Research articles for the 2019-05-10
Corporate Law and the Myth of Efficient Market Control
SSRN
In recent times, there has been an unprecedented shift in power from managers to shareholders, a shift that realizes the long-held theoretical aspiration of market control of the corporation. This Article subjects the market control paradigm to comprehensive economic examination and finds it wanting. The market control paradigm relies on a narrow economic model that focuses on one problem only, management agency costs. With the rise of shareholder power, we need a wider lens that also takes in market prices, investor incentives, and information asymmetries. General equilibrium theory (GE) provides that lens. Several lessons follow from reference to this higher-order economic theory. First, the presumption that markets can efficiently coordinate the economy is shown to be unfounded, unless one relies on heroic assumptions. Second, GE shows that shareholders suffer from misaligned incentives, undercutting any normative program grounded in shareholder empowerment. The third lesson is negative, as there are no economically-founded instructions for addressing the trade-offs between agency costs reduction and market inefficiency implied by the new shareholder corporation. Policy implications also follow. Given the lack of a clear normative template, only private ordering can be counted on to address each corporation’s specific tradeoffs between agency costs and market inefficiency. This conclusion leads to an endorsement of Delaware’s equitable adjudication system, the flexibility of which is well-suited to policing the bargaining process between managers and empowered shareholders.
SSRN
In recent times, there has been an unprecedented shift in power from managers to shareholders, a shift that realizes the long-held theoretical aspiration of market control of the corporation. This Article subjects the market control paradigm to comprehensive economic examination and finds it wanting. The market control paradigm relies on a narrow economic model that focuses on one problem only, management agency costs. With the rise of shareholder power, we need a wider lens that also takes in market prices, investor incentives, and information asymmetries. General equilibrium theory (GE) provides that lens. Several lessons follow from reference to this higher-order economic theory. First, the presumption that markets can efficiently coordinate the economy is shown to be unfounded, unless one relies on heroic assumptions. Second, GE shows that shareholders suffer from misaligned incentives, undercutting any normative program grounded in shareholder empowerment. The third lesson is negative, as there are no economically-founded instructions for addressing the trade-offs between agency costs reduction and market inefficiency implied by the new shareholder corporation. Policy implications also follow. Given the lack of a clear normative template, only private ordering can be counted on to address each corporation’s specific tradeoffs between agency costs and market inefficiency. This conclusion leads to an endorsement of Delaware’s equitable adjudication system, the flexibility of which is well-suited to policing the bargaining process between managers and empowered shareholders.
Debtor Protection and Business Dynamism
SSRN
We study the effect of debtor protection on business dynamism. We find that greater debtor protection, in the form of more lenient personal bankruptcy laws, increases firm entry only in sectors requiring low startup capital. We also find that debtor protection increases firm exit and job destruction rates among young small firms. This negative effect takes three years to materialize, and is persistent in time. Finally, we provide evidence consistent with two mechanisms underlying these changes in business dynamism: a reduction in credit supply and entry of lower quality firms following increases in debtor protection.
SSRN
We study the effect of debtor protection on business dynamism. We find that greater debtor protection, in the form of more lenient personal bankruptcy laws, increases firm entry only in sectors requiring low startup capital. We also find that debtor protection increases firm exit and job destruction rates among young small firms. This negative effect takes three years to materialize, and is persistent in time. Finally, we provide evidence consistent with two mechanisms underlying these changes in business dynamism: a reduction in credit supply and entry of lower quality firms following increases in debtor protection.
Fundamental Analysis of Chinese Stock Market
SSRN
I generate a fundamental signal library with more than 8000 fundamental signals by considering various combinations of the accounting variables in Chinese stock market. I take two standard approaches, time-series intercept tests and cross-sectional coefficient tests, to identify anomalies from this signal library. I ï¬nd that 142 signals can pass both of the two tests even after accounting for sample variation with bootstrap. I also take several aggregation techniques to extract information from these 142 signals and ï¬nd that PCA (Principal Component Analysis) performs best. Furthermore, I construct a new factor based on the 142 signals and augment the Fama-French three-factor model to form a four-factor model (A4). The four-factor model performs better than Fama-French three-factor model, Carhart four-factor model, Q4 factor model, Fama-French ï¬ve-factor model and at least as well as Fama-French six-factor model in terms of accomodating the hedge portfolio returns of over 8000 fundamental signals.
SSRN
I generate a fundamental signal library with more than 8000 fundamental signals by considering various combinations of the accounting variables in Chinese stock market. I take two standard approaches, time-series intercept tests and cross-sectional coefficient tests, to identify anomalies from this signal library. I ï¬nd that 142 signals can pass both of the two tests even after accounting for sample variation with bootstrap. I also take several aggregation techniques to extract information from these 142 signals and ï¬nd that PCA (Principal Component Analysis) performs best. Furthermore, I construct a new factor based on the 142 signals and augment the Fama-French three-factor model to form a four-factor model (A4). The four-factor model performs better than Fama-French three-factor model, Carhart four-factor model, Q4 factor model, Fama-French ï¬ve-factor model and at least as well as Fama-French six-factor model in terms of accomodating the hedge portfolio returns of over 8000 fundamental signals.
Googlization and Retail Investors’ Trading Activity
SSRN
According to Barber and Odean (2008), retail investors are net buyers of stocks that catch their attention. Using the Google Search Volume Index (SVI) as a proxy of attention, several papers document a positive relationship between the SVI and market trading volume, abnormal returns, and/or volatility. Such findings suggest that increased attention leads to a buying pressure that subsequently results in positive returns. In this paper, we focus on a sample of retail investors and use the SVI to test whether their aggregate (signed) trading activity is related to attention. We find that the relationship between the SVI and our retail investors’ trading activity is positive, even when controlling for some socio-demographics or subjective investor characteristics. However, our results do not bring evidence that this relationship is stronger for purchases than for sales, thereby providing no support for the price pressure hypothesis.
SSRN
According to Barber and Odean (2008), retail investors are net buyers of stocks that catch their attention. Using the Google Search Volume Index (SVI) as a proxy of attention, several papers document a positive relationship between the SVI and market trading volume, abnormal returns, and/or volatility. Such findings suggest that increased attention leads to a buying pressure that subsequently results in positive returns. In this paper, we focus on a sample of retail investors and use the SVI to test whether their aggregate (signed) trading activity is related to attention. We find that the relationship between the SVI and our retail investors’ trading activity is positive, even when controlling for some socio-demographics or subjective investor characteristics. However, our results do not bring evidence that this relationship is stronger for purchases than for sales, thereby providing no support for the price pressure hypothesis.
Indian Equities: The Mini Bear Market of 2018 and High Quality Stocks
SSRN
2018 was an interesting year. While headline Indian indexes held steady, the broader set of Indian equities suffered a bear market with average stock down nearly 40 to 50%. In this article, we look at warning signs that were present leading up to 2018. Further, via the performance of mid and small cap stocks within the India Moats Index, we show that high quality stocks held up better than rest of the market.
SSRN
2018 was an interesting year. While headline Indian indexes held steady, the broader set of Indian equities suffered a bear market with average stock down nearly 40 to 50%. In this article, we look at warning signs that were present leading up to 2018. Further, via the performance of mid and small cap stocks within the India Moats Index, we show that high quality stocks held up better than rest of the market.
Limited Attention and Overnight Return Puzzle in Chinese Stock Markets
SSRN
In this paper, we investigate an interesting puzzle that the average overnight return on market portfolio is signiï¬cantly negative in China’s stock market, which violates traditional assets pricing theory. More interestingly, this puzzle seems unique in China’s stock market, while the average overnight returns on various stock indices from other countries’ or regions’ markets are all positive or not significantly different from zero. Empirical evidence reveals that the limited attention theory can at least partially explain this phenomenon.
SSRN
In this paper, we investigate an interesting puzzle that the average overnight return on market portfolio is signiï¬cantly negative in China’s stock market, which violates traditional assets pricing theory. More interestingly, this puzzle seems unique in China’s stock market, while the average overnight returns on various stock indices from other countries’ or regions’ markets are all positive or not significantly different from zero. Empirical evidence reveals that the limited attention theory can at least partially explain this phenomenon.
On the Economic Value of Stock Market Return Predictors
SSRN
Kandel and Stambaugh (1996) demonstrate that forecasting variables with weak statistical support in predictive return regressions can exert considerable economic influence on portfolio decisions. Using a Bayesian vector autoregression framework with stochastic volatility in market returns and predictor variables, we assess the economic value of return predictability and reach a complementary conclusion. Statistically strong predictors can be economically unimportant if they tend to take extreme values in high-volatility periods, have low persistence, and/or follow distributions with fat tails. Several popular predictors exhibit these properties such that their impressive statistical results do not translate into large economic gains for investors.
SSRN
Kandel and Stambaugh (1996) demonstrate that forecasting variables with weak statistical support in predictive return regressions can exert considerable economic influence on portfolio decisions. Using a Bayesian vector autoregression framework with stochastic volatility in market returns and predictor variables, we assess the economic value of return predictability and reach a complementary conclusion. Statistically strong predictors can be economically unimportant if they tend to take extreme values in high-volatility periods, have low persistence, and/or follow distributions with fat tails. Several popular predictors exhibit these properties such that their impressive statistical results do not translate into large economic gains for investors.
Return Dispersion and Fund Performance: Australia â€" the Land of Opportunity?
SSRN
We examine the relation between cross-sectional stock return dispersion and active fund performance in Australia, drawing on the concept that higher return dispersion indicates greater opportunity for skilled managers to generate value. Australian active funds earn positive active returns when return dispersion is moderate-to-high, but not when it is low. We find meaningful differences between large-cap and small-cap funds. For large-caps, outperformance is modest in magnitude, and significant only when return dispersion is high for the most active funds. For small-caps, active returns are larger in magnitude and do not depend greatly on fund activeness. Applying a switching strategy between active funds and passive investment reveals that investors are better off retaining exposure to Australian active funds in all but low return dispersion environments. These results contrast with US findings that outperformance occurs only for the most active funds in the highest return dispersion environments.
SSRN
We examine the relation between cross-sectional stock return dispersion and active fund performance in Australia, drawing on the concept that higher return dispersion indicates greater opportunity for skilled managers to generate value. Australian active funds earn positive active returns when return dispersion is moderate-to-high, but not when it is low. We find meaningful differences between large-cap and small-cap funds. For large-caps, outperformance is modest in magnitude, and significant only when return dispersion is high for the most active funds. For small-caps, active returns are larger in magnitude and do not depend greatly on fund activeness. Applying a switching strategy between active funds and passive investment reveals that investors are better off retaining exposure to Australian active funds in all but low return dispersion environments. These results contrast with US findings that outperformance occurs only for the most active funds in the highest return dispersion environments.
The Effect of Futures Markets on the Stability of Commodity Prices
SSRN
Do futures markets have a stabilizing or destabilizing effect on commodity prices? Empirical evidence is inconclusive. We try to resolve this question by means of a learning-to-forecast experiment in which a futures market and a spot market are coupled. The spot market exhibits negative feedback between forecasts and prices, while the futures market is of the positive feedback type, which makes it susceptible to bubbles and crashes. We show that the effect of a futures market on spot price stability changes non-monotonically with the strength of the coupling between the spot and futures markets. This coupling depends positively on the number of speculators on the futures market and negatively on storage costs, speculator risk aversion, and the volatility of futures prices. In the end we observe a stabilizing effect on spot prices for weakly coupled markets and a destabilizing effect when the coupling with the futures market is strong.
SSRN
Do futures markets have a stabilizing or destabilizing effect on commodity prices? Empirical evidence is inconclusive. We try to resolve this question by means of a learning-to-forecast experiment in which a futures market and a spot market are coupled. The spot market exhibits negative feedback between forecasts and prices, while the futures market is of the positive feedback type, which makes it susceptible to bubbles and crashes. We show that the effect of a futures market on spot price stability changes non-monotonically with the strength of the coupling between the spot and futures markets. This coupling depends positively on the number of speculators on the futures market and negatively on storage costs, speculator risk aversion, and the volatility of futures prices. In the end we observe a stabilizing effect on spot prices for weakly coupled markets and a destabilizing effect when the coupling with the futures market is strong.
The Real Effects of Secondary Market Trading Structure: Evidence from the Mortgage Market
SSRN
A vast majority of mortgages in the U.S. are securitized into agency mortgage-backed securities (MBS), many of which are traded in the to-be-announced (TBA) forward market. By allowing different MBS to be traded based on a limited set of characteristics, TBA market generates liquidity, with the aggregate daily trading volume second only to the U.S. Treasury market. In this paper, we quantify the effect of the unique secondary market trading structure on individual borrowers’ mortgage rates, demand for mortgages, and consumer spending. With a simple model, we show that the benefit of access to the TBA market is higher for loans with less desirable prepayment characteristics. Then, exploiting sharp discontinuities in the probability of a loan to be included in an MBS eligible for TBA delivery, we estimate that TBA eligibility reduces mortgage rates by 10-40 basis points, depending on the prepayment risk of the loan. Furthermore, we also provide evidence that TBA eligibility affects borrowers’ refinancing decisions and subsequent durable consumption.
SSRN
A vast majority of mortgages in the U.S. are securitized into agency mortgage-backed securities (MBS), many of which are traded in the to-be-announced (TBA) forward market. By allowing different MBS to be traded based on a limited set of characteristics, TBA market generates liquidity, with the aggregate daily trading volume second only to the U.S. Treasury market. In this paper, we quantify the effect of the unique secondary market trading structure on individual borrowers’ mortgage rates, demand for mortgages, and consumer spending. With a simple model, we show that the benefit of access to the TBA market is higher for loans with less desirable prepayment characteristics. Then, exploiting sharp discontinuities in the probability of a loan to be included in an MBS eligible for TBA delivery, we estimate that TBA eligibility reduces mortgage rates by 10-40 basis points, depending on the prepayment risk of the loan. Furthermore, we also provide evidence that TBA eligibility affects borrowers’ refinancing decisions and subsequent durable consumption.
The Rise of Fast Trading: Curse or Blessing for Liquidity?
SSRN
We identify fast trading by directly measuring message traffic and the lifetime of orders for all market members on Euronext using their identification codes. We show that the fast-traded stocks exhibit the weakest decrease in both the relative spread and the cost of round trip trade. These stocks could have maintained their liquidity edge observed before the rise of fast trading, had they been better immune from it.
SSRN
We identify fast trading by directly measuring message traffic and the lifetime of orders for all market members on Euronext using their identification codes. We show that the fast-traded stocks exhibit the weakest decrease in both the relative spread and the cost of round trip trade. These stocks could have maintained their liquidity edge observed before the rise of fast trading, had they been better immune from it.
The Specter of the Giant Three
SSRN
This Article examines the large, steady, and continuing growth of the Big Three index fund managers â€" BlackRock, Vanguard, and State Street Global Advisors. We show that there is a real prospect that index funds will continue to grow, and that voting in most significant public companies will come to be dominated by the future “Giant Three.â€We begin by analyzing the drivers of the rise of the Big Three, including the structural factors that are leading to the heavy concentration of the index funds sector. We then provide empirical evidence about the past growth and current status of the Big Three, and their likely growth into the Giant Three. Among other things, we document that the Big Three have almost quadrupled their collective ownership stake in S&P 500 companies over the past two decades; that they have captured the overwhelming majority of the inflows into the asset management industry over the past decade; that each of them now manages 5% or more of the shares in a vast number of public companies; and that they collectively cast an average of about 25% of the votes at S&P 500 companies.We then extrapolate from past trends to estimate the future growth of the Big Three. We estimate that the Big Three could well cast as much as 40% of the votes in S&P 500 companies within two decades. Policymakers and others must recognize â€" and must take seriously â€" the prospect of a Giant Three scenario. The plausibility of this scenario exacerbates concerns about the problems with index fund incentives that we identify and document in other work.
SSRN
This Article examines the large, steady, and continuing growth of the Big Three index fund managers â€" BlackRock, Vanguard, and State Street Global Advisors. We show that there is a real prospect that index funds will continue to grow, and that voting in most significant public companies will come to be dominated by the future “Giant Three.â€We begin by analyzing the drivers of the rise of the Big Three, including the structural factors that are leading to the heavy concentration of the index funds sector. We then provide empirical evidence about the past growth and current status of the Big Three, and their likely growth into the Giant Three. Among other things, we document that the Big Three have almost quadrupled their collective ownership stake in S&P 500 companies over the past two decades; that they have captured the overwhelming majority of the inflows into the asset management industry over the past decade; that each of them now manages 5% or more of the shares in a vast number of public companies; and that they collectively cast an average of about 25% of the votes at S&P 500 companies.We then extrapolate from past trends to estimate the future growth of the Big Three. We estimate that the Big Three could well cast as much as 40% of the votes in S&P 500 companies within two decades. Policymakers and others must recognize â€" and must take seriously â€" the prospect of a Giant Three scenario. The plausibility of this scenario exacerbates concerns about the problems with index fund incentives that we identify and document in other work.
