Working Paper Abstracts – 2004

Working Paper Abstracts – 2004

S&P 500 Indexers, Tracking Errors and Liquidity
Marshall E. Blume and Roger M. Edelen

It is well known that a stock that is added to the S&P 500 index experiences on average a positive abnormal return from the announcement through the close on the change day and then a partial reversal. The reverse occurs for stocks dropped from the index. It is thus a puzzle why S&P 500 indexers have not adopted the early-trading strategy of trading at the opening price immediately following an announcement of a change in the index. This study shows that an indexer would add an average of 19.2 basis point more return per year. The catch is that the standard deviation of tracking error of this enhanced strategy is 23.9 basis points per year, which is much more than observed in practice–the standard deviation of the annual tracking error of the largest indexer Barclays is just 2.8 basis points a year. The paper then shows that to obtain the small tracking errors that are actually observed, an indexer must follow very closely an exact-replication strategy. Even so, two of the largest indexers have enhanced their returns. This enhancement in return is consistent with a more active management style than just trying holding all 500 stocks in the exact proportions as the index. Some index fund may lend securities to enhance return, and some may use derivatives. There are still other ways to enhance returns. As practitioners interviewed for this study suggest and as confirmed by empirical evidence, many indexers enter into bilateral agreements with providers of liquidity to trade at the closing price and are “paid” to enter into such agreements. The observed pattern of abnormal returns for changes in the index are exactly those that are needed to compensate liquidity providers for the risks that they require in providing liquidity to indexers.

Investing in Socially Responsible Mutual Funds
Christopher C. Geczy, Robert F. Stambaugh and David Levin

We construct optimal portfolios of mutual funds whose objectives include socially responsible investment (SRI). Comparing Portfolios of these funds to those constructed from the broader fund universe reveals the cost imposing the SRI constraint on investors seeking the highest Sharpe ratio. This SRI cost depends crucially on the investor’s views about asset pricing models and stock-picking skill by fund managers. To an investor who believes strongly in the CAPM and rules out magerial skill, i.e., a market-index investor, the cost of the SRI constraint is typically just a few basis points per month, measured in certainly-equivalent loss. To an investor who still disallows skill but instead believes to some degree in pricing models that associate higher returns with exposures to size, value, and momentum factors, the SRI constraint is much costlier, typically by at least 30 basis points per month. The SRI constraint imposes large costs on investors whose beliefs allow a substantial amount of fund-manager skill, i.e., investors who rely heavily on individual funds’ track records to predict future performance.

Estimating the Benchmark Yield Curve – A New Approach Using Stochastic Frontier Functions
Gangadhar Darbha

Estimating a risk free Term Structure of Interest Rates or Zero Coupon Yield Curve from the observed bond prices would involve controlling for the effects of security specific non-interest rate factors that affect bond prices. In ths paper, we propose a new framework to estimate benchmark- default and liquidity risk free- yield curve along with an illiquidity discount using the stochastic frontier functions. The methodology explicitly models the effects of security specific factors such as age, issue size, coupon and residual maturity on illiquidity discounts implicit in bond prices. Using the daily secondary market data from National Stock Exchange – Wholesale Debt Market for Government of India bonds for the period January 1997 to July 2002, we find that the new methodology not only identifies frontier yield curve that is significantly different from the standard zero coupon yield curve and gives reasonable estimates of illiquidity discounts, but also performs better than the standard yield curve models in terms of tracking observed bond prices.

Forecasting the Term Structure of Government Bond Yields
Francis X. Diebold and Canlin Li

Despite powerful advances in yield curve modeling in the last twenty years, comparatively little attention has been paid to the key practical problem of forecasting the yield curve. In this paper we do so. We use neither the no-arbitrage approach, which focuses on accurately fitting the cross section of interest rates at any given time but neglects time-series dynamics, nor the equilibrium approach, which focuses on time-series dynamics (primarily those of the instantaneous rate) but pays comparatively little attention to fitting the entire cross section at any given time and has been shown to forecast poorly. Instead, we use variations on the Nelson-Siegel exponential components framework to model the entire yield curve, period-by-period, as a three-dimensional parameter evolving dynamically. We show that the three time-varying parameters may be interpreted as factors corresponding to level, slope and curvature, and that they may be estimated with high efficiency. We propose and estimate autoregressive models for the factors, and we show that our models are consistent with a variety of stylized facts regarding the yield curve. We use our models to produce term-structure forecasts at both short and long horizons, with encouraging results. In particular, our forecasts appear much more accurate at long horizons than various standard benchmark forecasts.

Financial Asset Returns, Direction-of-Change Forecasting and Volatility Dynamics
Peter F. Christoffersen and Francis X. Diebold

We consider sets of phenomena that feature prominently – and separately- in the financial economics literature: conditional mean dependence (or lack thereof) in asset returns, dependence (and hence forecastability) in asset return signs, and dependence (and hence forecastability) in asset return volatilities. We show that they are very much interrelated, and we explore the relationships in detail. Among other things, we show that: (a) Volatility dependence produces sign dependence, so long as expected returns are nonzero, so that one should expect sign dependence, given the overwhelming evidence of volatility dependence; (b) The standard finding of little or no conditional mean dependence is entirely consistent with a significant degree of sign dependence and volatility dependence; (c) Sign dependence is not likely to be found via analysis of sign autocorrelations, runs tests, or traditional market timing tests, because of the special nonlinear nature of sign dependence; (d) Sign dependence is not likely to be found in very high-frequency (e.g., daily) or very low-frequency (e.g., annual) returns; instead, it is more likely to be found at intermediate return horizons; (e) Sign dependence is very much present in actual U.S. equity returns, and its properties match closely out theoretical predictions; (f) The link between volatility forecastability and sign forecastability remains in tact in conditionally non-Gaussian environments, as for example with time-varying conditional skewness and/or kurtosis.

Parametric and Nonparametric Volatility Measurement
Torben G. Andersen, Tim Bollerslev and Francis X. Diebold

Volatility has been one of the most active areas of research in empirical finance and time series econometrics during the past decade. This chapter provides a unified continuous-time, frictionless, no-arbitrage framework for systematically categorizing the various volatility concepts, measurement procedures, and modeling procedures. We define three different volatility concepts: (i) the notional volatility corresponding to the ex-post sample-path return variability over a fixed time interval, (ii) the ex-ante expected volatility over a fixed time interval, and (iii) the instantaneous volatility corresponding to the strength of the volatility process at a point in time. The parametric procedures rely on explicit functional form assumptions regarding the expected and/or instantaneous volatility. In the discrete-time ARCH class of models, the expectations are formulated in terms of directly observable variable(s). The nonparametric procedures are generally free from such functional form assumptions and hence afford estimates of notional volatility that are flexible yet consistent (as the sampling frequency of the underlying returns increases). The nonparametric procedures include ARCH filters and smoothers designed to measure the volatility over infinitesimally short horizons, as well as the recently popularized volatility measures for (non-trivial) fixed length time intervals.

The Nobel Memorial Prize for Robert Engle
Francis X. Diebold

Engle’s footsteps range widely. His major contributions include early work on band-spectral regression, development and unification of the theory of model specification tests (particularly Lagrange multiplier tests), clarification of the meaning of econometric exogeneity and its relationship to causality, and his later stunningly influential work on common trend modeling (cointegration) and volatility modeling (ARCH, short for AutoRegressive Conditional Heteroskedasticity). More generally, Engle’s cumulative work is a fine example of best-practice applied time-series econometrics: he identifies important dynamic economic phenomena, formulates precise and interesting questions about those phenomena, constructs sophisticated yet simple econometric models for measurement and testing, and consistently obtains results of widespread substantive interest in scientific, policy, and financial communities.

Although many of Engle’s contributions are fundamental, I will focus largely on the two most important: the theory and application of cointegration, and the theory and application of dynamic volatility models. Moreover, I will discuss much more extensively Engle’s volatility models and their role in financial econometrics, for several reasons. First, Engle’s Nobel citation was explicitly “for methods of analyzing economic time series with time-varying volatility (ARCH),” whereas Granger’s was for “for methods of analyzing economic time series with common trends (cointegration).” Second, the credit for creating the ARCH model goes exclusively to Engle, whereas the original cointegration idea was Granger’s, notwithstanding Engle’s powerful and well-known contributions to the development. Third, volatility models are a key part of the financial econometrics theme that defines Engle’s broader contributions, whereas cointegration has found wider application in macroeconomics than in finance. Last and not least, David Hendry’s insightful companion review of Granger’s work, also in this issue of the Scandinavian Journal, discusses the origins and development of cointegration in great depth.

In this brief and selective review, I attempt a description of “what happened and why”) as a popular American talk show host puts it). My approach has been intentionally to avoid writing a long review, as several extensive surveys of the relevant literatures already exist. In addition, I have de-emphasized technical aspects, focusing in stead on the intuition, importance, and nuances of the work. In Section 2, I discuss cointegration in the context of Engle’s previous and subsequent work, which facilitates the extraction of interesting and long-running themes, several of which feature prominently in Engle’s volatility models. I discuss the basic ARCH model in Section 3, and I discuss variations, extensions and applications in Section 4. I conclude in Section 5.

Overconfidence and Team Coordination
Simon Gervais and Itay Goldstein

We model a team in which the marginal productivity of a player increases with the effort of other players on the team. Because the effort of each player is not observable to any other player, the performance of the team is negatively affected by a free-rider problem and by a lack of effort coordination across players. In this contact, an overconfident player who overestimates her own marginal productivity works harder as well. This not only enhances team performance but may also create a Pareto improvement at the individual level. Indeed, although the overconfident player overworks, she benefits from the positive externality that other players working harder generates. Interestingly, the benefits of overconfidence may be long-lived even if players learn from their own team performance, as the overconfident player attributes the team’s success to her own ability, and not to the better coordination of the team. Because overconfidence naturally makes players work harder, monitoring, even when it is costless, may hurt by causing an overinvestment in effort.

Dynamic Portfolio Selection by Augmenting the Asset Space
Michael Brandt and Pedro Santa-Clara

We present a novel approach to dynamic portfolio selection that is no more difficult to implement than the static Markowitz model. The idea is to expand the asset space to include simple (mechanically) managed portfolios and compute the optimal static choice among managed portfolios is equivalent to a dynamic strategy. We consider managed portfolios of two types: “conditional” and “timing” portfolios. Conditional portfolios are constructed along the lines of Hansen and Richard (1987). For each variable that affects the distribution of returns and for each basis asset, we include a portfolio that invests in the basis asset an amount proportional to the level of the conditioning variable. Timing portfolios invest in each basis asset for a single period and therefore mimic strategies that buy and sell the asset allocation across stocks, bonds, and cash using the predictive ability of four conditioning variables.

Employees’ Investment Decisions about Company Stock
James Choi, David Laibson, Brigitte Madrian and Andrew Metrick

We study the relationship between past returns on a company’s stock and the level of investment in that stock by the participants in that company’s 410(k) plan. Using data on the 94,191 plan participants, we analyze several different decision points: the initial fraction of saving allocated to a company stock, the changes in this fraction, and the reallocations of portfolio holdings across different asset classes. Like Benartzi (2001), we find that high past returns on company stock induce participants to allocate more of their contributions to company stock. We also find, however, that high returns on company stock have the opposite effect on reallocations of portfolio holdings, with high returns leading to shifts away from company stock and onto other forms of equity. Overall, for company and stock decisions, participants in our sample appear to be momentum investors when making contribution decisions and contrarian investors when making trading decisions.

Consumption-Wealth Comovement of the Wrong Sign
James Choi, David Laibson, Brigitte Madrian and Andrew Metrick

Economic theory predicts that an unexpected wealth windfall should increase consumption shortly after the windfall is received. We test this prediction using administrative records on over 40,000 401(k) accounts. Contrary to theory, we estimate a negative short-run marginal propensity to consume out of idiosyncratic 401(k) capital gains shocks. These results cannot be interpreted as standard intertemporal substitution, since the idiosyncratic returns that we study do not predict future returns. Instead, our findings imply that many investors are influenced by a positive feedback effect, through which higher recent return encourage higher short-run saving. Like any other animal, 401(k) participants appear to increase behaviors that have high rewards in the past.

Incentives vs. Control: An Analysis of the U. S. Dual-Class Companies
Paul A. Gompers, Joy Ishii and Andrew Metrick

Dual-class common stock allows for the separation of voting rights and cash flow rights across the different classes of equity. We construct a large sample of dual-class firms in the United States and analyze the relationships of insider’s cash flow rights and voting rights with firm value, performance, and investment behavior. We find that relationship of firm value to cash flow rights is positive and concave and the relationship to voting rights is negative and convex. Identical quadratic relationships are found for the respective ownership variables with sales growth, capital expenditures, and the combination of R&D and advertising. Our evidence is consistent with an entrenchment effect of voting control that leads managers to underinvest and an incentive effect of cash flow ownership that induces managers to pursue more aggressive strategies.

SEC Regulation Fair Disclosure, Information, and the Cost of Capital
Armando Gomes, Gary Gorton and Leonardo Madureira

We empirically investigate the effects of the adoption of Regulation Fair Disclosure (“Reg FD”) by the U. S. Securities and Exchange Commission in October 2000. This rule was intended to stop the practice of “selective disclosure,” in which companies give material information only to a few analysts and institutional investors prior to disclosing it publicly. We find that the adoption of Reg FD caused a significant reallocation of information producing resources, resulting in a welfare loss for small firms, which now fact a higher cost of capital. The loss of “selective disclosure” channel for information flows could not be compensated for via other information transmission channels. This effect was more pronounced for firms communicating complex information and, consistent with the investor recognition hypothesis, for those losing analyst coverage. Moreover, we find no significant relationship of the different responses with litigation risks and agency costs. Our results show that Reg FD had unintended consequences and that “information” in financial markets may be more complicated than current finance theory admits.

Illiquidity and the Closed-End Country Fund Discounts
Ravi Jain, Yihong Xia and Matthew Qianli Wu

In a simple model of segmented markets and exogenous liquidity shock, the closed-end country fund premium is negatively affected by the illiquidity in the host market where shares of the country fund are traded and positively affected by the illiquidity in the home market where the underlying assets are traded. To the extent that expected and unexpected liquidity affects asset prices and returns, the closed-end country fund premium should reflect the difference between the illiquidity of the fund shares and its underlying assets. Using the Amihed measure of illiquidity, we examine this conjecture for U.S. traded single country closed-end funds, and find a strong association between the fund premium and illiquidity in both the host and home markets. Moreover, this relation is much stronger for funds investing in emerging markets where market segmentation is more likely to be binding. These funds are also more sensitive to the systematic liquidity faction, suggesting that the country fund premium may contain a significant liquidity risk premium.

Asymmetric Information and Financing with Convertibles
Archishman Chakraborty and Bige Yilmaz

Asymmetric information regarding firm prospects causes dilution, leading to adverse selection in inefficiencies in the market for new investments. However, if the market obtains information about the firm over time, issuing callable convertible securities with restrictive call provisions is optimal. Even when the market’s information is noisy, such securities can be designed to make payoff to new claim holders independent of the private information of the manager. The restrictive call provision serves as a commitment device, enabling the manager to call only when the stock price rises in the future. This solves the dilution and adverse selection problem costlessly. The same efficient outcome can also be implemented by issuing optimally designed floating price convertibles. This role of convertibles is similar to that of warranties in a lemons market for durable goods.

The Macroeconomy and the Yield Curve: A Dynamic Latent Factor Approach
Francis X. Diebold, Glenn D. Rudebusch and S. Boragan Aruoba

We estimate a model that summarizes the yield curve using latent factors (specifically, level, slope and curvature) and also includes observable macroeconomic variables (specifically, real activity, inflation, and the monetary policy instrument). Our goal is to provide a characterization of the dynamic interactions between the macroeconomy and the yield curve. We find strong evidence of the effects of macro variables on future movements in the yield curve and evidence for a reverse influence as well. We also relate our results to the expectations hypothesis.

International Differences in the Cost of Equity capital: Do Legal Institutions and Securities Regulation Matter?
Luzi Hail and Christian Leuz

This paper examines the international differences in firms’ cost of equity capital across 40 countries. We analyze whether the effectiveness of a country’s legal institutions and securities regulation is systematically related to cross-country differences in the cost of equity capital. We employ four different models using analyst forecasts to estimate firms’ implied costs of capital. We find that countries with extensive securities regulation and strong enforcement mechanisms exhibit lower levels of cost of capital than countries with weak legal institutions, even after controlling for various risk and country factors. The effects are strongest for institutions providing information to investors and enabling them to privately enforce their contracts. We also show that, consistent with theory, these effects become substantially smaller or insignificant as capital markets become more integrated.

Firms’ Capital Allocation Choices, Information Quality and the Cost of Capital
Christian Leuz and Robert E. Verrecchia

This paper establishes a link between firms’ capital investment decisions, the quality of the information they provide to a competitive market for their shares, and their cost of capital. We show that, if firms select projects to maximize share price, higher information quality reduces the cost of capital. The intuition is that better information improves the coordination between firms and investors with respect to capital investment decisions. Anticipating this effect, risk-averse investors demand a lower risk premium, i.e., they discount expected cash flows of firms with higher quality reporting at a lower rate of return. We show that this effect persists when investors price portfolios involving many assets. Idiosyncratic reporting components matter because they affect firms’ investment decisions and these real effects do not “disappear” when aggregating across firms.

Political Relationships, Global Financing and Corporate Transparency
Christian Leuz and Felix Oberholzer-Gee

This study examines the financing choices of firms operating in a weak institutional environment. We argue that in relationship-based systems, global financing and political connections are substitutes: Well-connected firms are less likely to access foreign capital markets because state-owned domestic banks provide capital at low cost. Moreover, the additional scrutiny that comes with foreign securities might be at odds with close political ties at home. Using data from Indonesia, we provide strong support for this hypothesis. Firms with close political ties to former President Soeharto are significantly less likely than non-connected firms to have publicly traded foreign securities. We also examine how returns before and during the Asian financial crises differ between firms with and without foreign securities. The former performed significantly better during the crises and their performance advantage increases considerably once we control for a firm’s closeness to the Soeharto regime. We show that simple return regressions in earlier work are downward biased if domestic opportunities such as political connections are ignored.

Estimating the Gains from Trade in Limit Order Markets
Burton Hollifield, Robert A. Miller, Patrik Sandas and Joshua Slive

We present a method for identifying and estimating the gains from trade in limit order markets and provide new empirical evidence that the limit order market is a good market design. The gains from trade in our model arise because traders have different valuations for the stock. We use observations from the traders’ order submissions and the execution and cancellation histories of the traders’ order submissions to estimate the distribution of traders’ unobserved valuations for the stock. We use the parameter estimates for our model to compute the current gains from trade in the limit order market and the gains from trade that the traders would attain in a perfectly liquid market.

Real-Time Price Discovery in Stock, Bond and Foreign Exchange Markets
Torben G. Andersen, Tim Bollerslev, Francis X. Diebold and Clara Vega

We characterize the response of U. S., German and British stock, bond and foreign exchange markets to real-time U. S. macroeconomic news. Our analysis is based on a unique data set of high-frequency futures returns for each of the markets. We find that news surprises produce conditional mean jumps; hence high-frequency stock, bond and exchange rate dynamics are linked to fundamentals. The details of the linkages are particularly intriguing as regards equity markets. We show that equity markets react differently to the same news depending on the state of the economy, with bad news having a positive impact during expansions and the traditionally-expected negative impact during recessions. We rationalize this by temporal variation in the competing “cash-flow” and the “discount rate” effects for equity valuation. This finding helps explain the time-varying correlation between stock and bond returns, and the relatively small equity market news effect when averaged across explanations recessions. Lastly relying on the pronounced heteroedasticity in the high frequency data, we document the important contemporaneous linkages across all markets and countries over and above the direct news announcement effects.

Large Blocks of Stock: Prevalence, Size and Measurement
Jennifer Dlugosz, Rudiger Fahlenbrach, Paul Gompers and Andrew Metrick

Large blocks of stock play an important role in many studies of corporate governance and finance. Despite this important role, there is no standardized data set for these blocks, and the best available data source, Compact Disclosure, has many mistakes and biases. In this paper, we document these mistakes and how to fix them. The mistakes and the bias tend to increase with the level of reported blockholdings: in firms where Compact Disclosure reports that aggregate blockholdings are greater than 50 percent, these aggregate holdings are incorrect more than half the time and average holdings for these incorrect firms are overstated by almost 30 percentage points. We also demonstrate that our fixes are economically and statistically significant in an analysis of the relationship between firm value and outside blockholders.

Estimating the Elasticity of Intertemporal Substitution When Instruments are Weak
Motohiro Yogo

In the instrumental variables (IV) regression model, weak instruments can lead to bias in estimators and size distortion in hypothesis tests. This paper examines How weak instruments affect the identification of the elasticity of intertemporal substitution (EIS) through the linearized Euler Equation. Conventional IV methods result in an empirical puzzle that the EIS is significantly less than one while its inverse is not different from one. This paper show that weak instruments can explain the puzzle and reports valid confidence intervals for the EIS using pivotal statistics. The EIS is less than one and not significantly different from xero for eleven developed countries.

Analyst Reputation, Underwriting Pressure and Forecast Accuracy
Lily Fang and Ayako Yasuda

We study the effect of analyst reputation on earnings forecast accuracy using the 1983 -2002 U.S. data. We find that All-American analysts are significantly more accurate than non-All-Americans. We also find that analysts who work at top-tier investment banks (large underwriters) are more accurate than others but become inaccurate in boom IPO markets, which is consistent with conflict of interest. Finally, we find that All-Americans do not become inaccurate in boom IPO markets. Personal reputation as measured by All-American status apparently mitigates the conflict of interest that becomes particularly acute for analysts employed at top-tier investment banks during boom years.

Can Mutual Fund Managers Pick Stocks? Evidence From Their Trades Prior to Earnings Announcements
Malcolm Baker, Lubomir Litov, Jessica A. Wachter and Jeffrey Wurgler

We test whether fund managers have stock-picking skill by comparing their holdings and trades prior to earnings announcements with the returns realized at those events. This approach largely avoids the joint-hypothesis problem with long-horizon studies of fund performance. Consistent with skilled trading, we find that, on average, stocks that funds buy earn significantly higher returns at subsequent earnings announcements than stocks that they sell. Funds display persistence in our event return-based metrics and those that do well tend to have a growth objective, large size, high turnover, and use incentive fees to motivate managers.

The Declining Equity Premium: What Role Does Macroeconomic Risk Play?
Martin lettau, Sydney C. Ludvigson and Jessica A. Wachter

Aggregate stock prices, relative to virtually any indicator of fundamental value, soared to unprecedented levels in the 1990s. Even today, after the market declines since 2000, they remain well above historical norms. Why? We consider one particular explanation: a fall in macroeconomic risk, or the volatility of the aggregate economy. Empirically, we find a strong correlation between low frequency movements in macroeconomic volatility and low frequency movements in the stock market. To model this phenomenon, we estimate a two-state regime switching model for the volatility and mean of consumption growth, and find evidence of a shift to substantially lower consumption volatility at the beginning of the 1990s. We then use these estimates from post war data to calibrate a rational asset pricing model with regime switches in both the mean and the standard deviation of consumption growth. Plausible parameterizations of the model are found to account for a significant portion of the run-up in asset valuation ratios observed in the late 1990s.

A Consumption-Based Model of the Term Structure of Interest Rates
Jessica A. Wachter

This paper proposes a consumption-based model that can account for many features of the nominal term structure of interest rates. The driving force behind the model is a time-varying price of risk generated by external habit. Nominal bonds depend on past consumption growth through habit and on expected inflation. When calibrated data on consumption, inflation, and the average level of bond yields, the model produces realistic volatility of bond yields and can explain key aspects of the expectations puzzle documented by Campbell and Shiller (1991) and Fama and Bliss (1987). When Actual consumption and inflation data are fed into the model, the model is shown to account for many of the short and long-run fluctuations in the short-term interest rate and the yield spread. At the same time, the model captures the high equity premium and excess stock market volatility.

Saving and Investing for Early Retirement: A Theoretical Analysis
Emmanuel Farhi and Stavros Panageas

We study optimal consumption and portfolio choice in a framework where investors save for early retirement and assume that agents can adjust their labor supply only through an irreversible choice of their retirement time. WE obtain closed form solutions and analyze the joint behavior of retirement time, portfolio choice, and consumption. Investing for early retirement tend to increase savings and stock market exposure, and reduce the marginal propensity to consume out of accumulated personal wealth. Contrary to common intuition, prior to retirement an investor might find it optimal to increase the proportion of financial wealth held in stocks as she ages, even when she receives a constant income stream and the investment opportunity set is also constant. This is particularly true when the wealth of the investor increases rapidly due to strong stock market performance, as was the case in the late 1990’s.

The Long-term Return on the Original S&P 500 Firms
Jeremy J. Siegel and Jeremy D. Schwartz

The S&P 500 Index, first compiled in March, 1957, is the most widely-used benchmark for measuring the performance of large capitalization, US-based stocks. The index of 500 stocks is continually updated, adding approximately 20 new firms each year that meet Standard and Poor’s criteria for market value, earnings, and liquidity while deleting an equal number that fall below these standards or are eliminated by mergers or other corporate changes.

We calculated the return of all 500 of the original S&P 500 firms and the new firms that have been subsequently added to the index. Contrary to earlier studies, we found that the buy-and-hold returns of the 500 original firms have outperformed the returns on the continually updated S&P 500 index and have done so with lower risk. The new firms added to the S&P 500 Index since 1957 have underperformed the original firms in nine of the ten industrial GICS sectors.

We also found that less than one-third of a sector’s return from 1957 through 2003 can be attributed to the expansion and contraction of the sector’s market value relative to the S&P 500 Index. Sector differences in dividend yields, capitalizations, and the number of firms admitted to the sector accounted for more two-third of the changes in market share.

The underperformance of the continually updated S&P 500 Index is due to the overvaluation of newly admitted firms, which have been caused by the cyclical fluctuations in investor sentiment and price pressures exerted by indexers. Relative to the updated S&P 500 index, the portfolios of original firms became heavily weighted with price-to-earnings stocks, particularly large oil producers that have outperformed growth stocks since 1957.

Taking a View: Corporate Speculation, Governance and Compensation
Christopher C. Geczy, Bernadette A. Minton and Catherine Schrand

Using a unique dataset from a well-known survey on derivatives us, this paper examines several questions about the use of derivatives to “take view” on interest rate and currency movements. Tests of what motivates firms to take a view suggest that they view speculation as a profitable activity. Firms specialize in taking a view on either interest rates or exchange rates, and specialization in FX contracts is positively related to the extent of the firm’s foreign operations. However, data do not support other theories of “rational” speculation such as the Campbell and Kracaw (1999) model. We also examine the association between speculation and governance mechanisms including compensation-based incentives, bonding contracts, and internal controls. Compensation-related incentives of the CFO, but not the CEO, are associated with the likelihood that a firm actively takes derivatives positions based on a market view. Moreover, firms with governance structures that allow for greater managerial power indicate fewer shareholder rights, in general, are more likely to take a view, but these firms also have more extensive and sophisticated internal controls and monitoring mechanisms specifically related to derivatives activities. Finally, we examine whether investors using publicly available information incorporate disclosures could identify firms that openly admit to speculation in the confidential survey. The answer is that they cannot.

Going Public: Public Debt or Public Equity?
Elazar Berkovitch, Ruth Gesser and Oded Sarig

We expand the private-public decision to include the choice of security with which to become public. We find that there are many firms that are public only with debt (Public Debt firms) and that they are significantly different from firms that are public only with equity (Public Equity firms). Specifically, Public Equity firms have higher sales volatility, volatility of returns on assets, and R&D intensity, and lower fraction of assets in place that Public Debt firms. This suggests that Public Equity firms are exposed to more information asymmetry than Public Debt firms. We find the same differences for financially unconstrained firms. We also find that firms with significant investments and R&D intensity are more likely to be public with equity than with debt. Examining firms around the time they transition from being public we find that transitioning firms have abundant cash and pay significant dividends both before and after the transition. Lastly, Public Debt firms are more profitable than Public Equity firms. WE interpret our results as indicating that agency and information collection motives dominate information asymmetry considerations in the private-public decision.