfolio companies serves as a potential instrument to guide funds’ investment decisions, future research would examine how these investment preferences exert price pressure (if any) on the stock of the portfolio companies. It would also help to ascertain whether the investment preferences of fund managers with respect to earnings management help to render the stock market more or less efficient. Originality/value: This paper contributes to the understanding of how actively managed funds perform stock selection. Earnings manipulation leads to negative earnings quality that would inhibit stock performance over time. Active fund managers, who dynamically manage their exposures to systematic and stock-specific risks (in their attempt to outperform their benchmark index), target firms that manage earnings less to form part of their investment portfolios.

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Accepted/In Press date: 9 January 2019
e-pub ahead of print date: 27 June 2019
Keywords: Accruals management, Active versus passive funds, Earnings management, Mutual funds, Real activities manipulations

Identifiers

Local EPrints ID: 432697
URI: http://eprints.soton.ac.uk/id/eprint/432697
ISSN: 1475-7702
PURE UUID: 69d26e35-5188-460f-bafb-2763b91d32f4
ORCID for Surendranath Jory: ORCID iD orcid.org/0000-0002-8265-0001

Catalogue record

Date deposited: 24 Jul 2019 16:30
Last modified: 28 Apr 2022 02:08

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Contributors

Author: Javeria Farooqi
Author: Thanh Ngo

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