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Bloopers & Blunders: Mutual Funds & Disciplining Corporate CEOs

"To keep investors from dropping out of their funds, managers will quickly unload a poor-performing stock. Witness the mutual funds' frenzied trading activity. Fidelity alone, for instance, accounts for about 8% of the daily trading volume of stocks listed on the New York Stock Exchange. With that kind of clout, CEOs listen.

Dumping stock is not the only way mutual fund managers are putting pressure on CEOs these days. As funds have grown larger and have taken huge positions in individual stocks, it's become more difficult to unload the lemons and find an adequate replacement of equal size. As a result, more and more fund managers are choosing, instead, to stick with a sagging stock and duke it out with the company's managers." Fortune, April 29 1996.

Don’t these two paragraphs seem contradictory? The first is saying that mutual funds are disciplining corporate managers by dumping the stocks of poorly performing companies, while the second is saying that large mutual funds are unable to dump underperforming stocks.

Also consider the second sentence of the first paragraph. Does it seem like they are trying to justify the large daily transaction volume of mutual funds as evidence of their disciplining power over corporate CEOs?

This does not necessarily make sense because stock prices can be falling, or are expected to fall, due to factors beyond the control of management. For example, if a fund manager expects the price of a stock to go down, for whatever reason, then the fund manager would be dumping that stock even if that company’s manager is doing a great job. Consider a simple illustration. Suppose you are a fund manager and you expect a recession in the U.S. or expect bonds to be performing better than stocks, say, for the next 6 months. Wouldn’t you be selling U.S. stocks? If you said yes, your decision had nothing to do with the managerial capabilities of corporate CEOs.

Thus, high selling volume by mutual funds does not necessarily imply that they are disciplining corporate managers.

By Alex Tajirian