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Author:

• Dr. Xin Wang
  Associate Professor of Accounting
  School of Business
  The University of Hong Kong

Abstract:

We examine whether international equity investors shift their portfolios toward stocks with higher financial reporting quality during periods of high political uncertainty. Our study is motivated by two primary factors. First, prior research shows evidence of investors’ “flight to quality” (e.g., to less risky securities) during periods of uncertainty. Second, recent theoretical research concludes that stocks with higher disclosure quality are assessed as less sensitive to systematic risk (such as political uncertainty). In our study, we employ national elections as exogenous increases in systematic risk. Elections are accompanied by significantly increased political uncertainty that is largely outside the control of firms and investors. In addition, national elections take place at different points in time across countries, which controls for possible confounding events such as global macro-economic trends. Using a large international sample of mutual funds that focus on local markets, we find that international mutual-fund managers shift their equity holdings to stocks with higher financial reporting quality during election periods when political uncertainty is higher. The flight-to-quality effect is less pronounced for elections with larger expected electoral margins in the pre-election period (i.e., when the incumbent is more likely to win the elections) and for countries with higher transactions costs. In contrast, the effect is more pronounced when governments have greater involvement in the local economy. Our inferences are robust to alternative proxies for political uncertainty and financial reporting quality and to numerous other sensitivity analyses.