The Distorting Effect of the Prudent-Man Laws on Institutional Equity Investments

Abstract

I examine the effect of prudent man laws on the behavior of institutional investors. Variation in exposure to legal liability across types of investment managers allows me to disentangle the effect of the prudent man law from other potential influences on manager behavior. Bank managers significantly tilt the composition of their portfolios toward stocks that are viewed by the courts as prudent, while mutual fund managers do not. I provide evidence that this tilting toward prudent stocks by bank managers is robust over the 1968-1989 period, and is unlikely to be due to passive indexing or limits on allowed portfolio positions. Analysis of aggregate institutional ownership patterns reveals that tilting is also observable in aggregate data, and that this is primarily driven by bank manager tilting. I show that differences in bank and mutual fund managers' tendency to tilt toward prudent stocks may explain their portfolio performance differences over time.

JEL Classification: G20