Financial Reporting Fraud and Delegated Investment

Abstract

Following the public revelation of financial reporting fraud against a company in their portfolio, professional money managers decrease (increase) their holdings in stocks with high (low) expected financial reporting fraud risk, reduce the total risk level of their funds, and allocate their portfolios closer to their respective benchmarks. Portfolio managers exposed to financial reporting fraud rely less on accounting information in their trading decisions subsequently, suggesting that fraud alters the behavior of investment managers by reducing their trust in security issuers. The results provide insight into the implications of fraud for professional investment decisions.

Keywords: financial reporting fraud, trust, mutual funds, trading behavior

JEL Classification: G14, G40, K42