INSEAD the business school for the world

Research

I specialize in three main areas of research:

  1. The role of information in financial markets
     
  2. Industrial organization and financial markets
      a. The effects of the organizational structure of mutual funds
      b. The role of strategic interaction and concentration in the product market
      
  3. The implications of investor demand. What do we learn from looking at investors' holdings?
      a. The determinants of portfolio choice,
      b. Investor demand and the financial markets,
      c. Investor demand and corporate finance: the asset pricing of corporate finance.

 

1) Information and Financial Markets

Investment Banks as Insiders and the Market for Corporate Control (joint with A.Bodnaruk and A.Simonov) Forthcoming, Review of Financial Studies.

 We study holdings in M&A targets by financial conglomerates which affiliated investment banks advise the bidders. We show that advisors take positions in the targets before M&A announcements. These stakes are positively related to the probability of observing the bid and to the target premium. We argue that this can be explained in terms of advisors, privy to important information about the deal, investing in the target in the expectation of its price to increase. We document the high profits of this strategy. We also document a positive relationship between the advisory stake and the deal characteristics. The advisory stake is positively related to the likelihood of deal completion and to the termination fees. However, these deals are not wealth-creating: there is a negative relation between the advisory stake and the viability of the deal. These results provide new insights into the conflicts of interest affecting financial intermediaries simultaneously advising on deals and investing in equities.


The bank-firm relationship: a trade-off between better governance and greater information asymmetry (joint with N. Dass). 2006

We study the governance role of banks and provide evidence of the following trade-off: while monitoring by the bank enhances the firm’s corporate governance, this also increases the informational asymmetry in the market.  We analyze this trade-off and quantify the “dark side” of the bank’s lending relationship with the firm (Rajan, 1992).  We define the power of the bank vis-à-vis the borrowing firm in terms of the exclusivity of the relationship as well as of the proximity to the borrowing firm.  We show that a “stronger” lending relationship, measured by greater proximity and exclusivity, improves monitoring and increases managerial turnover.  This in turn abates rent-appropriation by managers, reduces their insider trading as well as their incentives to initiate acquisitions, and lowers their risk-taking behavior.  This translates into lower volatility of cash-flows, and also, a lower stock volatility.  At the same time, however, a stronger lending relationship increases adverse selection in the market and reduces the investors’ incentives to hold the stock of the borrowing firm.  This brings down the stock’s liquidity as well as trading volume in the market and widens the information asymmetry. Institutional investors reduce their trading in the stock of firms that have a stronger relationship with their bank(s).  The net effect of a strong lending relationship on the firm’s value is positive.  The effect of a more exclusive bank-lending relationship increases the stock price after the inception of the loan by roughly 6%.  Our results have important normative implications for the role of banks in the development of financial markets.  Moreover, the impact of banks on stock-market liquidity is particularly relevant now as Glass-Steagall Act has been abolished – the abolition opens the possibility of banks trading directly on the basis of information they acquire during the course of their lending activity.


Monetary policy uncertainty and the stock market (joint with A. Locarno). CEPR Working Paper, January 2005.

We study the impact of the uncertainty about the type of monetary policy on financial markets. We derive a model where we explicitly link fundamental uncertainty and uncertainty about the type of monetary policy and generate testable implications of their relative impacts on asset prices. We argue that investors' learning about the stance of the monetary policy induces uncertainty that is reflected in asset premia. We show that inflation, by providing the investors with an opportunity to study the central banker's reaction, may help to reduce this uncertainty and, therefore, risk premia. We show that properly accounting for the uncertainty generated by investor's process of learning the stance of monetary policy helps to address the issue of the negative relationship between inflation and stock returns ("Fisher puzzle").


Is learning a dimension of risk? (joint with A. Simonov) Journal of Banking and Finance, 2005, Vol. 29, n° 10. Sarnat Prize as Best Paper Published in the Journal in the year.

We empirically assess how the uncertainty induced by investors' learning about the fundamentals affects stock returns. We identify two components of induced uncertainty: learning uncertainty and dispersion of beliefs. We characterize these in terms of their relationship to uncertainty about the fundamentals as estimated by surveys of economic forecasters and macro-economic indicators, and with measures of uncertainty embedded in derivative markets (open interest and implied volatility). We show that both learning uncertainty and dispersion of beliefs are conditionally priced.


Price manipulation in parallel markets with different degree of transparency, (joint with F. Drudi). Journal of Business, 2005, vol. 78, no. 5 . 

We provide a unique test of trading behavior under asymmetric information with parallel markets characterized by different degrees of transparency for the same asset. We consider the Treasury bond market and show that the informed dealers simultaneously place bids in the primary market and sell in the secondary market, repurchasing when the primary market closes. Price manipulation increases market depth in the more transparent market when the more opaque market is open. This supports the experimental findings of Bloomfield and O'Hara and shows how the existence of less transparent markets may increase the liquidity of the more transparent ones.


Reputation and interdealer trading. A microstructure analysis of the Treasury Bond market. (joint with A. Simonov). Journal of Financial Markets. 2003, 6:99-141.

Trading generates not only information about the payoff of the assets traded, but also information about the traders themselves. Over time this information creates reputation. By using a unique dataset on the Treasury bond market, we derive a measure of reputation. This is then used to group dealers on the basis of their reputation and to analyze how they react to the reputation of other dealers. We show that the same type of trade, on the same asset, in the same market can generate different volume and volatility patterns depending on the type of dealers originating it. We also identify the "salient traders". These traders, even if they do not originate the biggest volume of trade, have the highest impact on the market. These results have strong implications in terms of forecastability of future returns, volatility and overall trading volume because they show that most of the explanatory power of trades is due to salient traders.


Financial innovation and information: the role of derivatives when a market for information exists. Review of Financial Studies, 2002, 15: 927-957

We study the effects of financial innovation in a model of endogenous information acquisition. We determine the conditions under which the introduction of a derivative written on an existing stock increases or decreases the incentive to purchase information. We show that financial innovation produces some effects which hold across informational structures and others which differ. The former coincide with the few empirical results that are robust in the literature (effects on prices, risk premia, and volatility), while the latter coincide with the ones that differ experiment by experiment (effects on volume, correlation between volume and volatility, and market informational efficiency).

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2) Industrial Organization and Financial Markets

a) The Effects of the Organizational Structure of Mutual Funds

Information flows within financial conglomerates: evidence from the banks-mutual fund relationship, (joint with Z. Rehman). Journal of Financial Economics, Aug. 2008.

We investigate the flow of information within financial conglomerates by focusing on the effect that the lending behavior of affiliated banks has on the portfolio choice of the mutual funds belonging to the same conglomerate. We entertain two alternative hypotheses: either mutual funds are used to help the overall policy of the conglomerate of which they are part or they exploit the privileged inside information available to the affiliated bank. We find evidence for the latter. We show that the funds of the conglomerate increase their stakes in the firms that borrow from the affiliated banks in the period following the deal. No analogous finding is there for the unaffiliated funds. Using net-of-style returns, we show that this strategy enhances fund performance, on average, by 15 bps per month (1.8% per year) relative to that of unaffiliated funds in the post-deal era. Funds increase (decrease) their portfolio weights in those borrowing stocks which subsequently provide positive (negative) abnormal returns, suggesting that they exploit inside information not available to the market.

Incentives and mutual fund performance: Higher performance or just higher risk taking? (joint with R. Patgiri). The Review of Financial Studies, Advance Access published on March 29, 2008 .

We study the impact of contractual incentives on the risk-taking behavior and the performance of US mutual funds. We measure incentives using the shape, i.e. concavity, of the fee structure in the advisory contract. Compared to the standard linear fee structure, a concave structure should create a disincentive to take more risk. Our results show that a high incentive contract induces managers to take more risk and reduces the funds’ probability of survival. On the other hand, high-incentive funds deliver higher return. The net of these two effects is that incentives increase the risk-adjusted performance of the fund. In particular, the top incentive quintile of funds outperforms the bottom incentive quintile by about 2.7 percent per year. Moreover, the performance of the high-incentive funds is highly persistent. High-incentive winner funds from one year have a positive alpha of 41 basis points per month in the following year. By focusing on the funds' holdings, we show that active portfolio rebalancing is the main channel through which incentives increase performance.

Mutual Funds and Bubbles: The Surprising Role of Contractual Incentives (joint with N. Dass and R.Patgiri), The Review of Financial Studies, January 2008; 21: 51 - 99.

This paper deals with one of the potential causes of the financial market bubble of the late 1990s: herding behavior of mutual funds.  We study the relation between the incentives contained in the mutual fund advisory contracts and the fund managers’ propensity to ride a bubble.  We show that the incentives embedded in the contract induce managers to overcome their tendency to herd. We argue that investing in bubble stocks amounts to herding and contracts with high incentives induce managers to diverge from the pack, thus reducing their holding of bubble stocks.  Therefore, during a bubble, the contractual incentives effectively induce managers to invest less in bubble stocks and more in “old-economy” stocks. We show that mutual funds with high-incentive contracts diverged from the herd and had relatively lower exposure to bubble stocks in the period prior to March 2000. The different exposure to bubble stocks significantly impacted funds’ performance both before the bursting of the bubble and afterwards.

The rise of anonymous teams in fund management (joint with J. Reuter and E. Zitzewitz), 2007.

A mutual fund family’s decision to characterize a fund as being anonymously "team managed" is a decision about whether to give credit for the fund’s performance to the family or a named manager. This decision about who owns the fund’s track record—an important asset—involves tradeoff between providing stronger managerial incentives, influencing investor perceptions of the fund, and limiting ex post hold-up. Consistent with named managers facing stronger incentives, we find evidence that funds with named managers earn slightly higher risk-adjusted returns than anonymous team managed funds. Consistent with there being marketing benefits associated with named managers, we also find that the media is more likely to mention named-manager funds, and, since most media mentions of funds are positive, this leads to more inflows, especially among no-load funds. However, consistent with successful named managers enjoying more bargaining power, we find that departures of named managers reduce future inflows, and that the effect is strongest for funds with strong past performance. The share of funds managed by unnamed teams has increased by a factor of 4-5 in the last decade, suggesting a shift in these tradeoffs. Anecdotal evidence suggests that the hedge fund boom has increased opportunities for successful mutual fund managers, and we find that the shift to anonymous teams has been most pronounced in the asset classes and cities most a affected by the hedge fund boom.

 Favoritism in mutual fund families? Evidence of strategic cross-fund subsidization, (joint with J.M. Gaspar and P. Matos). Journal of Finance, Jan. 2006, 61:1, 73-104

We investigate whether mutual fund families strategically allocate performance across their member funds favoring those more likely to generate higher fee income or future inflows. We find evidence of strategic cross-fund subsidization of ‘high family value’ funds (i.e. high fees or high past performers) at the expense of ‘low value’ funds in the order of 6 to 28 basis points of extra net-of-style performance per month, depending on the criteria. This over-performance is above the one that would exist between similar funds not part of the same family. We further document how this family strategy takes place by looking at preferential allocation of IPO deals and at the amount of opposite trades among ‘high’ and ‘low value’ funds belonging to the same fund complex (a practice that can encompass ‘cross-trading’). Our findings complement the existing literature on distortions in delegated asset management by highlighting the role played by family affiliation.

Compensation and managerial herding: evidence from the mutual fund industry,(joint with R.Patgiri). Working Paper, 2005.

We test the corporate theory of managerial herding based on reputation and career concerns (Scharfstein and Stein, 1990) by focusing on the mutual fund industry. We investigate the trade-off between reputation and compensation and study how incentives in the advisory contract affect managerial herding and risk taking.  We consider two types of herding: category herding – the choice of operating in a category in which it is easier to preserve reputation, and stock herding – the choice of a trading strategy similar to the ones of the competitors.  We show that a high incentive contract induces entry in categories in which an extreme performance realization is more likely, the adoption of trading strategies different from the ones being followed by other funds and higher risk taking.  Family affiliation reduces (increases) the tendency to herd (to take risk) and, therefore, reduces the need for high incentive contracts.

 Mutual funds and the market for liquidity, (joint with L. Phalippou). CEPR Working Paper, 2004.

We study how actively managed equity mutual funds select the liquidity level of their portfolio and the effects of this selection on performance. We provide evidence of four key determinants of portfolio liquidity: portfolio size, the number of stocks held, family size and fee structure. We also show that liquidity is a persistent characteristic, but it is nevertheless dynamically managed so as to offset both exogenous liquidity shocks and changes in portfolio characteristics. Liquid funds are seen to strongly overperform (underperform) during illiquid (liquid) times but, on average, net performance is unaffected by liquidity.

Mutual fund competition and stock market liquidity,  CEPR Working Paper, 2004.

 We study how competition in the mutual fund industry affects stock market liquidity. We argue that mutual fund families operate as multi-product firms, jointly choosing fees, performance and number of funds and sharing common research facilities. The family-based organization generates economies of scale in information that induce a trade off between performance and number of funds. The presence of more and relatively less informed funds impacts the market, increasing stock liquidity. This intuition allows us to use observable equilibrium conditions in the mutual fund market that are related to fund informativeness (i.e., fees, size and performance of the funds and number of funds per family), to explain stock market liquidity. We test our theory using the universe of the US actively managed mutual funds in the past 20 years. We identify fund characteristics and relate them to stock liquidity. We show that the fund characteristics affect stocks in the way suggested by our theory: higher fees or better performance reduce stock liquidity, while a higher number of funds per family or bigger fund size increase stock liquidity. Proper identification allows us to pin down the direct impact of funds on stock liquidity, controlling for potential issues of reverse causality.

How do family strategies affect fund performance? When performance-maximization is not the only game in town. Journal of Financial Economics, 2003, 67:249-315.

This is a first attempt to study how the structure of the industry affects mutual fund behavior. I show that industry structure matters; the mutual fund families employ strategies that rely on the heterogeneity of the investors in terms of investment horizon by offering the possibility to switch across different funds belonging to the same family at no cost. I argue that this option acts as an externality for all the funds belonging to the same family, affecting the target level of performance the family wants to reach and the number of funds it wants to set up. By using the universe of the U.S. mutual fund industry, I empirically confirm this intuition. I find evidence of family driven heterogeneity among funds and show that families actively exploit it. I argue that the more families are able to differentiate themselves in terms of non-performance-related characteristics, the less they need to compete in terms of performance. Product differentiation—i.e., the dispersion in the “services” (fees, performance) that the competing funds offer—affects performance and fund proliferation. In particular, I show that the degree of product differentiation negatively affects performance and positively affects fund proliferation.

Why so many mutual funds? Mutual funds, market segmentation and financial performance, 1997. This is an old (and still to be revised) version, from which all my research in this area started. It owes much to an illuminating conversation on the "family game" with M. Gruber in 1995.

Why are there so many mutual funds around? What leads the industry to segment itself into an ever-increasing number of categories? What can be said about such a market configuration in terms of welfare? To address these questions we model the process that endogenously leads to market segmentation and to fund proliferation in the mutual fund industry. We argue that these phenomena can be seen as marketing strategies used by the managing companies to exploit investors’ heterogeneity. We explain category and fund proliferation providing an industry-specific micro foundation based on three competing effects: “signalling”, ”risk-hedging” and “learning-by-doing” externalities. We argue that market forces may induce a sub-optimal number of mutual funds and categories and identify the factors that determine such inefficiency. Mutual fund performance is endogenously derived as a function of investors’ and managing companies’ tastes and technology. This lets us shed new light on the determinants of mutual fund performance and reconsider the traditional methods of testing fund efficiency.
 

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b) The Role of Strategic Interaction and Concentration in the Product Market

 

Cosmetic Mergers: The Effect of Style Investing on the Market for Corporate Control (joint with Lei Zhang) Paris December 2007 Finance International Meeting AFFI - EUROFIDAI. Forthcoming, Journal of Financial Economics.

We study the impact of "style investing" on the market for corporate control. We argue that a firm may boost its market value by merging with a firm that belongs to an investment style that is more popular with the market. By using data on the flows in mutual funds, we construct a measure of popularity, which relies directly on the identification of sentiment-induced investor demand, rather than being a direct transformation of stock market data. We show that differences in popularity between bidder and target help to explain their pairing. The merger with a more popular target generates a halo effect from the target to the bidder that induces the market to evaluate the assets of the less popular bidder at the (inflated) market value of the more popular target. Both bidder and target premia are positively related to the difference in popularity between the target and the bidder. However, the target's ability to appropriate the gain is reduced by the fact that its bargaining position is weaker when the bidder's potential for asset appreciation is higher. We document a better short and medium-term performance of less popular firms taking over more popular firms. The bidder managers engaging in these cosmetic mergers take advantage of the window of opportunity induced by the deal to reduce their stake in the firm under convenient conditions.

Mimicking repurchases (joint with Z.Rehman and T.Vermaelen). Journal of Financial Economics, Vol. 84, Issue 3, June 2007, Pages 624-666 .

We study the tendency of firms to mimic the repurchase announcements of their industry counterparts. We argue that a firm, by repurchasing its shares, sends a positive signal about itself and a negative one about its competitors. This induces the competing firms to mimic the behavior of the repurchasing firm by repurchasing themselves. By using a broad sample of U.S. firms for the period 1984 to 2002, we show that in concentrated industries, a repurchase announcement lowers the stock price of the other firms in the same industry. The other firms then retaliate by repurchasing themselves in order to undo these negative effects. When repurchases do occur, they are chosen mostly as a strategic reaction to other firms’ initiating repurchases and are not motivated by the desire to time the market, i.e. to take advantage of a significantly undervalued stock price. We show that repurchasing firms in more concentrated industries, therefore, experience a lower increase in value in comparison to their less concentrated counterparts in the post-announcement era. Alternative methodologies used to estimate long-term performance confirm that it is only the low concentration firms that outperform the market, their non-repurchasing peers and their more concentrated counterparts by amounts that are economically and statistically significant.

Idiosyncratic Volatility and Product Market Competition (joint with J.M. Gaspar) The Journal of Business, 2006, vol. 79, no. 6

This paper investigates the relation between a firm’s competitive position and the idiosyncratic volatility of its stock price. We focus on two particular aspects of competitive conditions: the firm’s market power, interpreted as its ability to price above marginal cost, and the firm’s investment in innovation, proxied by the amount spent on research and development (R&D). We test the prediction that greater market power provides a firm with a natural hedge against idiosyncratic shocks. The empirical results show that firms with higher market power exhibit a lower absolute level of idiosyncratic volatility and also a higher ratio of systematic to total volatility. These findings are further supported by Granger causality tests, where we show that an increase in market power reduces idiosyncratic volatility, but not the reverse. We also produce evidence that investments in innovation make the firm more opaque to outside investors by showing that R&D spending increases idiosyncratic volatility but does not change the ratio of systematic to total risk. Our overall results contribute to the understanding of recent empirical trends of idiosyncratic volatility, and confirm the important link between stock market performance and the competitive environment of firms.

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3) Portfolio Choice and the Stock Market

a) Determinants of Portfolio Choice

Hedging, familiarity and portfolio choice (joint with A. Simonov). 2006, Review of Financial Studies 19(2):633-685

We exploit the restrictions of intertemporal portfolio choice in the presence of non-financial income risk to design and implement tests of hedging that use the information contained in the actual portfolio of the investor. We use a unique dataset of Swedish investors with information broken down at the investor level and into various components of wealth, investor income, tax positions and investor demographic characteristics. Portfolio holdings are identified at the stock level. We show that investors do not engage in hedging, but invest in stocks closely related to their non-financial income. We explain this with familiarity, that is the tendency to concentrate holdings in stocks with which the investor is familiar in terms of geographical or professional proximity or that he has held for a long period. We show that familiarity is not a behavioral bias, but is information-driven. Familiarity-based investment allows investors to earn higher returns than they would have otherwise earned if they had hedged.

Portfolio choice and menu exposure (joint with A. Carlsson and A. Simonov). 2005. Awarded the LECH Prize as the Best Paper in Behavioral Finance at EFA 2006 Zurich Meetings.

We study the impact of menu representation on portfolio choice and we show that investors choose assets as a function of the way they are represented in the menu available to them. We use the choices of mutual funds for retirement accounts of the Swedish population. We show that investors prefer the funds that belong to categories that are more represented in the menu. More numerous categories attract more investment than what portfolio theory would suggest. Moreover, an exogenous change in the menu changes investor demand. An increase in the representation of a category in the menu increases investment in the funds belonging to the same category, including the already existing ones. By using information on the performance of the funds that investors choose and the degree of concentration of the investor portfolio, we show that there is a consistent positive correlation between the investor’s sensitivity to menu exposure and his degree of informativeness. This suggests that menu exposure represents a rational way of coping with limited (private) information that decreases as information improves. Our findings shed light on the home bias puzzle and insight on the determinants of style investing. They also have direct normative implications in terms of Social Security reform.

History versus Geography: the role of college interaction in portfolio choice. (joint with A. Simonov). CEPR Working Paper, 2005.

We study the link between social interaction and portfolio choice. We concentrate on a form of interaction that is rooted back in the past: college-based interaction – defined as the one that relates the portfolio choice of an investor to that of the other investors who went to the same college. We explain it in terms of a common cultural imprinting and the development of long-term friendship and alumni networks and we directly quantify its impact on portfolio choice. We compare college-based interaction to other forms of social interaction, such as professional and geographical interaction, properly controlling for the standard motivations of portfolio theory, such as hedging of non-financial income risk, familiarity, wealth and income effect, a host of demographic, geographic and professional dummies, trend-chasing and momentum behavior. All the different sources of social interaction significantly affect stock-picking both statistically and economically. College-based interaction is, however, in general stronger than the other sources of social interaction and has an explanatory power higher than the standard determinants of portfolio choice, such as hedging non-financial income risk, familiarity and so on. The impact of college-based interaction is statistically and economically significant. Investors invest in the same stocks in which their former classmates do and skew their portfolios towards growth stocks if their former classmates do the same. Moreover, investors are more likely to herd with the other investors who went to the same college than with the rest of the population. College-based interaction also affects investors’ decision to concentrate their portfolios in few stocks.

Portfolio diversification, proximity investment and city agglomeration (joint with W. Goetzmann and A. Simonov). CEPR Working Paper, 2004. Version AFA 2004.

We study the puzzle of portfolio underdiversification and proximity investment from a novel perspective, linking it to the process of urbanism. We find that urban portfolios are more focused – i.e., less diversified and more concentrated in "close" stocks - than urban portfolios. We explain it in terms of the process of “knowledge-spillover” that characterizes urban environments. We test this against a number of alternative theories: real and perceived informational advantage, local social competition and hedging of non-financial risk. We show that the very same factors behind the drive to city agglomeration also affect both the degree of portfolio diversification and proximity investing, by influencing investor information and risk.

Behavioral biases and portfolio choice (joint with A. Simonov). EFA 2003 Annual Conference Paper No. 717. NBER Version.

We investigate the way investors react to prior gains/losses. We use a new and unique dataset with detailed information on investors' various components of wealth, income, demographic characteristics and portfolio holdings identified at the stock level. We test the theory of loss aversion against the alternative provided by standard utility theory and the house-money effect. We show that, on a yearly horizon, investors do not behave according to loss aversion and more in line with standard utility theory or the house-money effect. We also show that investors do not suffer from the mental accounting bias. Investors consider wealth in its entirety and risk taking in the financial market is affected by gains/losses in overall wealth, financial wealth and real estate wealth.

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b) Investor Demand and the Financial Markets

Disposition matters: volume, volatility and price impact of a behavioral bias (joint with W. Goetzmann) 2003, NBER Working Paper 9499, CEPR Working Paper, 2004. Journal of Portfolio Management, Winter 2008.

We test the market impact of behavioral biases. We focus on the disposition effect. We rely on the Grinblatt and Han (2002) model and derive several testable implications about the expected relationship between the preponderance of disposition-prone investors in a market and stock trading volume, volatility and returns. We identify disposition-motivated transactions by using a large sample of individual accounts over a six-year period in the 1990’s.  We then use them to construct behavioral factors. We show that, at a daily frequency, when the fraction of “irrational” investor purchases in a stock increases, the unexplained portion of the market price of the stock decreases, as does stock volatility and trading volume.  We further show that statistical exposure to a disposition factor explains cross-sectional differences in daily returns, after controlling for a host of other factors and characteristics.  The evidence is consistent with the hypothesis that trades between disposition-prone investors and their counter-parties impact relative prices.

Dispersion of opinion and stock return (joint with W. Goetzmann). Journal of Financial Markets, Vol. 8, Issue 3, Aug. 2005, Pages 324-349 .

We use a panel of more than 100,000 investor accounts in US stocks over the period 1991-1995 to test different theories relating dispersion of opinion to the stock market. We show that the dispersion of opinions of the investors in a stock positively affects the return and trading volume of the stock. Moreover, dispersion of opinions aggregates across many stocks and generates factors that have a market-wide effect, affecting stock equilibrium rate of returns. We also relate our investor-based measure of dispersion of opinions to the dispersion of analysts' forecasts and we show that it Granger causes it. 

Do demand curves for currencies slope down? (joint with J. Peress and H. Hau). CEPR Working Paper, 2005.

Do exchange rates react to exogenous capital movements? We explore this issue based on the redefinition of the MSCI international equity indices announced on December 10, 2000 and implemented in two steps on November 30, 2001 and May 31, 2002. The index changes implied major changes in the representation of different countries in the MSCI world index. Our event study shows a strong announcement effect in which countries with a decreasing equity representation vis-a-vis the US depreciated against the dollar. Around the two implementation dates, we find further systematic, but opposite, exchange rate effects, which can be interpreted as a result of excessive speculation on the first implementation date and insufficient speculation on the second date.

Behavioral factors in mutual funds flows (joint with W. Goetzmann and G. Rouwenhorst). Yale School of Management Working Paper, 2004.

Using a sample of daily net flows to nearly 1,000 U.S. mutual funds over a year and a half period, we identify a set of systematic factors that explain a significant amount of the variation in flows. We find that flows into equity funds -- both domestic and international – are negatively correlated to flows to money market funds and precious metals funds.  This suggests that investor rebalancing between cash and equity explains a significant amount of trade in mutual fund shares. We find that the factors derived from flows alone explain as much as 45% of the cross-sectional variation in mutual fund returns.  The fund flow factors provide significant incremental explanatory power in the cross-sectional regressions on daily returns.

Index funds and stock market growth (joint with W. Goetzmann). Journal of Business 2003, Vol. 76: 1-28.

We use 2 years of daily flows for three major Standard and Poor's index funds to analyze the relationship among index funds, asset prices, and volatility. We find strong contemporaneous correlation between inflows and returns, no evidence for positive feedback trading, and evidence that negative market returns may induce subsequent sales. Market volatility affects investors as dynamic risk sharing, but higher volatility does not drive investors from the market. Bullish newsletter sentiment is associated with greater inflows. We report high correlation among investor disagreement and market uncertainty and flows. Dispersion in advice and open interest correlate with lower inflows

Daily momentum and contrarian behavior of index fund investors (joint with W. Goetzmann) Journal of Financial and Quantitative Analysis, 2002, Vol. 37: 375-390.

We use a two-year panel of individual accounts in an S&P 500 index mutual fund to examine the trading and investment behavior of more than 91,000 investors who have chosen a low-cost, passively managed vehicle for savings. We identify classes of momentum investors and contrarian investors. We use these classes to build up 'behavioral factors' based on contrarian and momentum flows and we show that they are relevant for pricing. They perform well against a benchmark of loadings on latent factors extracted from returns.

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c) Investor Demand and Corporate Finance: the Asset Pricing of Corporate Finance.

 

Shareholder diversification and the decision to go public (joint with A.Bodnaruk, E.Kandel, and A. Simonov). Review of Financial Studies 2008 21(6):2779-2824.  

We study IPOs by focusing on the degree of portfolio diversification of the shareholders taking the company public. We argue that a less diversified shareholder has more to gain from taking the company public and would be more willing to accept a lower price for the sale of its shares, i.e. tolerate higher underpricing. We test these hypotheses by considering all the IPOs that took place in Sweden in the period 1995-2001. We have obtained detailed information on the portfolio composition of all the investors in the companies being taken public, both before and after the IPO, as well as the portfolio composition of investors in similar (in terms of size, book-to-market and industry) companies not taken public. The information is detailed at the stock level, for both private and public companies. We construct several proxies for portfolio diversification of the shareholders and relate them to both the probability of the IPO and the underpricing. We show that companies held by less diversified shareholders are more likely to go public and suffer a higher underpricing. We show that, as predicted, the degree of diversification explains a significant (economically and statistically) part of the probability of going public, and may account for between one third and one half of the reported underpricing. This suggests that the degree of diversification of controlling shareholders should play a prominent role in the discussion of the process of going public

Local ownership and private information: evidence of a monitoring-liquidity trade-off, (joint with J.M. Gaspar). Journal of Financial Economics 2007, 83, 751-792.

Finance literature has demonstrated an increasing interest on local owners (investors geographically close to firms in which they invest), arguing that they exhibit superior returns due to private information. We use local ownership as a proxy for the amount of private information in a stock. Using data on mutual fund holdings, we construct a measure of local ownership for a broad panel of U.S. firms. We show that, depending on the size of their stake, privately informed investors improve the quality of governance of the firm and induce value enhancing decisions (less over-investment and fewer acquisitions). At the same time, their presence in the firm increases the adverse selection discount required by the less informed investors to trade, reducing the firm’s liquidity. We provide evidence that both effects are properly factored in by the investors and impounded in the firm’s stock price. Our results contribute to the understanding of the liquidity-monitoring controversy and qualify the existing results of the emerging local ownership literature: the illiquidity borne out by the presence of local investors may play a role in the observed abnormal performance uncovered by these studies.

Shareholder investment horizon and the market for corporate control (joint with J.M. Gaspar and P. Matos), 76:1, Apr. 2005, 135-165

This paper investigates how the investment horizon of a firm’s institutional shareholders impacts the market for corporate control. We find that target firms with short-term shareholders are more likely to receive an acquisition bid, but get lower premiums. This effect is robust and economically significant: targets whose shareholders hold their stocks for less 4 months, one standard deviation away from the average holding period of 15 months, exhibit a lower premium by 3%. In addition, we find that bidder firms with short-term shareholders experience significantly worse abnormal returns around the merger announcement, as well as higher long-run underperformance. These findings suggest that firms held by short-term investors have a weaker bargaining position in acquisitions. Weaker monitoring from short-term shareholders may allow managers to proceed with value-reducing acquisitions or to bargain for personal benefits (e.g. job security, empire-building) at the expense of shareholder returns.

Can buybacks be a product of shorter shareholder horizon? (joint with J.M. Gaspar, P. Matos, R. Patgiri and Z. Rehman), CEPR Working Paper, 2004. Version AFA 2005.

We study payout policy decisions of US firms and examine how shareholder investment horizons influence firms’ decisions to buyback shares or increase their cash dividend.  We find that firms held by short-term investors have a higher propensity to payout through repurchases. Managers seem to cater to the preferences of investors who expect to cash out of their investment sooner, specially at times when the market is exhibiting a greater ‘premium’ for non-dividend-paying stocks. Market prices around repurchase program announcements impound the preferences of investors on payout policy. For firms with dividend programs already in place, the market return is found to be positively related to the presence of short-term investors, reflecting a pure ‘investor catering’ effect. However, announcement returns are negatively related to short-term investors if repurchases are rich in information content, as is the case for firms that have not paid dividends before. This suggests the market attributes a lower signaling power to buybacks by firms under pressure from short-term shareholders. Long-run post-announcement abnormal returns confirm these patterns. Shorter investment horizons can reconcile the popularity of share buybacks in the 1990s with the high valuation of share prices by historical standards, which give less credence to under-valuation motive of share repurchases.

Limits of arbitrage and corporate financial policy (joint with U.Peyer and Z.Tong). CEPR Working Paper, 2004. Version of UNC-DUKE Conference on Corporate Finance.

We focus on an exogenous event that changes the cost of capital of a company: the addition of its stock to the S&P500 index. We investigate how the companies react to it by modifying their corporate financial and investment policies. This allows us to test capital structure theories in an ideal controlled experiment where the effect of the index addition on the stock price is exogenous from a manager’s point of view. We find that the event decreases the cost of equity using the Fama-French three factor model. Consistent with the trade-off and market timing theory but inconsistent with the pecking order theory, we find a positive correlation between the announcement abnormal return and equity issues and investment and a negative correlation between equity issues and debt issues. Moreover, we provide a new test of Stein's (1996) market timing theory based on the market reaction to the financial and investment policies of financially constrained and unconstrained firms. We show that firms that are unconstrained but issue equity and increase investment reveal themselves to be managed by short horizon managers and generate a significantly lower long-run abnormal performance. Our results support a limits of arbitrage story in which the stocks display a downward sloping demand curve because the abnormal return and the change in institutional ownership around the event are significantly positively correlated. Our findings of a negative long-run abnormal return for firms that issue equity is consistent with the interpretation that companies themselves act as ‘arbitrageurs’ taking advantage of the window of opportunity.

Shareholder homogeneity and firm value: the disciplining role of non-controlling shareholders. (joint with E. Kandel and A. Simonov). Working Paper.

We study the relationship between shareholder similarity and firm value. We argue that shareholder similarity increases the value of the firm and its transparency versus the market. We test this hypothesis by using a dataset containing information on all the shareholders for each firm in Sweden from 1995 to 2001. We construct two proxies for shareholder similarity: the first based on the age cohort of the shareholders, and the second on their degree of college interaction. For each firm, we measure the degree of similarity across all its shareholders. We show that homogeneous shareholders act as a disciplining device on managers, inducing them to meet market expectations and to engage less in value-destroying activities. This leads to higher firm profitability, higher Tobin’s Q and lower analyst dispersion and forecast errors. We argue that shareholder similarity represents an alternative and indirect source of corporate governance based on the stock market.

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