It’s a Small World: The Importance of Social Connections with Auditors to Mutual Fund Managers’ Portfolio Decisions

Abstract

We find that mutual funds whose managers are socially connected with firm auditors hold more shares of these firms and generate superior portfolio returns. Cross-sectional results reveal that the relation between social connections and mutual fund stockholdings is more pronounced: when the social connections are stronger; when the auditor is in a better position or has stronger incentives to acquire private information; when the fund manager exercises more power; for small audit firms; for auditors in areas with poor investor protection; and for public firms with greater business opacity or private information. Other results are consistent with fund managers electing to schedule their corporate site visits to coincide with the fieldwork of their connected auditors, as would be expected if fund managers time their visits to meet with these auditors to facilitate information transfer. Additionally, we observe associations between fund trading prior to earnings surprises and audit opinions, and the presence of social connections between fund managers and firm auditors. Finally, we show that mutual funds and firms in which they invest tend to appoint connected auditors and pay them higher fees. Collectively, we document empirical patterns that would arise if socially connected auditors and mutual fund managers share information.

Keywords: Social Connections, Auditor Incentives, Mutual Fund Stockholding

JEL Classification: G11, G23, M42