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Abstract:
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. This suggests the existence of a common component to mutual fund investor behavior and indicates which asset classes may be regarded as economic substitutes by the participants in the market for mutual fund shares. 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. The negative correlation of equities to metals suggests that this timing is not simply due to liquidity concerns, but rather to sentiment about the equity premium.

We address the question of whether behavioral factors spread returns by using the mutual fund flow factors as pre-specified regressors in a Fama-MacBeth asset pricing framework. 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.

We consider a number of alternatives to explain our evidence including causality from returns to flows and vice-versa. Our evidence is consistent with the existence of a pervasive investor sentiment variable.

Abstract:
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 thousand investors who have chosen a low-cost, passively managed vehicle for savings. This allows us to characterize investors' heterogeneity in terms of their investment patterns. In particular, we identify positive feedback traders as well as contrarians whose activities are conditional upon preceding day stock market moves. We test the consistency and profitability of these conditional strategies over time. We find that more frequent traders are typically contrarians, while infrequent traders are more typically momentum investors.

The dynamics of these investor classes help us to partially examine the question of the marginal investor over the period of our study. We find that the behavior of momentum investors is typically more correlated to changes in the S&P 500 and we trace its dynamics over time. We build up "behavioral factors" based on contrarian and momentum flows and show that they perform well against a benchmark of loadings on latent factors extracted from returns. We also use the behavior of momentum and contrarian investors to build a measure of "market polarization". This captures the dispersion of beliefs among the investors and helps to account for asset pricing better than standard measures of dispersion of beliefs.

Abstract:
Our analysis of daily index fund flows indicates a strong contemporaneous correlation between fund inflows and S&P market returns. We also document a strong negative correlation between fund out flows and S&P market returns with the exception of outflows from a back-end load fund. These effects may be interpreted in two ways. Either investor supply and demand affects S&P market prices, or investors condition their demand and supply on intra-day market fluctuations. To sort out these effects, we examine trailing investor reaction to market moves. Our results suggest the market reacts to daily demand. However, only negative reactions appear due to past returns.

We investigate whether index investor demand shocks are permanent or temporary by examining the related behavior of the S&P futures index. Clear evidence supports the hypothesis that they are permanent. This result may help explain the unusual recent relative performance of the S&P 500 index.

Using the average market-timing newsletter recommendation over the period, we find that investors appear to react to "expert" advice about the market. Bullish newsletter sentiment is associated with greater inflows, although outflows are not well explained by newsletter advice. Dispersion in advice is associated with lower inflows. We find a high correlation among a number of variables used as a proxy for investor disagreement.

Abstract:
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.

insider trading, mergers and acquisitions, risk arbitrage

Abstract:
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.

inside trading, risk arbitrage, mergers and acquisitions

Abstract:
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 on the basis of basis of the "spillover" that the perfomance of a fund provides to all the other funds belonging to the same family.

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.

Mutual Funds, Financial Intermediation, Market Structure, Discrete Choice and Performance

Abstract:
In this paper, we estimate the behavioral component of 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 volume, volatility and stock returns. To do this, we use a large sample of individual accounts over a six-year period in the 1990's in order to identify investors who are subject to the disposition effect. We then use their trading behavior to construct behavioral factors. We show that when the fraction of irrational' investor purchases in a stock increases, the unexplained portion of the market price of the stock decreases. We further show that statistical exposure to a disposition factor explains cross-sectional differences in daily returns, controlling for a host of other factors and characteristics. The evidence is consistent with the hypothesis that trade between disposition-prone investors and their counter-parties impacts relative prices.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
In this paper, we estimate the behavioral component of 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 volume, volatility and stock returns. To do this, we use a large sample of individual accounts over a six-year period in the 1990's in order to identify investors who are subject to the disposition effect. We then use their trading behavior to construct behavioral factors. We show that when the fraction of "irrational" investor purchases in a stock increases, the unexplained portion of the market price of the stock decreases. We further show that statistical exposure to a disposition factor explains cross-sectional differences in daily returns, controlling for a host of other factors and characteristics. The evidence is consistent with the hypothesis that trade between disposition-prone investors and their counter-parties impact relative prices.

Abstract:
This paper studies one of the potential causes of the financial market bubble of the late 1990s: herding behavior of mutual funds. We show that the incentives contained in the mutual funds' advisory contracts 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 herd, thus reducing their holding of bubble stocks. The differential exposure to bubble stocks significantly impacted the funds' performance both in the period prior to March 2000 as well as afterwards.

Bubbles, mutual funds, compensation, herding, agency

Abstract:
We address the issue of how heterogeneity of trade among investors affects stock returns. We develop a model of the dispersion of opinion among investors that has implications for asset pricing. We test the relationship between dispersion of investor opinion and stock returns using a two-year panel of more than 91 thousand individual accounts in a S&P 500 index fund. We show that dispersion of opinion, proxied by the heterogeneity of trade among investor classes, explains part of the returns not accounted for by standard asset pricing factors. We show that the explanatory power of the dispersion of opinion increases at the very time when standard pricing models based on standard asset pricing factors fare worse.

Learning, Asset Pricing, Market Confidence, Behavioral Finance

Abstract:
We study the strategies of the market in the inter-dealer market. We show that market makers actively learn from the dealers they trade with and strategically react to the information content of the orders they receive. We identify "hiding" and "experimenting" as main types of market makers' strategies. We show how market makers in order to assess the informational content of the orders they receive. We provide empirical evidence of this, using a unique high-frequency dataset on the Italian Treasury Bond market disaggregated at dealer level.

Abstract:
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 "marginal traders" - i.e. the class of dealers that has 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 marginal traders.

Abstract:
This paper is an empirical investigation of how the uncertainty induced by investors' learning about the fundamentals affects stock prices. We identify two components of induced uncertainty: learning 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 learning uncertainty is a risk factor and it is priced. Furthermore, we show that, in a conditional pricing model, investor learning and dispersion of beliefs affect the time-variation of the economic risk premium.

conditional asset pricing, time-varying risk factors, learning uncertainty, filtering, trading volume

Abstract:
We address the issue of how the heterogeneity of trade among investors affects stock returns. We model and test the relationship between dispersion of opinion, heterogeneity of trade and stock returns. The empirical investigation makes use of a two-year panel of more than 91 thousand individual accounts in an S&P 500 index mutual fund. We show that dispersion of opinion, proxied by the heterogeneity of trade among investors, explains part of the returns not accounted for by the fundamentals. We analytically and empirically show that the explanatory power of the dispersion of opinion increases at the very time when standard pricing models based on fundamentals fare worse.

Index Funds, Heterogeneity of Beliefs, Learning

Abstract:
We study how actively managed equity mutual funds select the liquidity level of their equity portfolio and the effects of this selection on performance. We provide evidence of five key determinants of portfolio liquidity: portfolio size, portfolio concentration, the manager's trading frequency, investment style, 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 funds, liquidity

Abstract:
Using a large sample of US active equity mutual funds from 1983 to 2001, we show that portfolio liquidity is actively managed and chosen as a function of the multiple liquidity needs a fund has. Using portfolio liquidity as a parsimonious proxy for the severity of liquidity needs, we find that fund performance is independent of liquidity needs. We also find that unpredictable changes in market liquidity and short-term deviations from optimal liquidity level affect performance. These results are consistent with the view that liquidity impacts portfolio choice and that the provision of capital to mutual funds is competitive and optimal.

Mutual funds, liquidity

Abstract:
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 four 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 could 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.

Investment horizon, mergers and acquisitions, shareholder heterogeneity, institutional investors, short termism

Abstract:
We study the role of institutional investors in cross-border mergers and acquisitions (M&A). We find that foreign institutional ownership is positively associated with the intensity of cross-border M&A activity worldwide. Foreign institutional ownership increases the probability that a merger deal is cross-border, successful, and the bidder takes full control of the target firm. This relation is stronger in countries with weaker legal institutions and in less developed markets suggesting some substitutability between local governance and foreign institutional investors. The results are consistent with the hypothesis that foreign institutional investors act as facilitators in the international market for corporate control; they build bridges between firms and reduce transaction costs and information asymmetry between bidder and target. We conclude that cross-border portfolio investments of institutional money managers and cross-border M&A are complements in promoting financial integration worldwide.

Institutional investors, Mergers and acquisitions, Financial integration

Abstract:
We investigate whether mutual fund families strategically transfer performance across member funds to favor those more likely to increase overall family profits. We find that 'high family value' funds (i.e., high fees or high past performers) overperform at the expense of 'low value' funds. Such a performance gap is above the one existing between similar funds not affiliated with the same family. Better allocations of underpriced IPO deals and opposite trades across member funds partly explain why high value funds overperform. Our findings highlight how the family organization prevalent in the mutual fund industry generates distortions in delegated asset management.

IPO, mutual funds

Abstract:
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 overperformance is above the one that would exist between similar funds not part of the same fund 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. They are also relevant to the regulatory debate concerning 'cross-trading' between funds under common management.

mutual funds, mutual fund families, family strategies, cross-trading, subsidization

Abstract:
We study the effects of the controlling shareholders' portfolio diversification on the initial public offering (IPO) process. Less diversified shareholders have more to gain from taking their firm public, and are more willing to accept a lower price for shares. We test these hypotheses using the data on all IPOs in Sweden between 1995 and 2001. Using detailed information on the portfolio composition of shareholders in private and public firms, we construct several proxies of their portfolio diversification and relate them to the probability of the IPO and the underpricing. We show that the less diversified individual shareholders, especially those with lower wealth, sell more of their shares at the IPO. Firms held by less diversified controlling shareholders are more likely to go public, and exhibit higher underpricing. These effects are economically and statistically significant, while the diversification of noncontrolling shareholders has no effect. Our findings suggest that diversification of controlling shareholders plays a prominent role in the IPO process.

G120, G140, G240, G320

Abstract:
We study the effects of the controlling shareholders' portfolio diversification on the IPO process. Less-diversified shareholders have more to gain from taking their firm public, and are more willing to accept a lower price for shares. We test these hypotheses using the data on all IPOs in Sweden between 1995 and 2001. Using detailed information on the portfolio composition of shareholders in private and public firms, we construct several proxies of their portfolio diversification and relate them to the probability of the IPO and the underpricing. We show that the less-diversified individual shareholders, especially those with lower wealth, sell more of their shares at the IPO. Firms held by less-diversified controlling shareholders are more likely to go public, and exhibit higher underpricing. Both effects are economically and statistically significant, while the diversification of non-controlling shareholders has no effect. These findings suggest that diversification of controlling shareholders plays a prominent role in the IPO process.

IPO, diversification, underpricing

Abstract:
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.

IPO, diversification, underpricing

Abstract:
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 fund, incentive, risk taking, performance, persistence

Abstract:
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.

Payout policy, repurchases, product market competition, signaling

Abstract:
We study how dealers behave when there exist parallel markets for the same asset that are characterized by very different degrees of transparency. We show that the optimal trading strategy, depending on the features of the less transparent market and on the informational uncertainty in the more transparent one, may involve price manipulation. Specifically, informed dealers may refrain from trading in the more transparent market in order to exploit their informational advantage in the less transparent one, or they may use the more transparent market in order to manipulate prices. We show that both strategies (hiding and price manipulation) increase market depth in the more transparent market. We test the empirical implications of our model on the Italian Treasury bond market. We estimate dealers's strategies on both the primary and the secondary markets. We find that informed dealers place sell orders with other dealers at the time they have higher informational advantage and, at the same time, aggressively place bids in the primary market. This strategy generates losses in the more transparent market (secondary market) for the period during which the less transparent market (primary market) is open and then produces gains once the possibility of affecting the primary market is over. We find that, consistent with our model, market depth in the more transparent market increases as a result of these trading strategies. This supports the findings of Bloomfield and O'Hara (1999 and 2000) and shows how the existence of a less transparent market, far from reducing the liquidity of the more transparent market, may actually increase it.

Parallel markets, strategic behavior, empirical microstructure, interdealer-trading, information

Abstract:
We study how dealers behave when there exist parallel markets for the same asset that are characterized by very different degrees of transparency. We show that the optimal trading strategy, depending on the features of the less transparent market, may involve price manipulation. Informed dealers may refrain from trading in the more transparent market in order to exploit their informational advantage in the less transparent one, or they may use the more transparent market in order to manipulate prices. We prove that both strategies (hiding and price manipulation) increase market depth in the more transparent market. We empirically test these conclusions on the Italian Treasury bond market. We estimate dealers strategies jointly on both the primary and the secondary markets. We show that informed dealers place sell orders with other dealers at the time they have higher informational advantage. At the same time they aggressively place bids in the primary market and buy back when the primary market closes. This strategy generates losses in the more transparent market (secondary market) for the period when the less transparent market (primary market) is open and then produces gains once the possibility of affecting the primary market is over. We show that market depth in the more transparent market increases as a results of these strategies.

Parallel markets, strategic behavior, empirical microstructure, interdealer-trading, information

Abstract:
We relate the degree of investor portfolio focus to the broader urban economic context of the household. Using a detailed panel of investors in Sweden over the period 1995 to 2000, we find that the level of investor diversification, as measured by number of stocks in the portfolio and by the average correlation among holdings, is partially explained by city industrial characteristics. We find that rural portfolios are more diversified than urban portfolios and that portfolio diversification is characterized by factors associated with urban growth. We consider a number of theories to explain investor focus, including behavioral biases, real and perceived informational advantage, local social competition and hedging of non-tradable risk. We find little evidence to support social and hedging motives to explain the lack of portfolio diversification, and some evidence in favor of perceived informational advantage in an urban setting. We attribute this evidence as support for the broader 'knowledge spillover' processes documented in the recent urban economics literature. Portfolio effects may be added to the list of factors that define and differentiate urbanism.

Abstract:
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.

Portfolio choice, under-diversification, proximity investment, knowledge spillover, city agglomeration

Abstract:
We examine how shareholder investment horizons influence firms' payout decisions. We find that U.S. firms held by short-term institutional investors have a higher propensity to buybacks shares instead of using dividends. Firm managers seem to respond to the preferred payout policy of investors in their shareholder base. Share buybacks are used by if managers want to appease short-term oriented shareholders, while firms pay dividends if their stock is mostly held by long-term investors who have less need to liquidate their investment and may have a better tax treatment with dividends. We document two effects of investor pressure: for firms initiating payouts through a share buyback we find that the market reaction is lower the more short-term investors are holding the firm's stock, because such payout decisions are less well monitored; for firms that have already a payout policy at present, the market reacts more positively (and only temporarily) to a buyback in line with investor catering effects. Our findings help explain some of the puzzling recent findings relating the rise in institutional investment to a higher use of share buybacks.

Abstract:
Between 1993 and 2004, the share of mutual funds disclosing manager names to their investors fell significantly. We argue that the choice between named and anonymous management reflects a tradeoff between the marketing benefits of naming managers and the costs associated with their increased future bargaining power. Consistent with this tradeoff, we find that funds with named managers receive more positive media mentions, have greater inflows, and suffer less return diversion due to within family cross-subsidization, but that departures of named managers reduce inflows, especially for funds with better past performance. To the extent that the hedge fund boom differentially increased outside opportunities for successful named managers, we predict that it should have increased the costs associated with naming managers and led to more anonymous management. Indeed, we find that the shift towards anonymous management is greater in those asset classes and geographical areas with more hedge fund activity.

Mutual Funds, Team Management, Anonymous, Incentives, Hold up, Bargaining, Returns, Flows, Return Gap, Dilution

Abstract:
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.

Portfolio choice, home bias, style investing

Abstract:
We study whether firms tend to make the compensation of their managers dependent on the relative level of valuation. We consider compensation in the sample period between 1992 and 2003 and show that an increase in company valuation leads to an increase in the pay-for-performance sensitivity. This is rejecting the hypothesis that managers skim the company by setting their own compensation in a way consistent with the market timing theory. However our findings are consistent with the interpretation that this increase in the pay-for-performance sensitivity and increase in equity-based compensation is a way for effective boards to incentivize CEOs in the light of uncertainty whether the high valuation is due to the ability of the managers or due to luck. We find that firms with better governance are more likely to make their managers' compensation more sensitive to performance if the firm displays a high market-to-book ratio relative to its past or relative to the industry. We also find that firms which increase the compensation of their managers experience a price decrease in the following months, suggesting that the board is successfully timing the market or that their doubts about the high market-to-book ratio being due to skill was justified.

Executive Compensation, Corporate Governance

Abstract:
We focus on an exogenous event that changes the cost of equity of the firm - the addition of its stock to the S&P 500 index - and we use it to test capital structure theories in a controlled experiment, where the effect of the index addition on the stock price is exogenous from a manager's point of view. We investigate how firms modify their corporate financial and investment policies as a reaction to the addition to the index. Consistent with both traditional theories and Stein's (1996) market timing theory, we find bigger increases in equity issues and investment - partly through more acquisitions - in response to bigger drops in the cost of equity. However, in the 24 months after the index addition, firms that issue equity and increase investment display negative abnormal returns and they perform worse than firms that issue but do not increase investment. This finding is consistent only with the market timing theory of Stein (1996) and supports a "limits of arbitrage" story in which stocks display a downward sloping demand curve and firms themselves act as "arbitrageurs" taking advantage of the window of opportunity provided by the stock price change around the S&P 500 index addition.

Limits of arbitrage, S&P 500, market timing, capital structure

Abstract:
We focus on an exogenous event that changes the cost of capital of a company - the addition of its stock to the S&P 500 index - and investigate how 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. Consistent with both traditional theories and Stein's (1996) market timing theory, we find more equity issues and increases in investment in response to higher index addition announcement returns. However, in the 24 months after the index addition, firms that issue equity and increase investment display negative abnormal returns and they perform worse than firms that issue but do not increase investment. This finding is consistent only with the market timing theory of Stein (1996) and supports a 'limits of arbitrage' story in which the stocks display a downward sloping demand curve and companies themselves act as 'arbitrageurs' taking advantage of the window of opportunity.

Corporate financial policies, limits of arbitrage, market timing

Abstract:
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.

mergers and acquisitions, popularity, style investing, short-termism, mutual funds, dumb money

Abstract:
We study the link between portfolio choice and different 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 network and we directly quantify this bonding effect. We use a new dataset with information on portfolio choice - broken down at the stock level - wealth, income and demographic characteristics of a big panel of investors as well as information on the college they attended and their family situation at the time. We compare college-based interaction to other forms of social interaction, such as educational, professional and geographical interaction, properly controlling for all the standard motivations of portfolio theory, such as hedging of non-financial income risk, familiarity and information effects, 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 as well as the choice between direct and delegated investment, both statistically and economically. College-based interaction is, however, the most important of them and the third single most important factor affecting stock picking. The impact of college-based interaction aggregates at the market level and affects stock prices. For each company, we construct measures of the degree of strength of college-based interaction among shareholders. We show that an increase in the strength of interaction reduces stock return and volatility. This can be rationalized in terms of recent theories on the impact of dispersion of beliefs in the presence of short-sale constraints.

Portfolio choice, social interaction, education, asset pricing

Abstract:
We study the link between portfolio choice and different 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 network and we directly quantify this bonding effect. We use a new dataset with information on portfolio choice - broken down at the stock level - wealth, income and demographic characteristics of a big panel of investors as well as information on the college they attended and their family situation at the time.

We compare college-based interaction to other forms of social interaction, such as educational, professional and geographical interaction, properly controlling for all the standard motivations of portfolio theory, such as hedging of non-financial income risk, familiarity and information effects, 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 as well as the choice between direct and delegated investment, both statistically and economically. College-based interaction is, however, the most important of them and the third single most important factor affecting stock picking.

The impact of college-based interaction aggregates at the market level and affects stock prices. For each company, we construct measures of the degree of strength of college-based interaction among shareholders. We show that an increase in the strength of interaction reduces stock return and volatility. This can be rationalized in terms of recent theories on the impact of dispersion of beliefs in the presence of short-sale constraints.

Portfolio choice, education, individual investors, herding

Abstract:
We study the trade-off between liquidity and monitoring implicit in the bank-firm relationship. By virtue of their lending activity, banks have privileged access to inside information about the companies and their monitoring role helps them mitigate the managers' risk-taking behavior. However, banks can also act as an "insider" and exploit this privileged information in the financial markets. We show that a more exclusive and geographically closer relationship with the lender increases the illiquidity of the stock of the borrowing firm and reduces both, its trading volume as well as its aggregate volatility. We explain the reduction in volatility in terms of lower incentives for the mangers to take on risk. The fact that firms borrowing from closer banks reward their mangers with less options- or equity-based compensation (as opposed to fixed compensation) supports our claim about reduced risk-taking. Simultaneously, however, a more exclusive relationship with the banks leads to a higher options- and equity-based compensation. Next, focusing on the effect upon firm value, we show that the extent of information asymmetry inherent in the lending relationship - captured here by the proximity to the banks - negatively affects firm value. On the other hand, the power of the bank derived from its role as a monitor - captured in our case by the exclusivity of the lending relationship - positively affects firm value. Overall, we illustrate a new "corporate governance" channel and our findings provide a fresh perspective on how lending relationships affect the firm.

banks, geography, liquidity, monitoring, private information, relationship lending

Abstract:
We study the link between social interaction and stock market bubbles. We argue that an increase in social interaction may facilitate the birth of a cascade-type pattern and indirectly of a bubble. 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 this bonding effect. We study how it affects bubble-related portfolio decisions: the choice to focus in growth stocks, the decision to invest in a particular stock, the choice to herd and the decision to concentrate the portfolio in few stocks.

We use a new dataset with information on portfolio choice - broken down at the stock level - wealth, income and demographic characteristics of a big panel of investors as well as information on the college they attended and their family situation at the time. We show that 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.

College-based interaction is stronger than the other sources of interaction (professional and geographical) and ranks third as the single most important factor affecting portfolio choice, with an explanatory power higher than that of all standard determinants of portfolio choice, such as hedging non-financial income risk, information and familiarity and so on. This holds even after controlling for all the standard motivations brought forward in portfolio theory, such as hedging of non-financial income risk, familiarity and information effects, wealth and income effect, a host of demographic, geographic and professional dummies, trend-chasing and momentum behavior.

Portfolio choice, education, individual investors, herding

Abstract:
We study how the strategies and performance of an asset management company are affected by its internal organizational structure. Relying on Stein's (2002) theory of organizations, we argue that a more hierarchical structure reduces the incentives to collect "soft" information and to engage in proximity investment. This should lower portfolio concentration, increase managerial herding and reduce performance. We use information on the organizational structure of all the US mutual funds and insurance-managed funds investing in US corporate bonds. We show that more hierarchical structures invest less in firms located close to them and deliver lower performance. An additional layer in the hierarchical structure reduces the average performance by 24 basis points per month. At the same time, more hierarchical structures tend to herd more and to hold less concentrated portfolios. We also find that changes in fund structure quickly find their way into the behavior of fund managers. Overall, the organizational structure affects performance slightly more for mutual funds than insurance-managed funds, while it impacts proximity investment, herding and portfolio concentration more for insurance-managed funds than mutual funds.

Abstract:
We study how organizational complexity affects capital structure and firm value. We measure organizational complexity as the number of layers in the firm’s subsidiary structure, and focus on a sample of US firms over the period 1998-2006. We argue that organizational complexity makes the firm opaque and increases the asymmetry of information between the firm and the market. We show that organizational complexity is strongly related to standard information asymmetry proxies. In line with the predictions of the pecking order theory, firms characterized by a more complex organizational structure resort to less equity financing and more debt financing, have higher leverage, display a higher investment-cash flow sensitivity and build up greater “financial slack.” The higher information asymmetry created by organizational complexity, by reducing stock liquidity, reduces the value of equity.

Organizational structure; Capital structure; Pecking order

Abstract:
We examine the effects of the capital supply uncertainty (CSU) of the bond investor base on the leverage of the firm using novel data. We find that the CSU of the firm’s bond investor base has a negative and significant effect on the firm’s probability of issuing bonds, and a positive and significant effect on the firm’s probability of issuing equity and borrowing from banks. CSU has a negative and significant net effect on the leverage of the firm. The results are robust to controlling for the potential endogeneity of CSU. These incremental financing and the leverage results are driven by firms with highly concentrated investor bases. Finally, we find that CSU also affects the firm’s choice of debt maturity. Taken together, the findings suggest that the makeup of the firm’s bond investor base is very important in affecting the firm’s corporate financing policy and its capital structure.

institutional investors, supply uncertainty, corporate bonds, corporate finance, capital structure, clientele, capital base fragility

Abstract:
We study how the introduction of a defined contribution market based retirement system affects the propensity of the investor to participate in the stock market. By using data on the "Swedish experiment", we focus on the decision to invest directly in stocks and we see how it changes once the households are allowed to participate to the new pension system. We show that, the introduction of the possibility to invest in retirement funds increases the probability of stock market participation. That is, an individual that did not participate in the stock market has a higher probability of entering it once he has been presented with the new pension scheme. Moreover, the individuals who are more likely to enter the stock market are the ones who make a deliberate portfolio choice for the retirement money. This finding is not consistent with investors perceiving the investment in retirement accounts as a close substitute to investment in equity. Quite the contrary, it suggests that being induced to choose among different pension funds does "educate" the individual, inducing him to participate in the stock market.

Stock market participation, crowding out, pension reform

Abstract:
We study what determines catering through payout policy, and how the ability to cater affects firm policies. We create a catering index, measuring the extent to which the firm caters to its investors’ payout preferences. Catering is constrained by market segmentation and dispersion in investor payout preferences. The ability to cater grants the firm better equity financing conditions: catering firms experience a smaller stock price drop when issuing equity, and a positive market reaction to dividend announcements. Investors react to an increase in catering by raising their investment in the firm. Firms that cater have lower leverage, and invest more through capital expenditures and acquisitions.

Payout policy, mutual funds, catering

Abstract:
We examine the effects of institutional investors' credit supply uncertainty (CSU) in the corporate bond markets on the capital structure of the firm. We measure CSU as the bondholders' investment horizon, based on the idea that the shorter the investment horizon of investors, the higher the issuer's refinancing risk, i.e., the risk of not being able to roll over its maturing debt due to investors' credit supply uncertainty. We find that high CSU leads to lower leverage and lower probability of issuing bonds in the next period. High CSU, on the other hand, increases the firm's probability of issuing equity and borrowing from banks in the next period. Moreover, these effects are concentrated in firms whose bond investor base is more prone to credit supply imbalances, as measured by investor geographical concentration, herding propensity, and local bond preference. These findings suggest that the financial fragility arising from supply-based (as opposed to demand-based) factors have significant effects on the capital structure of the firm. While the positive effect of CSU on bank borrowing implies that issuers can substitute away from bonds into bank loans in times of high CSU, this substitution occurs only for firms whose bank relationships are nonexclusive. In contrast, CSU does not affect bank borrowing decisions of firms with exclusive bank relationships. Together, our findings suggest that investors' bond supply uncertainty and segmentation of the credit markets (bonds vs. bank loans) are important drivers of corporate financing policy and capital structure even for established firms with access to public bond markets.

supply-based financial fragility, credit market segmentation, corporate bonds, corporate finance, capital structure

Abstract:
We examine the relation between international institutional ownership and payout policy using a comprehensive data set of equity holdings from 37 countries over the years 2000-2007. We find that foreign institutional ownership is negatively associated with the likelihood that a firm pays dividends and the size of dividend payments. The greater the tax disadvantage of dividends to international investors, and the higher are transaction costs related to repatriating and reinvesting dividends, the more international investors push for fewer dividends. Stock price reactions around the ex-dividend day also show evidence of foreign institutions’ tax-aversion to dividends. The results support the existence of dividend clienteles around the world. In line with the clientele hypothesis, ownership by foreign institutions is positively associated with firms’ compliance with their shareholders’ desired payout and firm’s investment (i.e., capital expenditures and R&D expenditures).

Payout policy, Institutional ownership, Dividend clienteles

Abstract:
We study the role of institutional investors in cross-border mergers and acquisitions (M&As). We find that foreign institutional ownership is positively associated with the intensity of cross-border M&A activity worldwide. Foreign institutional ownership increases the probability that a merger deal is cross-border, successful, and the bidder takes full control of the target firm. This relation is stronger in countries with weaker legal institutions and in less developed markets, suggesting some substitutability between local governance and foreign institutional investors. The results are consistent with the hypothesis that foreign institutional investors act as facilitators in the international market for corporate control; they build bridges between firms and reduce transaction costs and information asymmetry between bidder and target. We conclude that cross-border portfolio investments of institutional money managers and cross-border M&As are complements in promoting financial integration worldwide.

Institutional investors, Mergers and acquisitions, Financial integration

Abstract:
Traditional portfolio balance theory derives a downward sloping currency demand function from limited international asset substitutability. Historically, this theory enjoyed little empirical support. We provide direct evidence by examining the exchange rate effect of a major redefinition of the MSCI global equity index in 2001 and 2002. The index redefinition implied large changes in the representation of different countries in the MSCI world index and therefore produced strong exogenous equity flows by index funds. Our event study reveals that countries with a relatively increasing equity representation experienced a relative currency appreciation upon announcement of the index change. Moreover, it shows that uninformative shocks can propagate from one asset class to another.

Abstract:
Do exchange rates react to exogenous capital movements? We explore this issue based on the redefinition of the MSCI international equity indices announced on 10 December 2000 and implemented in two steps on 30 November 2001 and 31 May 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.

Event study, exchange rates, global equity index funds, limits of arbitrage

Abstract:
We study how related conglomerates, financial conglomerates that had a previous advisory/underwriting relationship in the bond market with a firm and hold an equity stake in it, condition the firm's payout policy. We focus on share repurchases. We argue that the prior underwriting/advisory position in the bond markets leaves the conglomerate with a reputational concern about the institutions it has helped to place bonds with that induces it to use its equity stake to push against the wealth transfer from bondholders to equityholders embedded in the repurchase. We find a negative correlation between the probability of the share repurchase and the equity ownership by the related conglomerate. An equity stake of the related conglomerate is also associated with lower stock abnormal returns, both around the repurchase and in the long run. In particular, companies with equity ownership by related conglomerates exhibit 3(7)-day abnormal returns lower by 0.65%(1.32%) and 1(2,3)-year abnormal returns lower by 4.52%(8.64%,12.17%) then the abnormal returns of companies with no equity ownership by related conglomerates. This leads to lower wealth transfer from the bondholders to the equity holders. Indeed, the related conglomerate's stake is linked to a lower increase in the bond yields: the higher the stake, the lower the drop in price of the bonds around the repurchase. We present evidence that equity ownership by related conglomerates reduces the magnitude of wealth transfer in our sample by about 1/3.

financial conglomerate, share repurchase, wealth transfer, bonds

Abstract:
We study how bondholder concentration affects firm policies. We find that bondholder concentration is positively related to measures of cash retention and asset tangibility, and negatively related to payout and default risk. Bondholder concentration has a stronger impact on firm policies in the presence of stronger covenant protection, suggesting that bondholder concentration is instrumental to the activation of covenants. We show that bondholder concentration impacts managerial compensation and makes it more sensitive to default risk. Firms characterized by higher bondholder concentration are able to issue bonds at a lower yield spread, and their bonds command a lower yield spread in the secondary market. Instrumental variable estimation helps us interpret our results in a causal sense.

local financing, financial constraints, capital structure, idiosyncratic volatility, credit spread

Abstract:
We exploit the restrictions of intertemporal portfolio choice in the presence of nonfinancial income risk to test hedging using the information contained in the actual portfolio of the investor. We use a unique data set of Swedish investors with information broken down at the investor level and into various components of investor wealth, income, and demographic characteristics. Portfolio holdings are identified at the stock level. We show that investors do not hedge but invest in stocks closely related to their nonfinancial income. We explain this with familiarity, that is, the tendency to concentrate holdings in stocks to which the investor is geographically or professionally close 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.

Abstract:
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 to which the investor is geographically or professionally close 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.

Asset pricing, portfolio decision, hedging

Abstract:
We use a panel of more than 100,000 investor accounts in US stocks over the period 1991-1995 to construct an investor-based measure of dispersion of opinion, unlike the analyst based measure used in the literature. We use this measure to test two competing hypotheses: the sidelined investors hypothesis and the uncertainty/asymmetric information hypothesis. We find evidence that supports the sidelined-investors hypothesis. We show that the dispersion of opinion of the investors in a stock is positively related to the contemporaneous returns and trading volume of the stock and negatively related to its future returns. Moreover, dispersion of opinion aggregates across many stocks and generates factors that have a market-wide effect, affecting the stock equilibrium rate of return and providing additional explanatory power in a standard asset-pricing model. This supports the interpretation of dispersion of opinion as a risk factor. We also show that dispersion of opinion among retail investors Granger causes dispersion of opinion among analysts.

Dispersion of opinion, asset prices, volatility

Abstract:
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 thousand investors who have chosen a low-cost, passively managed vehicle for savings. This allows us to characterize investors' heterogeneity in terms of their investment patterns. In particular, we identify positive feedback traders as well as contrarians whose activities are conditional upon preceding day stock market moves. We test the consistency and profitability of these conditional strategies over time. We find that more frequent traders are typically contrarians, while infrequent traders are more typically momentum investors. The dynamics of these investor classes help us to partially examine the question of the marginal investor over the period of our study. We find that the behavior of momentum investors is typically more correlated to changes in the S&P 500 and we trace its dynamics over time. We build up behavioral factors' based on contrarian and momentum flows and show that they perform well against a benchmark of loadings on latent factors extracted from returns. We also use the behavior of momentum and contrarian investors to build a measure of market polarization. This captures the dispersion of beliefs among the investors and helps to account for asset pricing better than standard measures of dispersion of beliefs.

Abstract:
We study how the relative availability of bond and bank financing supply affects the firm's ability to use its leverage to buffer shocks, impacting the firm's stock and bond returns. We define a measure that proxies for the regional imbalance in the availability of bank and bond financing. We call this measure Debt "Imbalance". It proxies for a particular type of financial constraint that is more related to the local capital market to which the firm belongs, than to the characteristics of the firm itself. We show that Imbalance tilts the financial structure towards equity, increasing SEOs and lowering leverage. Firms characterized by higher debt imbalance also act as more financially constrained. Higher imbalance increases the sensitivity of cash holdings to cash flows, reduces dividend payment and makes the firm more likely to pay equity in mergers and acquisitions. This has important price implications. Imbalance, by constraining the investment of the firm, keeps the firm's Q above its marginal value and induces the firm to select higher value investments. Firms characterized by higher Imbalance have higher stock beta and idiosyncratic volatility. However, Imbalance is not a separate source of uncertainty, but merely increases the sensitivity of the firm's stock to market and idiosyncratic shocks. The bonds of firms characterized by higher Imbalance are more subject to Treasury yield shocks. The higher the Imbalance, the more a market shock will impact the bond yield and credit spread of the firm. A natural experiment confirms our story: the downgrade of GM and Ford bonds in 2005. We show that the contagion effect of the downgrade has affected more severly the bonds that are characterized by higher Imbalance.

Abstract:
This Paper investigates the link between a firm's competitive environment and the idiosyncratic volatility of its stock returns. We find that firms enjoying high market power, or established in concentrated industries, have lower idiosyncratic volatility. We posit that competition affects volatility in two distinct and inter-related ways. Market power works as a hedging instrument that smoothes out idiosyncratic fluctuations. At the same time, a high degree of market power implies lower information uncertainty for investors and, therefore, lower return volatility. We find strong support for both effects. Our results contribute to the understanding of recent trends of idiosyncratic volatility, and confirm the important link between stock market performance and the competitive environment of firms.

Idiosyncratic volatility, competition, market powers, uncertainty

Abstract:
In the present paper we analyze the relationship between index funds and asset prices. In particular, our analysis of daily index fund flows indicates a strong contemporaneous correlation between fund inflows and S&P market returns. We also document a strong negative correlation between fund out flows and S&P market returns with the exception of outflows from a fund with very high initial investment requirement. These effects may be interpreted in two ways. Either investor supply and demand affects S&P market prices, or investors condition their demand and supply on intra-day market fluctuations. To sort out these effects, we examine trailing investor reaction to market moves. Our results suggest the market reacts to daily demand. However, only negative reactions appear due to past returns. We investigate whether index investor demand shocks are permanent or temporary by examining the related behavior of the S&P futures index. Clear evidence supports the hypothesis that they are permanent. This result may help explain the unusual recent relative performance of the S&P 500 index. Using the average market-timing newsletter recommendation over the period, we find that investors appear to react to expert' advice about the market. Bullish newsletter sentiment is associated with greater inflows, although outflows are not well explained by newsletter advice. Dispersion in advice is associated with lower inflows. We find a high correlation among a number of variables used as a proxy for investor disagreement.

Abstract:
We study the puzzle of portfolio underdiversification and proximity investment from a novel perspective, linking it to the process of urbanization. We find that urban portfolios are more focused - i.e., less diversified and more concentrated in 'close' stocks. We explain it in terms of the process of 'professional specialization' that characterizes urban environments. We test this against a number of alternative theories: financial sophistication, social competition and hedging 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.

Portfolio choice, under-diversification, proximity investment, professional specialization, city agglomeration

Abstract:
We study how heterogeneity in investment horizons of institutional investors affects the IPO market. We document the fact that short-term investors prefer more liquid stocks than long-term investors and IPO stocks are very liquid in the after-market. On this premise, we argue that short-term investors should have higher reservation price than long-term investors for the IPO stocks. However, given the limited supply of short-term investors, the underwriter still prices the issue at the reservation price of long-term investors. Rationing induces short-term investors with unsatisfied demand to buy from long-term investors in the after-market trading, inducing a positive relation between short-term investor demand and both underpricing and trading at the IPO. We test this intuition by constructing a geography-based measure 'local fraction of short-term assets' which captures the cross-sectional variations in regional investor horizon clienteles. Consistent with our hypotheses, we find that local fraction of short-term assets is strongly positively related to IPO underpricing and after-market trading volume, and the fraction of IPO holdings by short-term investors after the IPO is significantly higher than certain benchmarks. Our results are consistent with the view that investor base heterogeneity affects asset returns.

institutional investors; investor horizon clientele, proximity investing, short-term investor fraction, IPOs, Amihud illiquidity, underpricing

Abstract:
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.

IPO, diversification, underpricing

Abstract:
We study the relationship between inflation and stock returns focusing on the signalling content of inflation. Investors use inflation to learn about the stance of the monetary policy. Depending on investors' beliefs, a change in consumption prices has different effects on the risk premium. A change in consumption prices that confirms investors' beliefs reduces stock risk premia, while a change that contradicts them increases risk premia. This may generate a negative correlation between returns and inflation that explains the Fisher puzzle. We model this intuition and test its implication on US data. We construct a market-based proxy of monetary policy uncertainty, we show that it is priced and that, by conditioning on it, the Fisher puzzle disappears.

Monetary policy uncertainty, asset pricing, learning risk, risk factors

Abstract:
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.

Mutual funds, stock liquidity, financial intermediation

Abstract:
We test the market impact of the disposition effect. We rely on the Grinblatt and Han (2002) model and derive testable implications about the expected relationship between the preponderance of disposition investors in the market and stock volatility, return and trading volume. We use a large sample of individual accounts over a six-year period to construct a variable that acts as proxy for the representation in the market of disposition investors. We show that, at a daily frequency, when the fraction of 'irrational' investor trades in a stock increases, stock volatility, return and trading volume decrease. We further show that such a stock-specific disposition acts as proxy to aggregates at the market level, generating a common factor. Statistical exposure to such a disposition-related factor explains cross-sectional differences in daily returns, after controlling for a host of other factors and characteristics.

Disposition effect, asset prices, volatility

Abstract:
We examine how shareholder investment horizons influence firms' payout decisions. We find that US firms held by short-term institutional investors have a higher propensity to buybacks shares instead of using dividends. Firm managers seem to respond to the preferred payout policy of investors in their shareholder base. Share buybacks are used by if managers want to appease short-term oriented shareholders, while firms pay dividends if their stock is mostly held by long-term investors who have less need to liquidate their investment and may have a better tax treatment with dividends. We document two effects of investor pressure: for firms initiating payouts through a share buyback we find that the market reaction is lower the more short-term investors are holding the firm's stock, because such payout decisions are less well monitored; for firms that have already a payout policy at present, the market reacts more positively (and only temporarily) to a buyback in line with investor catering effects. Our findings help explain some of the puzzling recent findings relating the rise in institutional investment to a higher use of share buybacks.

Payout policy, repurchases, institutional investors, investment horizon, short-termism, shareholder heterogeneity, investor catering

Abstract:
This Paper investigates the impact of ownership patterns on the way the firm is monitored, on the liquidity of its shares, and on its stock price. Building on the literature showing that local mutual funds (funds holding geographically close firms) enjoy superior returns due to private information, we use local ownership as a proxy for the amount of informed investment. Since location is reasonably exogenous, local ownership provides an identifying restriction that is used to address endogeneity concerns that have been raised in the literature (Demsetz and Lehn, 1985). Using data on a broad panel of US firms, we show that informed ownership improves the quality of governance of the firm and induces value-enhancing decisions (less over-investment and fewer but better acquisitions). At the same time, its presence in the firm increases the adverse selection discount required by less informed investors to trade, reducing the firm's liquidity. Both effects are properly impounded in the firm's stock price. Our results provide an economic interpretation of why ownership seems to be unrelated to performance. Informed investors affect prices indirectly, and in opposite directions: their monitoring activity tends to raise prices, but the lower liquidity induced by their presence tends to reduce prices.

Local ownership, corporate governance, liquidity, monitoring, mutual funds, private ownership

Abstract:
We study the process of wealth creation by alliances and relate it to the quality of governance of the firms engaging in alliances. We argue that alliances increase firm operating flexibility, reduce the agency costs related to the free-cash flows as well as the agency cost related to the distortion in the allocation of capital within the firm. Given the constraints on the use of free cash flows, managers at the helm of bad-governance firms will be more reluctant to engage in alliances. However, when alliances are undertaken, the reduction in the distortion in the allocation of capital should make value creation particularly strong in the presence of good governance. We show that firms engaging in alliances have both higher Tobin’s Q and positive short-term (3.02%) and long-term returns (0.38% per month over 36 months) following the announcement of the alliance. Firms characterized by better governance (both internal and external governance) are more likely to engage in alliances. Additionally, value creation by the alliances is related to the quality of governance of the firm. Firms engaging in alliances display higher Tobin’s Q and higher short-term and long-term returns following the announcement of the alliance if the quality of governance of the firm is high.

alliances, corporate governance, abnormal return and profitability

Abstract:
We study whether bondownership by peers affects international institutional investor demand of bonds and what implications this relationship has for the prices of new bond issues and the decisions of firms to issue abroad. We use detailed US corporate bond ownership data and show that the demand of US bonds by international institutions is positively affected by bondownership of other investors from the same country. International ownership is related to higher yield spreads for the domestic issues and to lower offering yield spreads for the international issues. Firms would gain by issuing in countries where its bondholders are located as their peers provide additional demand. Indeed, we observe that firm issuance decisions are affected by the previous composition of its bondownership, although we also find that positive effects of international investment is limited to US firms. The results are strongest for the firms that have higher deviation of analyst forecasts and lower ratings.

international bond issues, international bondownership, peers, trust

Abstract:
We study holdings in merger and acquisition (M&A) targets by financial conglomerates in 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 who are privy to important information about the deal, investing in the target in the expectation of its price increasing. We document the high profits of this strategy. 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.

G23, G32, G34

Abstract:
In the project proposed here, we intend to study how firms choose the maturity structure of their debt. We argue that because of lower information-gathering and monitoring costs, institutional investors would prefer to invest in firms with bonds outstanding across multiple maturities. We hypothesize that this preference of institutional investors for firms with bonds of multiple maturities should generate excess demand for these bonds, and should ultimately result in lower bond yields in the primary as well as secondary bond markets. Conditional on the presence of these benefits, the firms would try to respond by issuing bonds across the spectrum of maturities. In other words, if a firm already has bonds outstanding in a particularly maturity-niche, then it would issue bonds in a different maturity-niche in order to cover a wider spectrum of maturities, and especially so if its competitors have already issued bonds across multiple maturities. We propose to further analyze the preference of investors for multiple-maturity issuance under a specific scenario – when portfolio concentration is risky. Under such a scenario, e.g. after the downgrade of GM and Ford bonds in 2005, we would expect portfolio concentration to be risky and thus the appetite of institutional investors for multiple-maturity issuance to be diminished. This provides a natural experiment to test whether the firms that issue bonds across multiple maturities pay a lower yield in comparison with the firms that do not. The objective of this project is twofold. One, understanding these pricing implications of multiple-maturity issuance is particularly important for fund managers. And two, this project will enhance our understanding of debt maturity structure and throw new light on the topic by introducing the supply side of the story.

Abstract:
We study the impact of contractual incentives on the performance of mutual funds. We find that high-incentive contracts induce managers to take more risk and reduce the funds’ probability of survival. Yet, funds with high-incentive contracts deliver higher risk-adjusted return, and the superior performance remains persistent. The top incentive quintile of funds outperforms the bottom quintile by 2.70% per year. Moreover, high-incentive winner funds from one year have a positive alpha of 0.41% per month in the following year. Focusing on funds’ holdings, we show that active portfolio rebalancing is the main channel through which incentives increase performance.

G23, G30, G32

Abstract:
This article studies one of the potential causes of the financial market bubble of the late 1990s: the herding behavior of mutual funds. We show that the incentives contained in the mutual funds' advisory contracts 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 herd, thus reducing their holding of bubble stocks. The differential exposure to bubble stocks significantly impacted the funds' performance both in the period prior to March 2000, as well as afterwards.

Abstract:
We investigate whether mutual fund families strategically transfer performance across member funds to favor those more likely to increase overall family profits. We find that 'High family value' funds (i.e. high fees or high past performers) over-perform at the expense of 'Low value' funds. Such performance gap is above the one existing between similar funds not affiliated to the same family. Better allocations of underpriced IPO deals and opposite trades across member funds explain partly why 'High value' funds over-perform. Our findings highlight how the family organization prevalent in the mutual fund industry generates distortions in delegated asset management.

mutual funds, mutual fund families, family strategies, cross-trading, subsidization

Abstract:
We investigate the way investors react to prior gains/losses and the so called "familiarity" bias. 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 distinguish between different behavioral theories (loss aversion, house-money effect) and between behavioral and rational hypotheses (pure familiarity and information-based familiarity). We show that, on a yearly horizon, investors react to previous gains/losses according to the house-money effect. In terms of individual stock picking, we provide evidence in favor of the information-based theory and show that familiarity can be considered as a proxy for the availability of information as opposed to behavioral heuristics.

Behavioral finance, portfolio investment, loss aversion, familiarity bias, information

Abstract:
Asset managers often hold at the same time bonds and equity of the same firm. We study the implications of the presence of such “twin owners” for firm policies. We show that twin ownership is associated to corporate policies that are more favorable to the bondholders: firms with higher twin ownership have lower default risk, are more likely to make acquisitions, but less likely to use cash as the means of payment in the acquisition. Twin owners are able to affect firm policies by obtaining stronger covenant protection, as well as by influencing the risk taking incentives contained in managerial compensation. The impact of twin ownership on covenant protection and managerial incentives is stronger when the twin owners control a larger fraction of equity, when the firm is financially constrained, and when the firm does not have a lending relationship with a bank. The reduction in risk and probability of distress associated with twin ownership has a direct impact on the cost of debt. Higher twin ownership implies lower bond yield spreads both at the time of the issue and on the secondary market. The greater debt capacity that results from lower default risk and the lower cost of debt determines a positive relation between twin ownership and leverage.

institutional investors, corporate governance, bond and equity ownership, leverage, M&A

Abstract:
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 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 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.

IPO, diversification, underpricing