CLS Blue Sky Blog

How Institutional Ownership and Board Diversity Affect Innovation

In a new paper, we investigate the relationships between institutional ownership, board diversity, and corporate innovation in U.S.-listed firms. Institutional investors play a crucial role in a firm’s operation and exert considerable influence on the efficient monitoring of innovative investment. Theory predicts that institutional ownership has a positive effect on innovation investment. However, after separating the institutional investors into eight types and two categories – active (investment company, independent investment adviser, public pension fund) and passive (bank trust, insurance company, private pension fund, university and foundation endowments, miscellaneous) — we find that active institutional investors drove this positive relationship. A one standard deviation increase in active institutional ownership would increase the R&D investment ratio by 0.767 percent and have an even larger positive effect on the patent outputs and innovation efficiency.

The active institutional investor can influence the allocation of scarce resources to innovation investment and monitor how investments are used. With their information-processing capacity and large shareholdings, these investors tend to motivate a firm’s top managers to pay close attention to  innovation investment. The contracts for top managers of publicly listed firms are typically very short-term and do not shield the managers from the long-term reputational effects of failed innovation. The shareholders from active investors therefore become influential.

As for passive institutional investors, their impact on innovation is often negative and insignificant. The plausible reasons are that passive institutional investors mainly seek to maximize returns by holding a representative benchmark rather than monitoring  firms and encouraging them to invest long-term.

However, a banker on a board can change the effect of passive institutional investors on innovation from negative to positive by monitoring and advising, both of which can enhance firms’ innovative incentives.  As noted, more than 30 percent of the largest U.S. companies have bankers on their boards (Kroszner and Strahan, 2001), and they are influential in corporate decisions.

Female directors, substantial audit committee, and a large proportion of ethnic minority directors have a significant and positive impact on innovation. These findings imply that better audit quality, minority directors, and a female appointment to the board improved board monitoring and diversified advice and willingness to make risk-taking investments and promote innovation.

We measure innovation in three ways: innovation inputs, measured by the R&D expenditure ratio; innovation outputs, measured by the natural logarithm of 1 plus the number of granted patents; and innovative efficiency (IE), measured by patents granted in year t scaled by the R&D capitalization in years t-2 to t-6 (Hirshleifer et al., 2013). Our institutional investor data are obtained from a databased of  Form 13F filings. Our information about board diversity is taken from the BoardEx database, including the percentage of directors who serve as audit committee members, the proportion of ethnic minorities on a board, the number of women on a board, board size, board independence, and CEO duality.

We use the Sarbanes-Oxley (SOX) Act as a shock to investigate how institutional investors affect corporate innovation since SOX seemed to generate improvements in financial transparency and the quality of information disclosure (Engel et al., 2007). We use difference-in-differences (DID) analysis, with the five-year window centered on the event year to examine this shock. We first identify a control group where the firms are unaffected by SOX. Despite the mandatory implementation of SOX, the Securities and Exchange Commission allowed small firms (market values under $75 million) more time to comply. By contrast, the affected firms – the treatment group of companies with market values higher than $75 million, must comply. Our results show that enacting SOX made firms’ information more transparent to investors and significantly narrowed the gap between active and passive institutional investors on promoting innovation.

Although our results show that both active and passive institutional investors benefited from SOX in terms of pushing for innovation, firms with passive institutional investors  benefited more than did active institutional investors. We find that the passive institutional investors changed their roles and positively affected innovation investment after SOX. These findings are robust after addressing endogeneity concerns.


Engel, E., Hayes, R. M., &Wang, X. (2007). The Sarbanes-Oxley Act and firms’ going-private decisions. Journal of Accounting and Economics, 44(1–2), 116–145.

Hirshleifer, D., Hsu, P. H., &Li, D. (2013). Innovative efficiency and stock returns. Journal of Financial Economics, 107(3), 632–654.

Kroszner, R. S., &Strahan, P. E. (2001). Bankers on boards: Monitoring, conflicts of interest, and lender liability. Journal of Financial Economics62(3), 415–452.

This post comes to us from professors Thi-Thanh Phan at National Chengchi University and Hai-Chin Yu at Chung Yuan University in Taiwan. It is based on their recent article, “Innovation, Institutional Ownerships and Board Diversity,” available here.

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