Working Paper Abstracts – 2010
On the Size of the Active Management Industry
Lubos Pastor and Robert F. Stambaugh
We analyze the equilibrium size of the active management industry and the role of historical data—how investors use it to decide how much to invest in the industry, and how researchers use it to judge whether the industry’s size is reasonable. As the industry’s size increases, every manager’s ability to outperform passive benchmarks declines, to an unknown degree. We find that researchers need not be puzzled by the industry’s substantial size despite the industry’s negative track record. We also find investors face endogeneity that limits their learning about returns to scale and allows prolonged departures of the industry’s size from its optimal level.
Financial Expertise as an Arms Race
Vincent Glode, Richard C. Green, and Richard Lowery
We propose a model in which firms involved in trading securities overinvest in financial expertise. Intermediaries or traders in the model meet and bargain over a financial asset. As in the bargaining model in Dang (2008), counterparties endogenously decide whether to acquire information, and improve their bargaining positions, even though the information creates adverse selection. We add to this setting the concept of “financial expertise” as resources invested to lower the cost of later acquiring information about the value of the asset being traded. These investments are made before the parties know about their role in the bargaining game, as proposer or responder, buyer or seller. A prisoner’s dilemma arises because investments to lower information acquisition costs improve bargaining outcomes given the other party’s information costs, even though the information has no social benefit. These investments lead to breakdowns in trade, or liquidity crises, in response to random but infrequent increases in asset volatility.
Hedge Funds: Pricing Controls and the Smoothing of Self-Reported Returns
Gavin Cassar and Joseph Gerakos
We investigate the extent to which hedge fund managers smooth self-reported returns. In contrast with prior research on the “anomalous” properties of hedge fund returns, we observe the mechanisms used to price the fund’s investment positions and report the fund’s performance to investors, thereby allowing us to differentiate between asset illiquidity and misreporting-based explanations. We find that funds using less verifiable pricing sources and funds that provide managers with greater discretion in pricing investment positions are more likely to have returns consistent with intentional smoothing. Traditional controls, however, such as removing the manager from the setting and reporting of the fund’s net asset value and the use of reputable auditors and administrators are not associated with lower levels of smoothing. With respect to asset illiquidity vs. misreporting, investment style and portfolio characteristics explain 14.0–24.3 percent of the variation in our smoothing measures and pricing controls explain an additional 4.1–8.8 percent, suggesting that asset illiquidity is the major factor driving the anomalous properties of self-reported hedge fund returns.
CEO Pay and CEO Power: Evidence from a Dynamic Learning Model
Lucian A. Taylor
If CEOs have considerable power over their own compensation, then we expect them to avoid pay cuts following bad news about their ability, and win large pay raises following good news. Contrary to this view, I find that CEOs capture only 20-33% of the surplus resulting from good news, and they bear 8-20% of the negative surplus resulting from bad news. These estimates are from a model in which agents learn gradually about CEO ability, and CEOs’ bargaining power determines how their compensation responds to news about ability. I estimate the model’s parameters by applying GMM to data on stock returns and changes in CEO pay. Since CEOs do not capture their full surplus, CEO ability matters more for shareholders, which is supported by predictions and data on unanticipated CEO deaths. The model helps explain the sensitivity of CEO pay to lagged stock returns, and also the changes in stock return volatility around CEO successions.
Long Run Risks, the Macroeconomy, and Asset Prices
Ravi Bansal, Dana Kiku and Amir Yaron
What’s Vol Got to Do With It
Itamar Drechsler and Amir Yaron
Uncertainty plays a key role in economics, finance, and decision sciences. Financial markets, in particular derivative markets, provide fertile ground for understanding how perceptions of economic uncertainty and cashflow risk manifest themselves in asset prices. We demonstrate that the variance premium, defined as the difference between the squared VIX index and expected realized variance, captures attitudes toward uncertainty.
We show conditions under which the variance premium displays significant time variation and return predictability. A calibrated, generalized Long-Run Risks model generates a variance premium with time variation and return predictability that is consistent with the data, while simultaneously matching the levels and volatilities of the market return and risk free rate. Our evidence indicates an important role for transient non-Gaussian shocks to fundamentals that affect agents’ views of economic uncertainty and prices.
Macroeconomic Effects of Financial Shocks
Urban Jermann and Vincenzo Quadrini
In this paper we document the cyclical properties of U.S. firms’ financial flows. Equity payouts are procyclical and debt payouts are countercyclical. We develop a model with explicit roles for debt and equity financing and explore how the observed dynamics of real and financial variables are affected by ‘financial shocks’, that is, shocks that affect the firms’ capacity to borrow. Standard productivity shocks can only partially explain the movements in real and financial variables. The addition of financial shocks brings the model much closer to the data. The recent events in the financial sector show up clearly in our model as a tightening of firms’ financing conditions causing the GDP decline in 2008-09. Our analysis also suggests that the downturns in 1990-91 and 2001 were strongly influenced by changes in credit conditions.
Is U.S. Multinational Intra-Firm Dividend Policy Influenced by Capital Market Incentives?
Jennifer L. Blouin, Linda K. Krull and Leslie A. Robinson
This study finds evidence to suggest that public-company reporting by U.S. multinational corporations (MNCs) creates disincentives to repatriate foreign earnings. Firms that operate under both U.S. international tax laws and accounting rules potentially face two costs when they repatriate foreign earnings: an actual cash tax liability and a reduction in reported accounting earnings. Using a confidential dataset of financial and operating characteristics of the foreign affiliates of MNCs combined with public company data over a six year period, we find evidence that capital market incentives have a negative effect on the amount of foreign earnings repatriated by MNCs. This is the first empirical study of actual dividend payments to show that financial reporting is an important non-tax factor in repatriation decisions of multinational firms.
Explaining the Favprote Longshot Bias: Is it Risk-Love or Misperceptions?
Erik Snowberg and Justin Wolfers
The favorite-longshot bias describes the longstanding empirical regularity that betting odds provide biased estimates of the probability of a horse winning—longshots are overbet, while favorites are underbet. Neoclassical explanations of this phenomenon focus on rational gamblers who overbet longshots due to risk-love. The competing behavioral explanations emphasize the role of misperceptions of probabilities. We provide novel empirical tests that can discriminate between these competing theories by assessing whether the models that explain gamblers’ choices in one part of their choice set (betting to win) can also rationalize decisions over a wider choice set, including compound bets in the exacta, quinella or trifecta pools. Using a new, large-scale dataset ideally suited to implement these tests we ﬁnd evidence in favor of the view that misperceptions of probability drive the favorite-longshot bias, as suggested by Prospect Theory.
Ambiguous Infomration, Risk Aversion and Asset Pricing
I study the efects of aversion to risk and ambiguity (uncertainty in the sense of Knight (1921)) on the value of the market portfolio when investors receive public information that they ﬁnd diﬃcult to link to fundamentals and hence t reat as ambiguous. I show that small changes in public information can produce large changes in the stock price and systemic negative news may lead to higher valuations of the stock market than idiosyncratic negative events. Aversion to risk and ambiguity can explain high expected stock market returns and excess volatility and kurtosis of stock market returns. Moreover, the skewness of stock returns is negative(positive) if risk aversion of the marginal investor
is high low).
What “Triggers” Mortgage Default?
Ronel Elul, Nicholas Souleles, Souphala Chomsisengphet, Dennis Glennon and Robert Hunt
This paper assesses the relative importance of two key drivers of mortgage default: negative equity and illiquidity. To do so, we combine loan-level mortgage data with detailed credit bureau information about the borrower’s broader balance sheet. This gives us a direct way to measure illiquid borrowers: those with high credit card utilization rates. We find that both negative equity and illiquidity are significantly associated with mortgage default, with comparably sized marginal effects. Moreover, these two factors interact with each other: The effect of illiquidity on default generally increases with high combined loan-to-value ratios (CLTV), though is significant even for low CLTV. County-level unemployment shocks are also associated with higher default risk (though less so than high utilization) and strongly interact with CLTV. In addition, having a second mortgage implies significantly higher default risk, particularly for borrowers who have a first-mortgage LTV approaching 100 percent.
Risk and the CEO Market: Why Do Some Large Firms Hire Highly-Paid, Low-Talent CEOs?
Alex Edmans and Xavier Gabaix
This paper presents a market equilibrium model of CEO assignment, pay and incentives under risk aversion and heterogeneous moral hazard. Each of the three outcomes can be summarized by a single closed-form equation. In assignment models without moral hazard, allocation depends only on ﬁrm size and the equilibrium is effcient. Here, talent assignment is distorted by the agency problem as ﬁrms involving higher risk or disutility choose less talented CEOs. Such ﬁrms also pay higher salaries in the cross-section, but economy-wide increases in risk or the disutility of being a CEO (e.g. due to regulation) do not affect pay. The strength of incentives depends only on the disutility of effort and is independent of risk and risk aversion. If the CEO affects the volatility as well as mean of ﬁrm returns, incentives rise and are increasing in risk and risk aversion. We calibrate the effciency losses from various forms of poor corporate governance, such as failures in monitoring and ineffciencies in CEO assignment. The losses from misallocation of talent are orders of magnitude higher than from ineffcient risk-sharing.
Informaton Spillovers and Performance Persistence for Hedge Funds
Vincent Glode and Richard C. Green
We present a simple model that rationalizes performance persistence in hedge fund limited partnerships. In contrast to the model for mutual funds of Berk and Green (2004), the learning in our model pertains to proﬁtability associated with an innovative trading strategy or emerging sector, rather than ability speciﬁc to the fund manager. As a result of potential information spillovers, which would increase competition if informed investors were to partner with non-incumbent managers, incumbent managers will let informed investors beneﬁt from increases in estimated profitability following high returns realized with the trading strategy or in the sector.
Do Peer Firms Affet Corporate Financial Policy
Mark T. Leary and Michael R. Roberts
We show that corporate ﬁnancial policies are highly interdependent; ﬁrms make ﬁnancing decisions in large part by responding to the ﬁnancing decisions of their peers, as opposed to changes in ﬁrm-speciﬁc characteristics. We identify these peer eﬀects with a novel instrumental variables approach that uses the lagged idiosyncratic equity shocks to peer ﬁrms as a source of exogenous variation. On average, a one standard deviation change in peer ﬁrms’ leverage ratios is associated with a 9% change in own ﬁrm leverage ratios — a marginal eﬀect that is signiﬁcantly larger than that of any other observable determinant and one that is driven by interdependencies among security (i.e., debt and equity) issuance decisions. Further, we ﬁnd that the presence of these peer eﬀects is consistent with information-based theoretical models of learning and reputational considerations. Finally, we show that these peer eﬀects create an exeternality among ﬁnancial policies that ampliﬁes the eﬀects of changes in ﬁrm-speciﬁc capital structure determinants and alters their interpretation.
Skill, Luck and the Multiproduct Firm: Evidence from Hedge Funds
Rui J. P. de Figueriredo, Jr. and Evan Rawley
We propose that when managers require external investment to expand, higher skilled firms will diversify on average, even though managers can exploit asymmetric information about their ability to raise money from investors. We formalize this intuition in an equilibrium model and test our predictions using a large panel dataset on the hedge fund industry 1977-2006. We show that excess returns fall following diversification—defined as the launch of new fund—but are 11 basis points per month higher in diversified firms compared to a matched sample of focused firms. The evidence suggests that managers exploit asymmetric information about their own ability to time diversification decisions, but the discipline of markets ensures that better firms diversify on average. The results provide large sample empirical evidence that agency effects and firm capabilities both influence diversification decisions.
The Effect of Parent Firm Location on the Performance of Entrepreneurial Spawns: Evidence from Hedge Funds
Rui J. P. de Figueriredo, Jr., Evan Rawley, Philipp Meyer
We examine how parent firm location influences the performance of entrepreneurial spawns in the hedge fund industry. We find that hedge fund managers who previously worked for parent firms located in the industry hubs—New York and London—outperform their peers, regardless of where the hedge fund is located. These results are robust to controls for selection into job spells in New York/London based on all observable individual and parent firm characteristics. Interestingly, we do not find evidence that the actual location of the spawned hedge fund significantly impacts on its performance when controlling for the location of its parent firm. The evidence suggests that pre-founding agglomeration effects increase the value of individuals‘ human and social capital when they are still nascent entrepreneurs working for established firms, and that the entrepreneurs‘ pre-founding experience at the parent firms critically ―imprints‖ the new spawns and influences the spawns‘ capabilities and post-founding performance.
Short-term Termination without Deterring Long-term Investment: A Theory of Debt and Buyouts
The option to terminate a manager early minimizes investor losses if he is unskilled. However, it also deters a skilled manager from undertaking long-term projects that risk low earnings. This paper demonstrates how risky debt can overcome this tension. Leverage concentrates equity holders; stakes, creating incentives for them to learn the cause e of low earnings. If they result from investment) poor management) the firm is continued (liquidated). Therefore, unskilled managers are terminated and skilled managers can in-vest without fear of termination. Unlike models of managerial discipline based on total payout, here dividends are not a substitute for debt – they achieve termination upon non-payment, but not concentration, ex post monitoring and thus ex ante investment. Debt is dynamically consistent as the manager benefits from monitoring by a concentrated investor. In traditional theories, monitoring constrains the manager: here it frees him to take long-term projects, contrasting the standard intuition that debt reduces investment. The modal derives implications for how capital structure and dividend policy depend on the relative severity of difference agency problems.
How Much do Investors Care about Macroeconomic Risk? Evidence from Scheduled Economic Announcements
Pavel Savor and Mungo Wilson
Stock market returns are significantly higher on days when important macroeconomic news, such as that about inflation, unemployment, or interest rates, is scheduled for announcement. The average announcement day excess return from 1958 to 2008 is 10.6 basis points versus 1.0 basis points for all other days, suggesting that over 60% of the cumulative annual equity risk premium is earned on announcement days. In contrast, the risk-free rate is detectably lower on announcement days, consistent with a precautionary saving motive, Our results demonstrate the required trade-off between macroeconomic risk and asset returns, and provide an estimate of the premium investors demand to hear this risk.
Growth to Value: Option Excercise and the Cross Seciton of Equity Returns
Hengjie Ai and Dana Kiku
We put forward a general equilibrium model to study the link between the cross section of expected returns and book-to-market characteristics. We model two primitive assets: value assets, and growth assets that are options on assets in place. The cost of option exercise, which is endogenously determined in equilibrium, is highly procyclical and acts as a hedge against risks in assets in place. Consequently, growth options are less risky than value assets, and the model features a value premium. Our model incorporates long-run risks in aggregate consumption (as in Bansal and Yaron (2004)) and replicates the empirical failure of the conditional CAPM prediction. We calibrate the model and show that it is able to quantitatively account for the observed pattern in mean returns on book-to-market sorted portfolios, the magnitude of the CAPM-alphas, and other silent features of the cross-sectional data.
Accounting for Private Information
Laurence Ales and Priscila Mazeiro
We study the quantitative properties of constrained efficient allocation in an environment where risk sharing is limited by the presence of private information. We consider a life cycle version of a standard Mirrlees economy where shocks to labor productivity have a component that is public information and one that is private information. The presence of private shocks has important implications for the age profiles of consumption and hours. First, they introduce an endogenous dispersion of continuation utilities. As a result, consumption inequality rises with age even if the variance of the shocks does not. Second, they introduce an endogenous rise of the distortion on the marginal rate of substitution between consumption and leisure over the life cycle. This is because as agents age, the ability to properly provide incentives for work must become less and less tied to promises of benefits (through either increased leisure or consumption.) in future periods. Both of these features are also present in the data. We look at the data through the lens of our model and estimate the fraction of labor productivity that is private information. We find that for the model and data to be consistent, all of the shocks to labor productivities must be private information.
Composition of Wealth, Conditioning Information and the Cross-Section of Stock Returns
I tested conditional implication of linear asset pricing models in which variables reflecting changing composition of total wealth capture time-variation in the consumption risk exposures of asset returns. In estimate conditional moments of returns and factor risk prices nonparametrically and show that while the consumption risk of value stocks does increase relative to that of growth stocks in “bad” times, their conditional expected returns do not. Consequently, imposing the conditional moment restrictions results in large pricing errors, virtually eliminating the advantage of conditional models over the unconditional ones. Thus, exploiting conditioning information to impose joint restriction on both the time-series and cross-sectional properties of asset returns exposes an additional challenge for the canonical CCAPM. The puzzle is less pronounced for models that rely on the long-run consumption risk encoded in the aggregate financial wealth.
The Term Structures of Equity and Interest Rates
Martin Lettau and Jessica A. Wachter
This paper proposes a dynamic risk-based model capable of jointly explaining the term structure of interest rates, returns on the aggregate market and the risk and return characteristics of value and growth stocks. Both the term structure of interest rates and returns on value and growth stocks convey information about how the representative investor values cash flows of different maturities. We model how the representative investor perceives risks of these cash flows by specifying a parsimonious stochastic discount factor for the economy. Shocks to dividend growth, the real interest rate, and expected inflation are priced, but shocks to the price of risk are not. Given reasonable assumptions for dividends and inflation, we show that the model can simultaneously account for the behavior of aggregate stock returns, an upward-sloping yield curve, the failure of the expectations hypothesis and the poor performance of the capital asset pricing model.
Changing Institutional Preferences and Investment Performance: A Stock Holdings Perspective
Marshall E. Blume and Donald B. Keim
Institutional investors have rapidly increased their percentage holdings of US equities in recent years. In this paper we update previous research on the nature of institutional stock ownership, extending the evidence by twelve years to the end of 2008. In contrast to previous research, we find that institutions, and particularly hedge funds, have increased their holdings of smaller stocks and decreased their holdings of larger stocks over this period. Institutions as a whole now underweight the largest stocks and overweight the smallest stocks relative to market weights. We examine the implications of these patterns in institutional stock ownership for institutional investment performance.