Fund of Funds
From dissonance to resonance: Cognitive interdependence in quantitative finance
Daniel Beunza & David Stark
Economy and Society, forthcoming
Abstract:
This study explores the elusive social dimension of quantitative finance. We conducted three years of observations in the derivatives trading room of a major investment bank. We found that traders use models to translate stock prices into estimates of what their rivals think. Traders use these estimates to look out for possible errors in their own models. We found that this practice, reflexive modelling, enhances returns by turning prices into a vehicle for distributed cognition. But it also induces a dangerous form of cognitive interdependence: when enough traders overlook a key issue, their positions give misplaced reassurance to those traders that think similarly, disrupting their reflexive processes. In cases lacking diversity, dissonance thus gives way to resonance. Our analysis demonstrates how practices born in caution can lead to overconfidence and collective failure. We contribute to economic sociology by developing a socio-technical account that grapples with the new forms of sociality introduced by financial models - disembedded yet entangled; anonymous yet collective; impersonal yet, nevertheless, emphatically social.
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Educational Networks, Mutual Fund Voting Patterns, and CEO Compensation
Alexander Butler & Umit Gurun
Review of Financial Studies, forthcoming
Abstract:
Mutual funds whose managers are in the same educational network as the firm's CEO are more likely to vote against shareholder-initiated proposals to limit executive compensation than out-of-network funds are. This voting propensity is stronger when voting among the funds in a family is not unanimous. Furthermore, CEOs of firms who have relatively high levels of educationally connected mutual fund ownership have higher levels of compensation than their unconnected counterparts. This aspect of executive compensation is related to both the abnormal trading performance of the connected investors in the firm and the perceived quality of firm management by the connected investors.
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Stock option vesting conditions, CEO turnover, and myopic investment
Volker Laux
Journal of Financial Economics, forthcoming
Abstract:
Corporations have been criticized for providing executives with excessive incentives to focus on short-term performance. This paper shows that investment in short-term projects has beneficial effects in that it provides early feedback about Chief Executive Officer (CEO) talent, which leads to more efficient replacement decisions. Due to the threat of CEO turnover, the optimal design of stock option vesting conditions in executive compensation is more subtle than conventional views suggest. For example, I show that long vesting periods can backfire and induce excessive short-term investments. The study generates new empirical predictions regarding the determinants and impacts of stock option vesting terms in optimal contracting.
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Measuring Managerial Skill in the Mutual Fund Industry
Jonathan Berk & Jules van Binsbergen
NBER Working Paper, June 2012
Abstract:
Using the dollar-value a mutual fund manager adds as the measure of skill, we find that not only does skill exist (the average mutual fund manager adds about $2 million per year), but this skill is persistent, as far out as 10 years. We further document that investors recognize this skill and reward it by investing more capital with skilled managers. Higher skilled managers are paid more and there is a strong positive correlation between current managerial compensation and future performance.
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The influence of dispositional affect and cognition on venture investment portfolio concentration
Chien Sheng Richard Chan & Haemin Dennis Park
Journal of Business Venturing, forthcoming
Abstract:
We explore how an investor's dispositional affect and cognitive style influence venture investment portfolio concentration. Based on a field study using a sample of 128 judges from a business plan competition, we find that high positive affectivity investors construct more concentrated investment portfolios than their low positive affectivity counterparts, whereas high negative affectivity investors construct more diversified investment portfolios than their low negative affectivity counterparts. Further, investors who rely on analytical decision making display a weaker relationship between negative affectivity and investment diversification whereas investors who rely on emotion-based decision making display a stronger relationship between positive affectivity and investment concentration.
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Ruediger Fahlenbrach, Robert Prilmeier & Rene Stulz
Journal of Finance, forthcoming
Abstract:
Are some banks prone to perform poorly during crises? If yes, why? In this paper, we show that a bank's stock return performance during the 1998 crisis, which was viewed at the time as the most dramatic crisis since the Great Depression, predicts its stock return performance and probability of failure during the recent financial crisis. This effect is economically large and cannot be attributed to banks having the same chief executive in both crises or to exposure to common asset pricing factors. Our findings are consistent with persistence in a bank's risk culture and/or aspects of its business model that make its performance sensitive to crises. Banks that relied more on short-term funding, had more leverage, and grew more are more likely to be banks that performed poorly in both crises.
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Geographic dispersion and stock returns
Diego García & Øyvind Norli
Journal of Financial Economics, forthcoming
Abstract:
This paper shows that stocks of truly local firms have returns that exceed the return on stocks of geographically dispersed firms by 70 basis points per month. By extracting state name counts from annual reports filed with the Securities and Exchange Commission (SEC) on Form 10-K, we distinguish firms with business operations in only a few states from firms with operations in multiple states. Our findings are consistent with the view that lower investor recognition for local firms results in higher stock returns to compensate investors for insufficient diversification.
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No Place Like Home: Familiarity in Mutual Fund Manager Portfolio Choice
Veronika Pool, Noah Stoffman & Scott Yonker
Review of Financial Studies, forthcoming
Abstract:
We show that familiarity affects the portfolio decisions of mutual fund managers. Controlling for fund location, funds overweight stocks from their managers' home states by 12% compared with their peers. In team-managed funds, home-state overweighting is 37% larger than the fund location effect. The home-state bias is stronger if the manager is inexperienced, is resource-constrained, or spent more time in his home state. Home-state stocks do not outperform other holdings, confirming that home-state investments are not informed. The overweighting also leads to excessively risky portfolios.
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Nicola Gennaioli, Andrei Shleifer & Robert Vishny
NBER Working Paper, June 2012
Abstract:
We present a new model of money management, in which investors delegate portfolio management to professionals based not only on performance, but also on trust. Trust in the manager reduces an investor's perception of the riskiness of a given investment, and allows managers to charge higher fees to investors who trust them more. Money managers compete for investor funds by setting their fees, but because of trust the fees do not fall to costs. In the model, 1) managers consistently underperform the market net of fees but investors still prefer to delegate money management to taking risk on their own, 2) fees involve sharing of expected returns between managers and investors, with higher fees in riskier products, 3) managers pander to investors when investors exhibit biases in their beliefs, and do not correct misperceptions, and 4) despite long run benefits from better performance, the profits from pandering to trusting investors discourage managers from pursuing contrarian strategies relative to the case with no trust. We show how trust-mediated money management renders arbitrage less effective, and may help destabilize financial markets.
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Vladimir Atanasov, Vladimir Ivanov & Kate Litvak
Journal of Finance, forthcoming
Abstract:
We provide the first systematic analysis of the role of reputation in limiting opportunistic behavior by venture capitalists towards four types of counterparties: entrepreneurs, investors, other VCs, and buyers of VC-backed startups. Using a hand-collected database of lawsuits, we document that more reputable VCs (i.e., VCs that are older, have more deals, more funds under management, and syndicate with larger networks of venture capitalists) are less likely to be litigated. We also find that litigated VCs suffer declines in future business relative to carefully selected peers. These negative effects are stronger for more reputable VCs, and when VCs are defendants to multiple lawsuits or sued by entrepreneurs. Our results suggest that reputational mechanisms help deter VC opportunism.
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What Determines the Stock Market's Reaction to Monetary Policy Statements?
Alexander Kurov
Review of Financial Economics, forthcoming
Abstract:
We find that information communicated through monetary policy statements has important business cycle dependent implications for stock prices. For example, during periods of economic expansion, stocks tend to respond negatively to announcements of higher rates ahead. In recessions, however, we find a strong positive reaction of stocks to seemingly similar signals of future monetary tightening. We provide evidence that the state dependence in the stock market's response is explained by information about the expected equity premium and future corporate cash flows contained in monetary policy statements. We also show state dependence in the average stock returns on days of scheduled FOMC meetings and in the impact of monetary policy statements on stock and bond return volatility.
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Doing battle with short sellers: The conflicted role of blockholders in bear raids
Naveen Khanna & Richmond Mathews
Journal of Financial Economics, forthcoming
Abstract:
If short sellers can destroy firm value by manipulating prices down, an informed blockholder has a powerful natural incentive to protect the value of his stake by trading against them. However, he also has a potentially conflicting incentive to use his information to generate trading profits. We show that a speculator can exploit this conflict and force the blockholder to buy a disproportionately large amount to prevent value destruction. This is costly for the blockholder because the trades must sometimes be executed at inflated prices. Given reasonable constraints on short sellers, a sufficiently large blockholder will have the incentive to absorb these losses and prevent a bear raid. However, conditions exist under which outside intervention may be warranted.
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Competition Among University Endowments
William Goetzmann & Sharon Oster
NBER Working Paper, June 2012
Abstract:
The asset allocation of university endowments has recently shifted dramatically towards alternative investments. In this paper we examine the role played by strategic competition in motivating this shift. Using a metric capturing competition for undergraduate applications, we test whether endowment performance relative to a school's nearest competitor is associated with the likelihood of changing investment policy, and conditionally, whether the nature of that change is consistent with the goal of "catching up" to its closest rival. Conditional on indicating a policy change, we find that endowments appear to use marketable alternatives - i.e. hedge funds - to catch up to competitors. More generally, we find evidence that endowments with below median holdings of alternative investments tend to shift policies in that direction. Besides herding behavior we also find trend-chasing behavior. Endowments with recent positive experience with various alternative asset classes tend to increase exposure to them. We consider the long-run implications of this competitive and trending behavior for the ability of endowments to deliver intergenerational equity.
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Jie (Jack) He, Jun ‘Qj' Qian & Philip Strahan
Journal of Finance, forthcoming
Abstract:
Initial yields on both AAA-rated and non-AAA rated mortgage-backed security (MBS) tranches sold by large issuers are higher than yields on similar tranches sold by small issuers during the market boom years of 2004-2006. Moreover, the prices of MBS sold by large issuers drop more than those sold by small issuers, and the differences are concentrated among tranches issued during 2004-2006. These patterns suggest that investors priced the risk that large issuers received more inflated ratings than small issuers, especially during booming periods.
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Incentives to Innovate and the Decision to Go Public or Private
Daniel Ferreira, Gustavo Manso & André Silva
Review of Financial Studies, forthcoming
Abstract:
We model the impact of public and private ownership structures on firms' incentives to invest in innovative projects. We show that it is optimal to go public when exploiting existing ideas and optimal to go private when exploring new ideas. This result derives from the fact that private firms are less transparent to outside investors than are public firms. In private firms, insiders can time the market by choosing an early exit strategy if they receive bad news. This option makes insiders more tolerant of failures and thus more inclined to invest in innovative projects. In contrast, the prices of publicly traded securities react quickly to good news, providing insiders with incentives to choose conventional projects and cash in early.