Findings

Exposure

Kevin Lewis

March 02, 2018

Circle of Incompetence: Sense of Understanding as an Improper Guide to Investment Risk
Andrew Long, Philip Fernbach & Bart de Langhe
Journal of Marketing Research, forthcoming

Abstract:
Consumers incorrectly rely on their sense of understanding of what a company does to evaluate investment risk. In three correlational studies, greater sense of understanding was associated with lower risk ratings (Study 1) and with prediction distributions for future stock performance with lower standard deviations and higher means (Studies 2 and 3). In all studies, sense of understanding was unassociated with objective risk measures. Risk perceptions increased when we degraded sense of understanding by presenting company information in an unstructured versus structured format (Study 4). Sense of understanding also influenced downstream investment decisions. In a portfolio construction task, both novices and seasoned investors allocated more money to hard-to-understand companies for a risk-tolerant client relative to a risk-averse one (Study 5). Study 3 ruled out an alternative explanation based on familiarity. The results may explain both the enduring popularity and common misinterpretation of the “invest in what you know” philosophy.


Investor Ideology
Patrick Bolton et al.
Columbia University Working Paper, February 2018

Abstract:
This paper analyzes the voting patterns of institutional investors from their proxy voting records. It estimates a spatial model of voting, using the W-NOMINATE scaling for voting in legislatures. We find that institutional investors’ ideology (or ideal points) can be mapped onto a left-right dimension, just as legislators’ ideologies can be represented along a left-right spectrum. The far-left investors are socially responsible investors and the far-right investors are “greedy” investors, those opposed to proposals that could financially cost shareholders. There are significant ideological differences across institutional investors and there is no shareholder unanimity. The proxy adviser Institutional Shareholder Services (ISS) plays a role similar to a political party. A second adviser, Glass Lewis, has fewer followers. We find that the ideology of ISS is center-left, to the left of most institutional investors and Glass Lewis. Furthermore, Vanguard and Blackrock are center-right, and the ideology reflected in management proposals and voting recommendations is far to the right. Investors on the left support a more social orientation of the firm on environmental and other issues. They also support fewer executive compensation proposals.


Front Page News: The Effect of News Positioning on Financial Markets
Anastassia Fedyk
Harvard Working Paper, January 2018

Abstract:
This paper estimates the effect of presentation of information on financial markets, using a natural experiment in prominent “front page” positioning of news on the Bloomberg terminal. The front page and non-front page articles are indistinguishable by either algorithmic analysis or by the target audience of active finance professionals. Front page positioning induces 280% higher trading volumes and 180% larger price changes within the first ten minutes after news publication. Front page articles also see a stronger price drift for 30-45 minutes after publication. Subsequently, non-front page news begins to catch up, but the incorporation of non-front page information is substantially more gradual. As a result, the initial effects of positioning persist for days after publication. The effects induced by positioning are even stronger than the differences between articles of varying editorial importance.


The Misguided Beliefs of Financial Advisors
Juhani Linnainmaa, Brian Melzer & Alessandro Previtero
Indiana University Working Paper, December 2017

Abstract:
A common view of retail finance is that conflicts of interest contribute to the high cost of advice. Using detailed data on financial advisors and their clients, however, we show that most advisors invest personally just as they advise their clients. Advisors trade frequently, chase returns, prefer expensive, actively managed funds, and underdiversify. Advisors' net returns of -3% per year are similar to their clients' net returns. Advisors do not strategically hold expensive portfolios only to convince clients to do the same; they continue to do so after they leave the industry.


High Frequency Trading and Extreme Price Movements
Jonathan Brogaard et al.
Journal of Financial Economics, forthcoming

Abstract:
Are endogenous liquidity providers (ELPs) reliable in times of market stress? We examine the activity of a common ELP type — high frequency traders (HFTs) — around extreme price movements (EPMs). We find that on average HFTs provide liquidity during EPMs by absorbing imbalances created by non-high frequency traders (nHFTs). Yet HFT liquidity provision is limited to EPMs in single stocks. When several stocks experience simultaneous EPMs, HFT liquidity demand dominates their supply. There is little evidence of HFTs causing EPMs.


Tips from TIPS: The Informational Content of Treasury Inflation-Protected Security Prices
Stefania D’Amico, Don Kim & Min Wei
Journal of Financial and Quantitative Analysis, February 2018, Pages 395-436

Abstract:
Treasury Inflation-Protected Securities (TIPS) are frequently thought of as risk-free real bonds. Using no-arbitrage term structure models, we show that TIPS yields exceeded risk-free real yields by as much as 100 basis points when TIPS were first issued and up to 300 basis points during the 2007–2008 financial crisis. This spread predominantly reflects the poorer liquidity of TIPS relative to nominal Treasury securities. Other factors, including the indexation lag and the embedded deflation protection in TIPS, play a much smaller role. Ignoring this spread also significantly distorts the informational content of TIPS break-even inflation, a widely used proxy for expected inflation.


Is being Sharia compliant worth it?
Jamil Jaballah, Jonathan Peillex & Laurent Weill
Economic Modelling, forthcoming

Abstract:
We investigate the effect of Sharia compliance on stock valuations. To this end, we examine the price effects of additions to and deletions from the Dow Jones Islamic Market Index (DJIMI). Using the event study methodology, we measure abnormal returns for companies from Muslim countries and the US over the period of 2000–2017. We find that additions to the Islamic index lead to a positive stock market reaction in Muslim countries but a negative reaction in the US. Conversely, deletions from the Islamic index generate a negative stock market reaction in Muslim countries but a positive one in the US. The differing valuation effects can be explained by different perceptions of investors. In Muslim countries, investors have a positive perception of the Sharia compliance because of religious beliefs, while in the US they negatively react because of a negative perception of Islam and of the restrictions associated with Sharia compliance.


Decision-making, financial risk aversion, and behavioral biases: The role of testosterone and stress
John Nofsinger, Fernando Patterson & Corey Shank
Economics & Human Biology, May 2018, Pages 1–16

Abstract:
We examine the relation between testosterone, cortisol, and financial decisions in a sample of naïve investors. We find that testosterone level is positively related to excess risk-taking, whereas cortisol level is negatively related to excess risk-taking (correlation coefficient [r]: 0.75 and −0.21, respectively). Additionally, we find support for the dual-hormone hypothesis in a financial context. Specifically, the testosterone-to-cortisol ratio is significantly related to loss aversion. Individuals with a higher ratio are 3.4 times more likely to sell losing stocks (standard error [SE]: 1.63). Furthermore, we find a positive feedback loop between financial success, testosterone, and cortisol. Specifically, financial success is significantly related to higher post-trial testosterone and cortisol by a factor of 0.53 (SE: 0.14). Finally, we find that in a competitive environment, testosterone level increases significantly, leading to greater risk-taking than in noncompetitive environment. Overall, this study underscores the importance of the endocrine system on financial decision-making. The results of this study are relevant to a broad audience, including investors looking to optimize financial performance, industry human resources, market regulators, and researchers.


Democratizing Art Markets: Fractional Ownership and the Securitization of Art
Amy Whitaker & Roman Kräussl
NYU Working Paper, January 2018

Abstract:
Using unique historical sales data from the Leo Castelli Gallery, we introduce a novel model of evaluating art market returns using first-sale prices alongside auction results. We create a sample portfolio to analyze what would have happened if the artists Jasper Johns and Robert Rauschenberg had retained 10% equity in the work they sold through their dealer in the years 1958 to 1963, which was the start-up phase of the artists’ careers. We find that this retained-equity portfolio would have performed from 2.8 up to 140.8 times better (Rauschenberg) and from 24.9 up to 986.8 times better (Johns) than the S&P 500 over the same period. Modeling equity portfolios for artists changes the fundamental structure of art markets. Because the fractional equity is a property right under the Coase theorem, this system introduces a secondary market for shares in artwork. These shares could trade using a technology such as the blockchain and would allow more democratic and diversifiable access to investment in art markets. Our framework extends to other creative industries in which early-stage work is difficult to value.


Arbitrage Involvement and Security Prices
Byoung-Hyoun Hwang, Baixiao Liu & Wei Xu
Management Science, forthcoming

Abstract:
We propose that hedge funds more aggressively buy underpriced stocks when they are allowed to short. To test our proposition, we utilize the institutional feature in Hong Kong in virtue of which only stocks added to a special list can be shorted. Our first-stage analysis uses hedge fund holdings data and provides evidence that the emergency of shortable securities, indeed, causes hedge funds to more aggressively buy seemingly underpriced stocks. Our second-stage analysis presents evidence that hedge funds’ increased involvement in these stocks helps correct underpricing and moves prices in the direction of fundamentals.


Passive versus Active Fund Performance: Do Index Funds Have Skill?
Alan Crane & Kevin Crotty
Journal of Financial and Quantitative Analysis, February 2018, Pages 33-64

Abstract:
We apply methods designed to measure mutual fund skill to a cross section of funds that is unlikely to exhibit managerial portfolio selection skill: index funds. Surprisingly, these tests imply index fund skill exists, is persistent, and is in similar proportion as in active funds. We use the distribution of passive fund performance to gauge the incremental ability of active managers. Outperformance by top active funds is lower when benchmarked to the index fund distribution and disappears when we account for residual risk. Stochastic dominance tests suggest no risk-averse investor should choose a random active fund over a random index fund.


Marketing Mutual Funds
Nikolai Roussanov, Hongxun Ruan & Yanhao Wei
University of Pennsylvania Working Paper, December 2017

Abstract:
Marketing and distribution expenses constitute a large fraction of the cost of active management in the mutual fund industry. We investigate their impact on the allocation of capital to funds and on returns earned by mutual fund investors. We develop and estimate a structural model of costly investor search and fund competition with learning about fund skill and endogenous marketing expenditures. We find that marketing is nearly as important as performance and fees for determining fund size. Restricting the amount that funds can spend on marketing substantially improves investor welfare, as more capital is invested with passive index funds and price competition decreases fees on actively managed funds. Average alpha increases as active fund size is reduced, and the relationship between fund size and fund manager skill net of fees is closer to that implied by a frictionless model. Decreasing investor search costs would also imply a reduction in marketing expenses and management fees as well as a shift towards passive investing.


Fiscal Policy, Consumption Risk, and Stock Returns: Evidence from U.S. States
Zhi Da, Mitch Warachka & Hayong Yun
Journal of Financial and Quantitative Analysis, February 2018, Pages 109-136

Abstract:
We find that consumption risk is lower in states that implement countercyclical fiscal policies. Moreover, firms with an investor base that is concentrated in countercyclical states have lower stock returns, along with firms that relocate their headquarters to a countercyclical state. Therefore, countercyclical fiscal policies lower the consumption risk of investors and, consequently, their required equity return premium. This conclusion is confirmed by smaller declines in market participation during recessions in countercyclical states. Overall, the location of a firm’s investor base enables state-level fiscal policy to influence stock returns.


High-Frequency Measures of Informed Trading and Corporate Announcements
Michael Brennan, Sahn-Wook Huh & Avanidhar Subrahmanyam
Review of Financial Studies, forthcoming

Abstract:
We explore the dynamics of informed trading around corporate announcements of merger bids, dividend initiations, SEOs, and quarterly earnings by calculating daily posterior probabilities of informed buying and selling. We find evidence of informed trading before the announcements and a significant part of the news in announcements is impounded in stock prices before the announcements by pre-event informed trading. We also find evidence of informed trading after the announcements. Most strikingly, the probability of informed trading after merger bids predicts the probability of the bid being withdrawn or met with a competing bid. For other announcements, post-announcement informed trading probabilities predict subsequent returns.


Securities Transaction Taxes and Market Quality
Anna Pomeranets & Daniel Weaver
Journal of Financial and Quantitative Analysis, February 2018, Pages 455-484

Abstract:
We study changes in market quality associated with 9 modifications to the New York State securities transaction tax (STT) between 1932 and 1981 and 3 changes to the federal STT between 1932 and 1966. We find that when there is an increase in the level of an STT, individual stock volatility increases, bid–ask spreads widen, price impacts are greater, and volume decreases. We examine the propensity of traders to switch trading locations to avoid the tax and find mixed evidence that they will change locations. Overall, our findings support the notion that the imposition of or increases in an STT harm market quality.


Decision Fatigue and Heuristic Analyst Forecasts
David Hirshleifer et al.
NBER Working Paper, February 2018

Abstract:
Psychological evidence indicates that decision quality declines after an extensive session of decision-making, a phenomenon known as decision fatigue. We study whether decision fatigue affects analysts’ judgments. Analysts cover multiple firms and often issue several forecasts in a single day. We find that forecast accuracy declines over the course of a day as the number of forecasts the analyst has already issued increases. Also consistent with decision fatigue, we find that the more forecasts an analyst issues, the higher the likelihood the analyst resorts to more heuristic decisions by herding more closely with the consensus forecast and also by self-herding (i.e., reissuing their own previous outstanding forecasts). Finally, we find that the stock market understands these effects and discounts for analyst decision fatigue.


The Information Content of Realized Losses
Peter Kelly
Review of Financial Studies, forthcoming

Abstract:
Examining the trades of company insiders, I find that a sale of stock at a loss is a much more negative signal about future returns than is a sale of stock at a gain. I consider a range of explanations for my results and find that the evidence is most consistent with the idea that investors derive direct disutility from selling a stock at a loss. Since selling a stock at a loss is painful, an investor who sells at a loss must have particularly negative information. This result offers a novel measurement of the strength of the disposition effect.


Are Financial Constraints Priced? Evidence from Textual Analysis
Matthias Buehlmaier & Toni Whited
Review of Financial Studies, forthcoming

Abstract:
We construct novel measures of financial constraints using textual analysis of firms’ annual reports and investigate their impact on stock returns. Our three measures capture access to equity markets, debt markets, and external financial markets in general. In all cases, constrained firms earn higher returns, which move together and cannot be explained by the Fama and French (2015) factor model. A trading strategy based on financial constraints is most profitable for large, liquid stocks. Our results are strongest when we consider debt constraints. A portfolio based on this measure earns an annualized risk-adjusted excess return of 6.5%.


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