Do Foreign Institutional Investors Reward Transparency and Disclosure: Evidence from Istanbul Stock Exchange

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2013 12: 31Journal of Emerging Market FinanceBengi Ertuna and Ali Tükel

Disclosure: Evidence from Istanbul Stock ExchangeDo Foreign Institutional Investors Reward Transparency and

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Editor’s Introduction 31

Do Foreign Institutional Investors Reward Transparency and Disclosure

Evidence from Istanbul Stock Exchange

Bengi ErtunaAli Tükel

AbstractCorporategovernancehasemergedasa leading investmentcriterionfor institutional investors with the rise of cross-border portfolioflows,especiallyformarketswithweakinvestorprotection.Thisstudyprovides firm-levelevidenceontherelationshipbetweenthe levelofforeign institutional investment and the transparency and disclosureperformanceofcompanieslistedontheIstanbulStockExchange.Wedevelopaself-constructedtransparencyanddisclosureindex,consistingofvoluntaryandmandatorycomponents,andfindthatonlyvoluntarydisclosureispositivelyassociatedwithforeigninstitutionalinvestment.Weconcludethatfirmsthatoperateinmarketswithlowergovernancestandards can indeed attract more institutional investment throughbetterdisclosure,beyondwhatisrequiredbyregulations.

Article

JournalofEmergingMarketFinance12(1)31–57

©2013InstituteforFinancialManagementandResearch

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WashingtonDCDOI:10.1177/0972652712473396

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Bengi Ertuna(correspondingauthor),BoğaziçiUniversity,SchoolofAppliedDisciplines,HisarCampus,Bebek,34342,Istanbul,Turkey.E-mail:[email protected] Tükel,BoğaziçiUniversity,SchoolofAppliedDisciplines,HisarCampus,Bebek,34342,Istanbul,Turkey.E-mail:[email protected]

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32 Bengi Ertuna and Ali Tükel

Journal of Emerging Market Finance, 12, 1 (2013): 31–57

JEL Classification: G32,G34

KeywordsCorporate governance, disclosure and transparency, institutionalinvestors,emergingmarket,Turkey

Introduction

As cross-border investment flows increase, institutional investors are not only buying shares of foreign companies but are also exposing themselves to the governance context of different countries (Bebchuk and Weisbach 2010). Recent research reveals that they are rather selective about where they invest. They stay away from poor governance, notably weak shareholder protection and low information disclosure (Aggarwal et al. 2005; Ferreira and Matos 2008; Leuz et al. 2009), a finding that holds both at the country level and the firm level. This article aims to find answers to the following questions: Do foreign institutional investors respond to increased transparency at the firm level in markets with weak shareholder protection? Do they differ in this respect from other foreign investors? Or from the perspective of firms in these markets, can they escape from the constraints of their legal and regulatory settings and build a strong investor base? These questions are relevant not only for institutional investors diversifying their portfolios but also for companies in emerging markets that lack a domestic institutional investor base. It has been observed in recent literature that these questions are under researched. Ferreira and Matos (2008) report that evidence on the role of institutional investors is scarce outside the US, while Aggarwal et al. (2005) state that research on portfolio preferences at the firm level originates mostly from high-income countries with strong investor protection and disclosure standards.

In this study, we provide firm-level evidence from the Istanbul Stock Exchange (ISE) on the relationship between the level of foreign institutional investment and corporate governance. Turkey has been characterised in prior research as an emerging market with weak investor protection and low information disclosure. Yet, the ISE, which has been open to foreign investment for the past two decades, has attracted a



Istanbul Stock Exchange 33


significant amount of foreign investment, with around two-thirds of the free float owned by foreign investors. We analyse the relationship between the shares of different categories of foreign investors and the level of transparency and disclosure to see whether foreign institutional investors respond to better disclosure and transparency. We use a unique data set made available only recently, since 2005, by the Central Registry Agency (CRA) for Turkey. The CRA provides the breakdown of holdings in every stock by investor type for the publicly traded portion (the free float), allowing for the distinction between foreign versus domestic investors, as well as institutional versus other investors. Using this data, we calculate the shares of institutional versus non-institutional foreign investors in free float for the firms included in the ISE-100 index at the end of 2006. We construct a transparency and disclosure index (TDI) to analyse the impact of transparency and disclosure on the holdings of different foreign investor types. The TDI includes criteria based on the local regulatory framework and consists of a mandatory part and a voluntary part, a distinction which has so far not been used in connection with corporate governance in Turkey. In order to isolate the impact of disclosure and transparency from firm characteristics, we use hierarchical regression.

After controlling for firm characteristics that have been shown in prior research to be attractive for foreign investors, we find that only higher voluntary disclosure at firm level is associated with higher foreign institutional investment. In contrast to institutional investors, foreign non-institutional investors have a preference only for large companies and better disclosure does not seem to matter for them. Our findings support the results of previous research that firms that operate in legal environments with weak investor protection and low information disclosure can indeed attract more institutional investment by improving their firm-level governance through better disclosure, beyond what is required by regulations. We also find that foreign institutional investors have a preference for firms with majority family control, a finding which is not in line with the larger part of previous research. We provide explanations for this finding with the institutional characteristics of the context.

Recent studies on comparative corporate governance research have incorporated firm-level data but Bebchuk and Hamdani (2009) criticise these studies for using corporate governance rating systems that are





relevant for companies without a controlling shareholder. While such companies may dominate the US and the UK, they are quite rare in other markets, specifically emerging ones (La Porta et al. 1999). We aim to contribute to the literature by developing a transparency and disclosure measurement that takes into account the relevant regulatory framework in this market and provides empirical results from a large emerging market characterised by weak shareholder protection and low information disclosure. We also differentiate between types of foreign investors as institutional and non-institutional.

The rest of the article is arranged as follows: we first review related literature and develop our hypotheses. Then we provide information on the Turkish context. In the subsequent sections, we introduce our data and methodology and describe the development of the TDI. We provide the results of our analysis before we conclude in the last section.

Literature Review

The discussion on institutional investors and their investment preferences may well have started with Merton’s argument that investors invest in securities they know about (Merton 1987). The body of literature on which we base our hypotheses goes back to La Porta et al. who find that strong investor protection and high-quality accounting information are associated with greater market valuation (La Porta et al. 1997, 1998) and with higher firm value (La Porta et al. 2002). The relationship they find between country-level corporate governance variables and firm value are extended to the preferences of institutional investors by recent research. Aggarwal et al. (2005), studying US mutual funds in 30 emerging markets, find that countries with better accounting standards, shareholder rights and legal frameworks attract greater US mutual fund investment relative to benchmark indices. Their finding that high-quality accounting and disclosure practices matter more in countries with weak shareholder protection has been a motivation for our study and we build on it in our hypothesis development.

Ferreira and Matos (2008), studying the holdings of institutional investors from 27 countries investing in 48 recipient countries, report that all investors prefer stocks from countries with good disclosure standards. However, they find that the legal environment is negatively





related to the presence of foreign institutions, contrary to the suggestions of La Porta et al. (1998) in terms of law and finance. They interpret this as investors’ decision to invest abroad balancing weak shareholder protection against strong investment prospects or diversification benefits. They also suggest that this finding may explain the preference of US institutions for emerging markets. Ferreira and Matos (2008) conclude that despite the relevance of some country-level factors, a significant part of variation in institutional holdings is explained by firm-level characteristics, suggesting that institutional money actively selects which firms to invest in, beyond just following country-level allocations.

Empirical research into the preferences of foreign investors at the firm level starts with Kang and Stulz’s study (1997) of Japan and Dahlquist and Robertsson’s study (2001) for Sweden. Both find a strong preference for firms with large market capitalisations. This finding is shared later by multi-country studies, both for foreign institutional investors as in Aggarwal et al. (2005) and Ferreira and Matos (2008) and for all US investors in Edison and Warnock (2004) in emerging markets and in Leuz et al. (2009) for US investors in 29 countries, including both developed and emerging markets. Institutional investors behave like all foreign investors in their preference for large firms, in line with Falkenstein’s study (1996) of US mutual funds allocation in US stocks.

Leuz et al. (2009) and Ferreira and Matos (2008) find a preference for firms included in the MSCI equity indices. Institutional investors include not only actively managed funds, but index funds with passive manage-ment strategies. The inclusion of the MSCI equity index may also capture the effect of these passive strategies.

Prior research finds a strong preference of US investors for stocks that are listed in the US as American Depository Receipts (ADRs). However, some studies make a distinction between exchange-listed ADRs and unlisted ADRs,1 which are not subject to US investor protection regulations, including accounting and disclosure requirements. Edison and Warnock (2004) report that there is a strong positive relationship between US portfolio investment and listed ADRs, but the same relationship is not significant for unlisted ADRs. Aggarwal et al. (2005) find that both listed and unlisted ADRs have a significant positive impact on US funds’ allocation decisions, but the effect of listed ADRs is





significantly higher than that of unlisted ADRs. This finding suggests that cross-listing represents a proxy for better corporate governance or the option that ‘corporations seeking external capital will opt into legal regimes that are more protective of minorities’ as suggested by La Porta et al. (1999).

Finally, we refer to the literature on closely held firms. Research shows that large block holders dominate the ownership structures of firms in most countries outside of the US (Claessens et al. 2000; La Porta et al. 1999). The controlling shareholders typically have control rights considerably in excess of cash flow rights, often achieved through pyramid structures, dual-class shares and cross-shareholdings. It is often families who are the controlling owners and manage the firms they control. This leads to agency problems, not in the form of managers expropriating shareholders, but of controlling families expropriating the minority shareholders. La Porta et al. (1999) suggest that higher cash flow ownership by the controlling shareholders may mitigate this incentive for expropriation. In their 2002 study, La Porta et al. show that this problem leads to lower firm values. Thus, they suggest that higher cash flow ownership indeed improves valuation. Claessens et al. (2002) reach similar results in their study of East Asian economies as they show that the difference between cash flow rights and control rights is associated with a value discount and the discount generally increases with the size of the wedge between control rights and cash flow rights. Similarly, Lins (2003) finds in a study covering firms from emerging markets that management control in excess of cash flow ownership is negatively related to firm value, but he also finds that large non-management block holders can mitigate the valuation discount associated with this agency problem.

Do lower firm values associated with control rights higher than cash flow rights imply lower holdings by foreign institutional investors? Ferreira and Matos (2008) find that all institutional investors indeed hold fewer shares of firms that are closely held or that are associated with concentrated control rights. Furthermore, they report that insti-tutions seem to avoid more closely held firms in countries with weak legal environments. Leuz et al. (2009) find that their several measures of the family/management control variable are negatively and significantly associated with US investment in the sub-sample of countries





with low disclosure requirements, low securities regulation and low anti-director rights. In the sub-sample of countries with the opposite country-level characteristics, the coefficient of the same variable is not statistically significant. Only Edison and Warnock (2004) report a positive coefficient on the regression of the closely held variable on US holdings in the East Asian stocks; however, they interpret this relationship ‘counterintuitive’.

In multi-country studies, it is difficult to include variables on information disclosure and corporate governance attributes at the firm level due to lack of available and comparative data. Some researchers overcome this problem by using proxies for firm-level governance. Leuz et al. (2009) use block holders’ controlling rights, while Aggarwal et al. (2005) use firm-level accounting quality, a limited measure of disclosure. They find that it is positively and significantly related to US mutual funds’ holdings. This problem creates a space for single-country studies where firm-level data sets including several dimensions of corporate governance can be constructed. The results from such studies may complement multi-country studies in revealing the separate corporate governance mechanisms that institutional investors prefer. We aim to contribute to the literature by providing firm-level evidence on the relationship between the level of foreign institutional investment and the disclosure and transparency dimension of corporate governance, using a self-constructed TDI.

Evidence from literature reveals that in weak investor protection/low disclosure context, foreign institutional investors prefer companies with better governance. In a context characterised by majority control by fam-ilies, the risk of expropriation is a major concern for portfolio investors, who are minority shareholders. We identify transparency and disclosure as a mechanism that mitigates the expropriation risk; therefore, we choose it as a proxy for better governance at the firm level. Based on the foregoing discussion and the distinction we make between mandatory versus voluntary information disclosure, we develop the following hypotheses:

Hypothesis 1a: The share of foreign institutional investors is posi-tively associated with higher voluntary information disclosure at the firm level.





Hypothesis 1b: The share of foreign institutional investors is posi-tively associated with higher mandatory information disclosure at the firm level.

The extension of our hypotheses is that the same association does not hold for non-institutional foreign investors.

Hypothesis 2a: The share of foreign non-institutional investors is not positively associated with higher voluntary information disclo-sure at the firm level.

Hypothesis 2b: The share of foreign non-institutional investors is not positively associated with higher mandatory information disclo-sure at the firm level.

The Turkish Context

ISE and Foreign Investment

The ISE has opened up to foreign investment in 1989 and since then foreign investors have played a significant role. According to data published by the CRA of Turkey, the share of foreign portfolio investors in total free float on the ISE was 65.1 per cent as of year-end 2006. Out of that share, 42.1 per cent belonged to institutional investors, corresponding to 27.4 per cent of float. In contrast to the substantial presence of foreign institutional investors, domestic institutional investment in the stock market remains negligible, at only 1.1 per cent of float. Compared to other emerging markets, foreign portfolio investment in Turkey is relatively high. Leuz et al. (2009) report that in their 29 country sample, US portfolio investment in 2006 as a percentage of float averages 6.4 per cent, against Turkey’s 32.8 per cent, the second highest share in the sample.

This high level of foreign institutional involvement is surprising, as results from recent research would not place Turkey in any institutional investor’s favourite market list. La Porta et al. (1998) include Turkey in the list of countries with French origin civil law that offers weaker shareholder protection as compared to English origin civil law. On their measure of anti-director rights, which ‘measures how strongly the legal





system favors minority shareholders against managers or dominant shareholders in the corporate decision making process, including the voting process’, Turkey scores a 2.0; lower than the average of civil law of French origin of 2.33 and a common law of English origin of 4.0 (La Porta et al. 1998). In terms of public disclosure standards, Turkey also ranks low. La Porta et al. (2006), in their indices of securities markets regulation, calculate a disclosure requirements index with six items. The index average across the 50 countries in the sample is 0.60; the average is 0.78 for English legal origin countries, 0.45 for French legal origin countries and it is 0.50 for Turkey. In their study using the data of La Porta et al. (2006), Leuz et al. (2009) categorise countries below 0.75 as ‘low disclosure’ category. Finally, guidelines which institutional investors have set for themselves are in line with the conclusions from academic research. A market analysis carried out in 2003 for the benefit of the California Public Employees Retirement System (CalPERS), covering 27 emerging markets and seven categories of country and market factors, including transparency and market regulation/investor protection, reports that Turkey had the median score with 2.08, just above the score of 2, the minimum necessary for inclusion in the permissible country list (Ladekarl and Zervos 2004). To our knowledge, foreign institutional investment in the ISE has not been studied at the firm level, apart from a small sample of ISE firms having been included in large sample studies covering a number of emerging markets (Aggarwal et al. 2005; Leuz et al. 2009).

Corporate Governance Environment

Against this background not so favourable for institutional investors, the Capital Markets Board (CMB), the regulatory authority for capital markets in Turkey, has initiated efforts, since 2003, to improve corporate governance standards with the aim of better integration with global markets and published the Corporate Governance Principles (CGP). The new standards are not mandatory; the CMB has adopted the ‘comply or explain’ approach and firms have started to publish their compliance reports as part of their required disclosures.

Following the introduction of corporate governance principles, corporate governance has attracted increased research interest. There is a





growing body of academic research on corporate governance in Turkey (Ararat and Yurtoğlu 2006). Aksu and Kosedag (2006) provide a first study of the disclosure practices of ISE firms. Collaborating with Standard & Poor on scoring methodology, they provide transparency and disclosure rankings for the 52 largest ISE listed firms based on their 2003 disclosures. Their research covers 106 attributes, grouped in three sub-categories of ownership structure, financial disclosure and board structure. Aksu and Kosedag (2006) find an average score of 41 per cent, concluding that transparency and disclosure performance of Turkish firms are ‘at best moderate’ with the highest score in the financial disclosure category.

There are a couple of recent studies on the ownership and control structures in Turkey. Demirag and Serter (2003) examine the direct and indirect owners of capital through cash flow and voting rights, using a sample of 100 largest companies on the ISE as of year-end 1999. They find a highly concentrated ownership structure with families as the most common ultimate owners. In their sample, 68 companies are controlled by families, with an average voting rights of 65.75 per cent, obtained with average ultimate ownership (or cash flow rights) of 52 per cent. The second study by Orbay and Yurtoglu (2006) uses a larger sample of 218 firms listed on the ISE, data for 2001 and finds similar results. Families control 173 companies in the sample (79 per cent of the total), with average voting rights of 66.1 per cent versus an average cash flow rights of 54.0 per cent.

Data and Methodology

Using transparency and disclosure scores as predictors, we examine the incremental impact of mandatory and voluntary TDI scores on the shares of foreign institutional investors in order to reveal whether these investors actively select better firm-level transparency and disclosure. We apply the same construct to the shares of foreign non-institutional investors in order to find out how their preferences compare to those of institutional investors. We present the variables used in investigating the role of foreign institutional investors, together with their operational definitions and data sources, in the following paragraphs.





Measure of Foreign Holdings: Share of Foreign Institutional versus Non-institutional Investors

We use stock holding data at the firm level, which has been recently made available by the CRA of Turkey. The CRA publishes on their website the breakdown of holdings in each firm with respect to investor type. As a part of the process of dematerialisation of securities issued in Turkey, all investors, individual or institutional, are required to open accounts with the CRA. The CRA categorises investors into investor types, based on the information obtained from investors at account opening stage. Investors are categorised into foreign versus domestic, and each category is further divided into sub-categories as individual, corporate, fund and other. We take the ‘foreign fund’ category which includes mutual funds, pension funds and other institutional investors as our foreign institutional investor variable and all other foreign investors as non-institutional foreign investors. Data used in the study is as of year-end 2006 and expressed as a percentage of free float, namely, shares traded on the ISE, excluding non-traded shares held by block holders.

Foreign Institutional (FOR-INST): Foreign institutional investment is calculated as the percentage of foreign institutional investors’ holdings in total free float of the company as of year-end 2006 for each firm in the sample.2 While Edison and Warnock (2004) and Ferreira and Matos (2008) use share of institutional investors in market capitalisation, we choose, together with Leuz et al. (2009), the share of free float. We do not use market capitalisation consid-ering the fact that investors who fear governance problems can protect themselves by lowering the price they are willing to pay for a firm. This behaviour will lower the market value of the firm, but will not necessarily lead to lower investment.

Foreign Non-institutional (FOR-NONINST): We take foreign non-institutional investment in each firm as the sum of the holdings of foreign investors in the individual, corporate and other investors categories (excluding institutional) and calculate the variable as the share of this sum in the free float of the firm, as of year-end 2006.





Control Variables that Explain the Level of Foreign Portfolio Investments

Prior research has arrived at a consensus, as described earlier, that some firm characteristics influence the level of foreign portfolio investments, especially in emerging market settings. These variables include firm size, inclusion in the MSCI Index, cross-listing in the US and majority control by block holders. We define the control variables we use in our analysis as follows:

Firm Size (SIZE): Firm size is calculated as the natural logarithm of market capitalisation of companies as of year-end 2006. Market capitalisation is calculated by the number of shares outstanding in each firm by the year-end closing stock price.3 We expect SIZE to be significantly and positively associated with both dependent variables, based on the findings in literature that foreign investors invariably prefer large companies.

MSCI-EM Index (MSCI-EM): Presence of a company in the MSCI-EM (Emerging Markets) Index is used as an indicator of presence and recognition in international financial markets. This index is used as the benchmark for over 90 per cent of all interna-tional equity assets under management in the US.4 Data on MSCI-EM (Emerging Markets) – Mid & Large Cap Index as of 29 December 2006 is retrieved from MSCI Barra and used as a dummy variable indicating the presence of a given company in the index. Again in line with findings from literature, we expect foreign investors to prefer firms that are included in the MCSI Index.

Cross-listing: In contrast to similar prior research, we do not include ADRs or US cross-listing among our firm-level explanatory vari-ables. There is only one ISE company with an ADR that is traded on a US exchange. There are 11 firms that have as unlisted ADRs which trade on the OTC or under Rule 144A. As mentioned earlier in the literature survey, the positive impact of ADRs on foreign investment is strong for only listed ADRs while the impact of unlisted ADRs depend more on firm-level accounting and disclo-sure practices. We exclude this variable because we think that using measures on context-specific disclosure index is better than





using a proxy for better disclosure, thus including the variable Transparency and Disclosure Index.

Family Control (FAMILY): According to Leuz et al. (2009), the most stringent measure of effective managerial control is when family/management control rights exceed 50 per cent of the total out-standing shares of a firm. We use this relative measure of family control, which is set equal to one, when a family has over 50 per cent of the control rights in a firm either directly or through pyra-mid structures or it has the right to elect a majority of board mem-bers with the privileged minority shares and zero, if otherwise. Based on recent research (Ferreira and Matos 2008; Leuz et al. 2009), this variable is expected to be related significantly and negatively to both dependent variables.

Industry (INDUSTRY): In addition to the variables derived from lit-erature, we introduce an additional firm-level variable for compa-nies operating in the financial sector. Financial firms, that is, banks and insurance companies, are subject to sector-specific reg-ulations. They are required to comply with more stringent corpo-rate governance and disclosure standards as compared to other ISE listed firms. The industry variable takes on the value of one for banks or insurance companies and 0 otherwise. If the addi-tional regulations matter for foreign investors, the INDUSTRY variable should be positively related.

Transparency and Disclosure Measure: Construction of TDI Index

We use transparency and disclosure levels of firms as predictors of the share of foreign institutional (FOR-INST) and non-institutional (FOR-NONINST) investors. We measure the public disclosure levels of companies through a self-constructed TDI, based on the relevant legislation, namely, the provisions of CGP. The CGP has four sections and the TDI consists of 50 criteria that are extracted from the provisions of the Transparency and Disclosure section. Criteria included in TDI are presented in Appendix 1. We hand collect the data for the measurement of the TDI scores of companies. The TDI is applied by the two researchers independently to companies in the sample and discrepancies between the





two researchers’ scores are eliminated through the mutual evaluation of the criterion.

The CGP are on a comply-or-explain basis, hence voluntary in nature. However, some of the provisions of the CGP have long been required disclosure via earlier regulations of the CMB. This distinction allows us to divide the TDI into two sub-indices as mandatory and voluntary.

TDI-Mandatory (TDI-MAN): TDI-Mandatory (TDI-MAN) sub-index includes the public disclosure criteria that were required disclo-sure before the introduction of the CGP. It is calculated as per-centage disclosed by the company out of the 17 mandatory, required disclosure items.

TDI-Voluntary (TDI-VOL): TDI-Voluntary (TDI-VOL) sub-index includes only the criteria introduced by the CGP and that remain as voluntary disclosure. It is calculated as percentage disclosed by the company out of the 33 voluntary, recommended disclosure items.

The regulatory authority requires ISE listed companies to dis-close their compliance status by publishing a Corporate Governance Compliance Report (CGCR) on their websites. Our index uses the 2006 reports to hand collect data for the measure-ment of TDI scores. Data is collected from the ISE, the annual reports, CGCRs and minutes of shareholders’ meetings posted on company websites.

Sample and Sample Characteristics

Our sample consists of all the companies included in the ISE100 index, the broadest based index of the ISE, as of year-end 2006. Five companies that did not have a company website at the time of data collection and one company that did not provide shareholder information are excluded from our sample.

Summary statistics for foreign holdings, control and predictor variables are presented in Table 1. As of year-end 2006, the average share of foreign institutional investors (FOR-INST) in the free float of ISE-100 companies is 19.46 per cent, with a standard deviation of 16.39 per cent.5 While there are three companies with no foreign institutional





investment, the maximum value is 63 per cent. The share of foreign non-institutional investors (FOR-NONINST) has a mean value of 28.12 per cent, higher than that of institutional investors.

Market capitalisation of companies varies considerably, ranging between 8.3 million TL and 18.9 billion TL, with a mean of 2.01 billion TL and a median of 567 million TL. There are 33 companies in our sample which are included in the MSCI-EM Index (Mid&Large Cap). Sixty per cent of the companies in our sample are majority-controlled by families (FAMILY). This high level suggests the existence of potential conflicts of interests between controlling families and minority shareholders. In the sample, 35 per cent of companies operate in the financial sector (INDUSTRY).

Table 1. DescriptiveStatisticsofDependent,ControlandPredictorVariables

Variables(N=94) Mean SD

DependentVariables1.ForeignInstitutional

(FOR-INST) Percentageshareofforeigninstitutionalinvestorsinfreefloat

19.46 16.39

2.ForeignNon-institutional

(FOR-NONINST)

Percentageofforeignnon-institutionalinvestorsinfreefloat

28.12 21.18

ControlVariables3.FirmSize (SIZE) Logarithmofmarket

capitalisationofthecompany20.36 1.46

4.MSCI-EMIndex (MSCI-EM) PresenceofthecompanyinMSCI-EMLargeandMidCapIndex

0.35 0.48

5.FamilyControl (FAMILY) Dummyindicatingthepresenceoffamilycontrolinthecompany

0.60 0.49

6.Industry (INDUSTRY) Industrydummyforcompaniesinthefinancialsector

0.35 0.48

Predictors7.TDI-Voluntary (TDI-VOL) TransparencyandDisclosure

Index—Voluntaryitems69.63 13.67

9.TDI-Mandatory (TDI-MAN) TransparencyandDisclosureIndex—Mandatoryitems

82.66 13.21

Source: Developedbytheauthors.





The TDI-VOL has a mean score of 69.63 per cent. Disclosure scores on mandatory items (TDI-MAN) are higher, with a mean score of 82.66 per cent. It is interesting to note that ISE100 do not achieve full scores on TDI-MAN which are required disclosure according to regulations of CMB. The statistics on disclosure represent a general improvement in transparency and disclosure scores over those reported by Aksu and Kosedag (2006), which relate to an earlier period and a smaller sample.

Models Estimated

In line with our hypotheses, we expect FOR-INST to be positively related with the indicators of better disclosure, namely, TDI-VOL and TDI-MAN. We also expect to find no relation between FOR-NONINST and the same predictor variables. We use hierarchical regression in order to test whether the transparency and disclosure measures have incremental explanatory power over the variables on firm characteristics which have been documented in prior literature to impact foreign portfolio investments. We specify two different models, based on our four hypotheses. Model 1 tests our Hypotheses 1a and 1b. In our first model, we regress the dependent variable FOR-INST on control variables in Step 1 and then include predictor variable in Step 2 to observe its incremental influence. Control variables that are used in Step 1 are firm size (SIZE), MSCI-EM Index (MSCI-EM), family control (FAMILY) and a dummy variable for financial sector (INDUSTRY). Transparency and disclosure measure, the TDI index, is used as the predictor variable in Step 2. We use TDI-VOL to estimate Model 1a, and then replace it with TDI-MAN to estimate Model 1b. The aim of using alternative specifications to Model 1 is to test whether institutional foreign investors respond to the level of voluntary versus mandatory information disclosure.

Model 2 tests our remaining two hypotheses. In our second model, we replace the dependent variable with FOR-NONINST with the same independent variables in Steps 1 and 2, to test whether the incremental impact of predictor variables holds for foreign non-institutional inves-tors as well or is specific for foreign institutional investors. Similar to





Model 1, we use alternative specifications of Model 2, using TDI-VOL to estimate Model 2a and then replace it with TDI-MAN to estimate Model 2b.

Multicollinearity is tested using variance inflation factors (VIFs). VIF values of all independent variables range between 1.175 and 2.038 and indicate no sign of multicollinearity according to an acceptable upper bound of 4. Bivariate correlations also indicate an acceptable level of correlation among independent variables. The highest bivariate correlation among explanatory variables is between SIZE and MSCI-EM Index and is 0.601. Correlation matrix including all variables is presented as Table 2.

FOR-INST is highly correlated with the presence of the firm in the MSCI-EM Index, while family control and industry exhibited insignificant influence on their share at the univariate level. On the other hand, FOR-NONINST is not related with inclusion in the MSCI-EM Index. FOR-NONINST is negatively and significantly related to majority family control, a finding common with previous literature. Non-institutional investors also seem to prefer firms in the financial sector. Both TDI-VOL and TDI-MAN are significantly related to the two dependent variables; however, the coefficient between FOR-INST and TDI-VOL is higher and more significant.

The bivariate correlation between SIZE and the two disclosure variables TDI-VOL and TDI-MAN is positive and highly significant, a finding in line with results of research on the determinants of firm-level transparency. Prior research has shown that firm size is positively associated with disclosure; a recent example is Aksu and Kosedag (2006) for Turkey. The correlation matrix including all the variables in our analysis is presented in Table 2.

Hierarchical Regression Results

The results provide partial support for Hypothesis 1a but not for Hypothesis 1b; in other words, foreign institutional investors reward better information disclosure, but respond only to voluntary and not to mandatory information. For the dependent variable FOR-INST, the predictor variable TDI-VOL provides additional explanatory power over



Tab

le 2

. CorrelationCoefficientsofD

ependent,C

ontrolandPredictorVariables

Variables(

N=94)

12

34

56

78

DependentVariables

1.FOR-IN

ST1

2.FOR-NONINST

0.160

1(0.121)

ControlVariables

3.SIZE

0.591***

0.513***

1(0.000)

(0.000)

4.MSCI-EM

0.571***

0.168

0.601***

1(0.000)

(0.104)

(0.000)

5.FAMILY

0.042

−0.266**

−0.222**

−0.030

1(0.684)

(0.010)

(0.033)

(0.774)

6.IN

DUSTRY

0.147

0.241**

0.347***

0.118

−0.232**

1(0.156)

(0.018)

(0.001)

(0.256)

(0.025)

Predictors

7.TDI-V

OL

0.459***

0.191*

0.434***

0.314***

−0.038

0.210**

1(0.000)

(0.064)

(0.000)

(0.002)

(0.719)

(0.041)

8.TDI-M

AN

0.210**

0.271***

0.353***

0.092

0.104

0.121

0.455***

1(0.041)

(0.008)

(0.000)

(0.377)

(0.321)

(0.242)

(0.000)

Sou

rce:

Developedbytheauthors.

Not

es:

FOR-IN

STisthepercentageshareofforeigninstitutionalinvestorsinfreefloat;FO

R-NONINSTisthepercentageofforeign

non-institutionalinvestorsinfreefloat;SIZEiscalculatedasthelogarithmofm

arketcapitalisationofthecom

pany;M

SCI-EMisa

dummyvariableindicatingthepresenceofthecom

panyinMSCI-EMLargeandMidCapIndex;FAMILYisadum

myindicatingthe

presenceoffam

ilycontrolinthecom

pany;INDUSTRYisadum

myforcompaniesinthefinancialsector;TDI-V

OLispercentage

TDIscoreofacom

panyonvoluntarydisclosureitem

s;TDI-M

ANispercentageTDIscoreofacom

panyonmandatorydisclosure

items.

N

=94;*denotessignificanceatthe0.10level,**atthe0.05level,***atthe0.01level(two-tailedtests).

Num

bersinparenthesesarep-values.





and above the control variables. Control variables, which are entered as Step 1, significantly account for an important portion of the variation in FOR-INST in Model 1, with an R2 of 0.443. The predictor variable that is entered in Step 2 generates a significant increase in the explanatory power only in Model 1a, where TDI-VOL is used as a measure of transparency and disclosure. The change in R2 is 4.1 per cent and it is statistically significant. In Model 1a, the coefficient of TDI-VOL is positive and significant at the 0.009 level.

On the other hand, when we estimate Model 1b using TDI-MAN, the index score on mandatory criteria, the increase in R2 is not significant. This finding supports that the share of foreign institutional investors is positively associated with higher information disclosure, but only if the information is voluntary in nature. Our results imply that foreign institutional investors respond to higher voluntary disclosure, but not to higher mandatory disclosure.

For both Models 1a and 1b, control variables SIZE and MSCI-EM Index are positively and significantly associated with the share of foreign institutional investors. The coefficients of the variables SIZE and MSCI-EM Index are both statistically significant at 1 per cent level. Effect of the control variable INDUSTRY is not significant. In contrast to other control variables, results of the variable FAMILY are not uniform. In Step 1 of the model, where only the control variables are included, the coefficient is positive and significant at 10 per cent. When voluntary index score is included in Step 2 of Model 1a, the coefficient remains positive but its significance declines. It becomes significant again when the mandatory index score is used as a predictor variable in Step 2 of Model 1b.

Our results provide support for Hypotheses 2a and 2b, indicating that the share of foreign non-institutional investors is not positively associated with higher information disclosure, neither voluntary nor mandatory. For the dependent variable FOR-NONINST, transparency and disclosure scores do not provide additional explanatory power over and above the control variables. Change in R2 is insignificant in both Models 2a and 2b, where TDI-VOL and TDI-MAN scores are used respectively.

The control variables that are entered in Step 1 significantly account for an important portion of the variation in FOR-NONINST in Model 2, with an R2 of 0.311. Similar to the results for FOR-INST, the variable





SIZE has positive and highly significant association with FOR-NONINST. The results of MSCI-EM are different from the results in Model 1. The relationship is negative and significant only at the 10 per cent level. Contrary to foreign institutional investors, non-institutional investors invest less in companies in the MSCI-EM Index. Similar to Model 1, the effect of the control variable INDUSTRY is not significant. Finally, the coefficient of the variable FAMILY is negative but not significant. We present our hierarchical regression results of the four alternative specifications in Table 3.

The results from our multivariate analysis display the difference between the preferences of the two investor types. The voluntary transparency and disclosure variable, TDI-VOL, provides incremental explanatory power only for foreign institutional investors (Model 1a). Neither institutional nor non-institutional investors respond to better mandatory disclosure. Our findings provide evidence that only higher voluntary firm-level disclosure is related with higher foreign institu-tional investment. Furthermore, foreign non-institutional investors do not seem to care for higher disclosure, either mandatory or voluntary. This finding may be interpreted as an outcome of the signalling phenomenon. It is well documented that information asymmetries exist between foreign investors and local investors, who are the controlling shareholders (Leuz et al. 2009). In the presence of such asymmetries, foreign institutional investors may consider the willingness of local controlling shareholders to disclose information beyond what is required by regulators as a signal for the firm’s underlying financial performance.

Foreign investors, both institutional and non-institutional, prefer large companies. Firm size (SIZE) has a significantly positive relation with the share of foreign investors in all specifications. This finding replicates for Turkey the finding of all previous research (Aggarwal et al. 2005; Dahlquist and Robertsson 2001; Falkenstein 1996; Kang and Stulz 1997). Presence of the company in the MSCI-EM Index (MSCI-EM) is significant and has a positive influence only for foreign institutional investors. Since our variable FOR-INST includes both actively managed funds and index funds with passive investment strate-gies, the MSCI-EM Index may be capturing the effect of these index tracking passive funds.





Table 3. EstimationResultsoftheHierarchicalRegressions

DependentVariables

FOR-INST(Model1) FOR-NONINST(Model2)

Model1a Model1b Model2a Model2b

Step1 Step2 Step2 Step1 Step2 Step2

ControlVariablesSIZE 0.442*** 0.362*** 0.413*** 0.585*** 0.593*** 0.553*** (0.000) (0.001) (0.001) (0.000) (0.000) (0.000)MSCI-EM 0.312*** 0.293*** 0.325*** −0.194* −0.192* −0.180 (0.002) (0.003) (0.002) (0.084) (0.090) (0.116)FAMILY 0.145* 0.130 0.146* −0.135 −0.134 −0.135 (0.082) (0.108) (0.083) (0.146) (0.153) (0.148)INDUSTRY −0.016 −0.040 −0.019 0.031 0.034 0.028 (0.853) (0.636) (0.829) (0.743) (0.731) (0.770)Predictors TDI-VOL 0.227*** −0.021 (0.009) (0.834) TDI-MAN 0.066 0.073 (0.445) (0.449)R2 0.443 0.484 0.447 0.311 0.311 0.315ModelF 17.692*** 16.531*** 14.206*** 10.041*** 7.955*** 8.110*** (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)∆inR2 0.041 0.004 0.000 0.005Ffor∆inR2 7.065*** 0.589 0.044 0.580 (0.009) (0.445) (0.834) (0.449)

Source: Developedbytheauthors.Notes: FOR-INSTisthepercentageshareofforeigninstitutionalinvestorsinfreefloat;

FOR-NONINSTisthepercentageofforeignnon-institutionalinvestorsinfreefloat;SIZEiscalculatedasthelogarithmofmarketcapitalisationofthecompany;MSCI-EMisadummyvariableindicatingthepresenceofthecompanyinMSCI-EMLargeandMidCapIndex;FAMILYisadummyindicatingthepresenceoffamilycontrol in thecompany; INDUSTRY isadummyforcompanies inthefinancialsector;TDI-VOLispercentageTDIscoreofacompanyonvoluntarydisclosureitems;TDI-MANispercentageTDIscoreofacompanyonmandatorydisclosureitems.

N =94;*denotessignificanceatthe0.10level,**atthe0.05level,***atthe0.01level.Numbersinparenthesesarep-values.

Foreign institutional and non-institutional investors also differ on family control (FAMILY). We find similar results in prior research for non-institutional foreign investors, who seem to avoid family controlled





companies. An interesting finding of our research is for foreign institutional investors who seem to prefer companies with family control. This finding is in contrast with the larger part of prior literature, but similar to the finding of Edison and Warnock (2004) on US holdings in East Asian stocks. It suggests that foreign institutional investors do not avoid, but on the contrary, seem to favour the presence of a controlling family. This may partly be explained by the fact that in the ISE companies, families retain control with not only a majority of voting rights, but also with a majority of cash flow rights. In Turkey, the wedge between the cash flow and control rights is relatively low (Demirag and Serter 2003; Orbay and Yurtoglu 2006). Thus, the resulting incentive structure, that is, control through majority cash flow rights, may reduce the risk of expropriation by the controlling shareholders. Another explanation for our finding may be based on Merton (1987), who suggests that an increase in the investor base of the firm may be in the interest of controlling shareholders. In the absence of domestic institutional investors, controlling families on the ISE have no other option than foreign institutional investors for developing a loyal investor base. This may be done through what Bebchuk and Weisbach (2010) call ‘informal contacts’ between institutional investors and firms. These contacts may provide private information which is not available publicly. The positive coefficient on the FAMILY variable may be capturing the impact of such contacts, which are ‘by its nature private and difficult to quantify’ (Bebchuk and Weisbach 2010).

Finally, being a financial sector company does not influence the preference of either type of foreign investor despite the differences in regulatory structure and stringent disclosure requirements.

In the context of the ISE, where an institutional investor base can only be expanded by attracting foreign investors, controlling share-holders have the incentive to improve firm-level transparency and dis-closure. Improving transparency and disclosure on voluntary items appears as an effective mechanism, while improvements on mandatory disclosure items do not have the same impact. To the best of our knowledge, our study is the first study to document the differences in investment patterns between foreign institutional and non-institutional investors.





Conclusions

We develop a self-constructed TDI for companies on the ISE and use this index and a unique data set of foreign portfolio investment to investigate the investment behaviour of these investors on the ISE. We find that in a weak investor protection and low disclosure country, foreign institutional investors prefer to invest in companies with better transparency and disclosure. These investors, facing information asymmetries, may be interpreting a greater willingness to disclose information as a signal of the underlying governance and performance of the company. It is voluntary criteria they respond to and not mandatory items. Institutional investors are unique in this respect, for other types of foreign investors better disclosure does not result in higher investment.

We conclude that firms in a weak investor protection and low information disclosure context can indeed escape from the constraints of their regulatory and legal setting by voluntarily improving disclosure at the firm level. In other words, as Ferreira and Matos (2008) assert, ‘there is some hope for a “good” firm in a “bad” country’. In the absence of domestic institutional investors, controlling shareholders’ planning to develop a loyal investor base has no alternative other than attracting foreign institutional investors. We show that in the ISE this can be achieved by better disclosure and transparency. Our conclusions are relevant not only for firms but also for regulatory authorities, specifically in emerging markets, that encourage better corporate governance to develop and deepen the financial markets.

We contribute to the research on comparative corporate governance literature by focusing on institutional investors’ role in influencing firm-level transparency and disclosure in an emerging market. Our study provides evidence on the immediate impact of the recently introduced corporate governance code in Turkey on the disclosure practices of ISE listed companies and the reaction of foreign institutional investors. We identify two possible routes to extend our research. One is to break our voluntary disclosure index down to its components in order to determine the attributes that institutional investors perceive as indicators of relevant disclosure and transparency. The second route is to investigate the dynamics of the interaction between institutional investors and controlling families, focusing especially on the monitoring mechanisms they employ.



App

endi

x 1.

Tra

nspa

renc

y an

d D

iscl

osur

e In

dex—

Man

dato

ry a

nd V

olun

tary

Ite

ms

DisclosureItems

Status

Area

%Disclosure

1Listofboardmem

bersandduties

MAN.

Board/Managem

ent

982

Statem

entonhow

boardoperates

VOL.

Board/Managem

ent

983

Informationonboardcom

mittees

VOL.

Board/Managem

ent

984

Corporategovernanceprinciplescom

pliancereport

VOL.

Transparency

985

Balancesheet(currentandpastyear)

MAN.

Financial

966

Incomestatem

ent(currentandpastyear)

MAN.

Financial

967

Statem

entofchangesinstockholders’equity

MAN.

Financial

968

Notestofinancialstatements

MAN.

Financial

969

Annualreport—

past

VOL.

Financial

9610

Hum

anresourcepolicies

VOL.

Stakeholders

9611

Com

panywebsiteexists

VOL.

Transparency

9612

Auditor’sreport

MAN.

Financial

9413

Annualreport(currentyear)

MAN.

Financial

9214

Investorrelationsdepartmentandpersonnel

VOL.

Ownership

9215

Internalcontrolsystem

VOL.

Board/Managem

ent

9016

Ownershipstructure(identityandshare)

MAN.

Ownership

9017

Managem

entreport/analysisofcurrentyear

MAN.

Transparency

9018

ArticlesofAssociation

VOL.

Ownership

8819

Policiesforotherstakeholders

VOL.

Stakeholders

8820

Cashflowstatement

MAN.

Financial

8621

Informationonprivilegedshares

VOL.

Ownership

8622

Listoftopmanagers–executives

MAN.

Board/Managem

ent

8423

Interimfinancialstatements

MAN.

Financial

8424

Corporatesocialresponsibilityactivities

VOL.

Stakeholders

8425

Currentinfo.oncompanywebsite

VOL.

Transparency

84



26Accessinformationtoinvestorrelations

VOL.

Ownership

8227

NoticeofmeetingsandagendatoGeneralAssem

bly

VOL.

Ownership

8228

Englishversionofwebsite

VOL.

Transparency

8229

Proxyforms

VOL.

Ownership

8030

Directors’salaries,bonusesandotherbenefits

VOL.

Board/Managem

ent

7831

Codeofethics

VOL.

Stakeholders

7832

Marketshareorindustryinformation

MAN.

Transparency

7633

Summaryofkeyratios

MAN.

Financial

7434

MinutesofG

eneralAssem

bly

VOL.

Ownership

7435

Traderegistrationinformation

VOL.

Transparency

7436

Directors’potentialconflictsofinterests

VOL.

Board/Managem

ent

7237

Disclosurepolicy

VOL.

Transparency

7238

Dividendpolicy

VOL.

Ownership

6639

Experienceandqualificationsofboardmem

bers

VOL.

Board/Managem

ent

6240

Statusofboardmem

bers(independentdirectors)

VOL.

Board/Managem

ent

6241

Publiclydisclosedmaterialinformation

MAN.

Transparency

6242

Listofpotentialinsidetraders

VOL.

Transparency

6043

Ultimatecontrollingshareholders

VOL.

Ownership

5244

Amendm

entstoarticlesofassociation

MAN.

Ownership

4645

Experienceandqualificationsoftopexecutives

MAN.

Board/Managem

ent

4046

Frequentlyaskedquestions

VOL.

Transparency

3847

Qualificationsofboardmem

bership

VOL.

Board/Managem

ent

2248

Basicperformanceforecasts

VOL.

Financial

1849

Prospectusesandcirculars

VOL.

Transparency

1850

Conflictsofinterestwithauditors

VOL.

Transparency

2

Sou

rce:

Developedbytheauthors.

Not

es:

Statusindicateswhetherthedisclosureismandatoryorvoluntary.AreaindicatesthesectioninCGP.





Notes1. Unlisted ADRs are defined as Level I, trading on OTC or under Rule 144A.2. Data is available at http:www.mkk.com.tr/MkkComTr/tr/piyasa/istatistik_y.

jsp in Turkish.3. Data on number of shares outstanding and stock prices were obtained from

http://www.imkb.gov.tr/bultenler.htm and http://www.imkb.gov.tr/veri.htm 4. This information is obtained from the MSCI Barra website (http://www.

mscibarra.com/products/indices/equity/index.jsp).5. This is somewhat lower than the market-value adjusted average of 27.4 per

cent which was mentioned in the introduction.

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Documents

Do Foreign Institutional Investors Reward Transparency and Disclosure: Evidence from Istanbul Stock Exchange