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Abstract:
We introduce a new measure of active portfolio management, Active Share, which represents the share of portfolio holdings that differ from the benchmark index holdings. We compute Active Share for domestic equity mutual funds from 1980 to 2003. We relate Active Share to fund characteristics such as size, expenses, and turnover in the cross-section, and we also examine its evolution over time. Active Share predicts fund performance: funds with the highest Active Share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence. Non-index funds with the lowest Active Share underperform their benchmarks.

Portfolio management, Active Share, tracking error, closet indexing

Abstract:
We investigate how the market for corporate control (external governance) and shareholder activism (internal governance) interact. A portfolio that buys firms with the highest level of takeover vulnerability and shorts firms with the lowest level of takeover vulnerability generates an annualized abnormal return of 10 - 15% only when public pension fund (blockholder)ownership is high as well. A similar portfolio created to capture the importance of internal governance generates annualized abnormal returns of 8%, though only in the presence of 'high' vulnerability to takeovers. Further, we show that the complementary relation exists for firms with lower industry-adjusted leverage and is stronger for smaller firms. The complementary relation is confirmed using accounting measures of profitability. Using data on acquisitions, firm level Q's and accounting performance, we explore possible interpretations, providing preliminary evidence for a risk effect as well.

corporate governance, shareholder control, shareholder activism

Abstract:
We investigate how the market for corporate control (external governance) and shareholder activism (internal governance) interact. A portfolio that buys firms with the highest level of takeover vulnerability and shorts firms with the lowest level of takeover vulnerability generates an annualized abnormal return of 10 - 15% only when public pension fund (blockholder) ownership is high as well. A similar portfolio created to capture the importance of internal governance generates annualized abnormal returns of 8%, though only in the presence of high vulnerability to takeovers. Further, we show that the complementary relation exists for firms with lower industry-adjusted leverage and is stronger for smaller firms. The complementary relation is confirmed using accounting measures of profitability. Using data on acquisitions, firm level Q's and accounting performance, we explore possible interpretations, providing preliminary evidence for a risk effect as well.

Abstract:
This paper introduces measures of volatility and skewness that are based on individual stock options to explain credit spreads on corporate bonds. Implied volatilities of individual options are shown to contain important information for credit spreads and improve on both implied volatilities of index options and on historical volatilities when explaining the cross-sectional and time-series variation in a panel of corporate bond spreads. Both the level of individual implied volatilities and the implied-volatility skew matter for credit spreads. The empirical estimates are in line with the coefficients predicted by a theoretical structural firm value model. Importantly, detailed principal component analysis shows that our newly constructed determinants of credit spreads reverse the finding in
the literature that structural models leave a large part of the variation in credit spreads unexplained. Furthermore, our results indicate that option-market liquidity has a spillover effect on the short-maturity corporate bond market, and we show that individual option prices contain information on the likelihood of rating migrations.

Abstract:
We investigate the relationship between CEO centrality - the relative importance of the CEO within the top executive team in terms of ability, contribution, or power - and the value and behavior of public firms. Our proxy for CEO centrality is the fraction of the top-five compensation captured by the CEO. We find that CEO centrality is negatively associated with firm value (as measured by industry-adjusted Tobin's Q). Greater CEO centrality is also correlated with (i) lower (industry-adjusted) accounting profitability, (ii) lower stock returns accompanying acquisitions announced by the firm and higher likelihood of a negative stock return accompanying such announcements, (iii) higher odds of the CEO's receiving a 'lucky' option grant at the lowest price of the month, (iv) greater tendency to reward the CEO for luck in the form of positive industry-wide shocks, (v) lower likelihood of CEO turnover controlling for performance, and (vi) lower firm-specific variability of stock returns over time. Overall, our results indicate that differences in CEO centrality are an aspect of firm management and governance that deserves the attention of researchers.

Abstract:
We investigate the relationship between CEO centrality - the relative importance of the CEO within the top executive team in terms of ability, contribution, or power - and the value, performance and behavior of public firms. Our proxy for CEO centrality is the fraction of the aggregate compensation of the top-five executive team captured by the CEO. We find that CEO centrality is negatively associated with firm value (as measured by industry-adjusted Tobin's Q). This result is robust to controlling for all standard controls in Q regressions as well as additional controls such as CEO tenure, whether the CEO is a founder or a large owner, and whether the company's top-five aggregate compensation is high or low relative to peer companies. CEO centrality also has a rich set of relations with firms' behavior and performance. In particular, CEO centrality is correlated with (i) lower (industry-adjusted) accounting profitability, (ii) lower stock returns accompanying acquisitions announced by the firm and higher likelihood of a negative stock return accompanying such announcements, (iii) higher odds of the CEO's receiving a "lucky" option grant at the lowest price of the month, (iv) greater tendency to reward the CEO for luck due to positive industry-wide shocks, (v) lower performance sensitivity of CEO turnover, and (vi) lower firm-specific variability of stock returns over time.

Executive compensation, corporate governance, CEOs, executives, options, equity-based compensation, non-equity compensation, Tobin's Q, firm entrenchment, CEO turnover, independent directors, CEO chair, acquisitions, CEO turnover, pay for luck., variability of returns, pay distribution, internal pay

Abstract:
Deviations from put-call parity contain information about future returns. Using the difference in implied volatility between pairs of call and put options to measure these deviations we find that stocks with relatively expensive calls outperform stocks with relatively expensive puts by 51 basis points per week. We find both positive abnormal performance in stocks with relatively expensive calls and negative abnormal performance in stocks with relatively expensive puts, a result which cannot be explained by short sales constraints. Using rebate rates from the stock lending market, we confirm directly that our findings are not driven by stocks that are hard to borrow. Options with more leverage generate greater predictability. Controlling for size, deviations from put-call parity are more likely to occur in options with underlying stocks that face more information risk. Deviations from put-call parity also tend to predict returns to a larger extent in firms that face a more asymmetric information environment, and in firms with high residual analyst coverage. We also find that the degree of predictability decreases over the sample period. Our results are consistent with mispricing during the earlier years of the study, with a gradual reduction of the mispricing over time.

options, predictability, put-call parity

Abstract:
We investigate the effects of shareholder governance mechanisms on bondholders and document two new findings. First, the impact of shareholder control (proxied by large institutional blockholders) on credit risk depends on takeover vulnerability. Shareholder control is associated with higher (lower) yields if the firm is exposed to (protected from)takeovers. In the presence of shareholder control, the difference in bond yields due to differences in takeover vulnerability can be as high as 66 basis points. Second, event risk covenants reduce the credit risk associated with strong shareholder governance. Therefore, without bond covenants, shareholder governance and bondholder interests diverge.

corporate governance, takeovers, shareholder controls

Abstract:
We investigate the distribution of pay in the top executive team in public companies. In particular, we study the CEO's pay slice (CPS), defined as the fraction of the aggregate top-five total compensation paid to the CEO. The level of a firm's CPS might reflect the relative centrality of the CEO in the top executive team in terms of ability, contribution to the firm, or power.

We find that CPS has been going up over the past decade. During this period, CEOs have increased their fraction of both equity-based compensation and non-equity compensation. The level of CPS is associated with various characteristics of the top team and the firm's governance arrangements. Among other things, CPS is high when the CEO has long tenure; when the CEO chairs the board; when few other executives are members of the board; and when the firm has more entrenching provisions.

High CPS is associated with lower firm value as measured by Tobin's Q. Using a simultaneous equations approach yields findings consistent with the possibility that this negative correlation is at least partly due to high CPS, or the relative CEO centrality it might reflect, bringing about a lower Tobin's Q. Consistent with the negative correlation between high CPS and Q, high CPS is associated with a less favorable market reaction, and a higher likelihood of a negative market reaction, to acquisitions announced by the firm. We also find that high CPS is associated with lower variability of stock returns over time. Overall, our results indicate that the distribution of compensation in the top executive team is an aspect of pay arrangements and corporate governance that deserves researchers' attention.

Executive compensation, corporate governance, CEOs, options, equity-based compensation, non-equity compensation, Tobin's Q, entrenchment, independent directors, board size, CEO tenure, CEO turnover, acquisitions, variability of returns, pay distribution, and internal pay equity

Abstract:
We use a unique database on the ownership stakes and compensation of equity mutual fund directors to analyze whether the directors' incentive structure is related to fund performance. We find that governance plays an economically substantial and statistically significant role. The ownership stakes of both independent and non-independent directors matter for fund performance. Further, the various governance variables interact: funds with high director ownership outperform those with low director ownership only when director compensation is low, and ownership by independent directors only matters when non-independent director ownership is high. We find that funds with high director ownership are better able to continue to perform well than funds with low director ownership. Our results cannot be explained by the previously documented relation between fund governance and mutual fund fees. We also provide evidence that the relation between fund performance and director ownership is not due to directors ex-ante picking the best performing funds.

Abstract:
This paper considers the impact of takeover (or acquisition) likelihood on firm valuation. If firms are more likely to acquire during times when they have free cash and/or when the required rate of return is low, takeover targets become more sensitive to shocks to aggregate cash flows and/or to the price of risk. Thus, ceteris paribus, firms that are exposed to takeovers will have a different rate of return from firms that are protected from takeovers. Using estimates of the likelihood that a firm will be acquired, we create a takeover-spread portfolio that buys firms with a high likelihood of being acquired and shorts firms with low likelihood of being acquired. Relative to the Fama-French model, the takeover-spread portfolio generates annualized abnormal returns of up to 12% between 1980 and 2004. Further, the takeover-spread portfolio is shown to be important in explaining cross-sectional differences in equity returns. Additionally, using a two-beta model that distinguishes cash flow shocks from discount rate shocks, we show that firms more likely to be taken over have higher betas on the aggregate cash factor. Finally, we provide an explanation for the existence of abnormal returns associated with governancespread portfolios (Gompers, Ishii and Metrick, 2003 and Cremers and Nair, 2005), and relate the takeover-spread portfolio returns to takeover activity in the economy.

Governance, equity prices, risk, time-varying risk premia, takeovers

Abstract:
Attempts to characterize stock return predictability have generated a plethora of papers documenting the ability of various variables to explain conditional expected returns. However, there is little consensus on what the important conditioning variables are, giving rise to a great deal of model uncertainty and data snooping fears. In this paper, we introduce a new methodology that explicitly takes the model uncertainty into account by comparing all possible models simultaneously and in which the priors are calibrated to reflect economically meaningful prior information. Therefore, our approach minimizes data snooping given the information set and the priors. We compare the prior views of a skeptic and a confident investor. The data imply posterior probabilities that are in general more supportive of stock return predictability than the priors for both types of investors, over a wide range of prior views. Furthermore, the stalwarts such as dividends and past returns do not perform well. The out-of-sample results for the Bayesian average models show improved forecasts relative to the classical statistical model selection methods, are consistent with the in-sample results and show some, albeit small, evidence of predictability.

Abstract:
Attempts to characterize stock return predictability have generated a plethora of papers documenting the ability of various variables to explain conditional expected returns. However, there is little consensus on what the important conditioning variables are, giving rise to a great deal of model uncertainty and data snooping fears. In this paper, we introduce a new methodology that explicitly takes the model uncertainty into account by comparing all possible models simultaneously and in which the priors are calibrated to reflect economically meaningful prior information. Therefore, our approach minimizes data snooping given the information set and the priors. We compare the prior views of a skeptic and a confident investor. The data imply posterior probabilities that are in general more supportive of stock return predictability than the priors for both types of investors, over a wide range of prior views. Furthermore, the stalwarts such as dividends and past returns do not perform well. The out-of- sample results for the Bayesian average models show improved forecasts relative to the classical statistical model selection methods, are consistent with the in-sample results and show some, albeit small, evidence of predictability.

Abstract:
This paper examines the impact on shareholder voting of the mutual fund voting disclosure regulation adopted by the SEC in 2003, using a paired sample of proposals submitted before and after the rule change. We focus on how voting outcomes relate to institutional ownership and the voting behavior of mutual funds. While voting support for management has decreased over time, there is no evidence that mutual funds' support for management declined after the rule change, as expected by advocates of disclosure. In fact, in the context of management-sponsored proposals on executive equity incentive compensation plans, mutual funds appear to have increased their support for management after the rule change. We also find that this result is not due to changes in compensation plan features, nor that voting outcomes were plausibly related to broker voting, which was eliminated in a parallel 2003 stock exchange rule change. Finally, there is some evidence that firms with greater mutual fund ownership adopt a higher frequency of sponsoring executive equity incentive compensation plans, which could partly explain our findings.

Proxy Voting, Mutual Funds, Institutional Investors, Disclosure

Abstract:
The methodology of Bai and Ng (2002, 2003) for decomposing large panel data into systematic and idiosyncratic components is applied to both returns and turnover. Combining this with a GLS-based principal components approach, we demonstrate that their procedure works well for both returns and turnover despite the presence of severe heteroscedasticity and non-stationarity in turnover of individual stocks. We then test Lo and Wang's (2000) theoretical model's restriction that returns and turnover should have the same number of systematic factors. This is songly rejected by the data, suggesting stock price and trading volume may not be compatible under the existing multi-factor asset pricing-trading framework. We also demonsate that several commonly used turnover measures may understate the price impact of stock trading.

Abstract:
The methodology of Bai and Ng (2002, 2003) for decomposing large panel data into systematic and idiosyncratic components is applied to both returns and turnover. Combining this with a GLS-based principal components approach, we demonstrate that their procedure works well for both returns and turnover despite the presence of severe heteroscedasticity and non-stationarity in turnover of individual stocks. We then test Lo and Wang s (2000) theoretical model s restriction that returns and turnover should have the same number of systematic factors. This is strongly rejected by the data, suggesting stock price and trading volume may not be compatible under the existing multi-factor asset pricing-trading framework. We also demonstrate that several commonly used turnover measures may understate the price impact of stock trading.

Abstract:
The methodology of Bai and Ng (2002, 2003) for decomposing large panel data into systematic and idiosyncratic components is applied to both returns and turnover. Combining this with a GLS-based principal components approach, we demonstrate that their procedure works well for both returns and turnover despite the presence of severe heteroscedasticity and non-stationarity in turnover of individual stocks. We then test Lo and Wang s (2000) theoretical model s restriction that returns and turnover should have the same number of systematic factors. This is strongly rejected by the data, suggesting stock price and trading volume may not be compatible under the existing multi-factor asset pricing-trading framework. We also demonstrate that several commonly used turnover measures may understate the price impact of stock trading.

Abstract:
This paper applies the methodology of Bai and Ng (2002, 2004) for decomposing large panel data into systematic and idiosyncratic components to both returns and turnover. Combining the methodology with a generalized-least-squares-based principal components procedure, we demonstrate that this approach works well for both returns and turnover despite the presence of severe heteroscedasticity and non-stationarity in turnover of individual stocks. We then test the duo-factor model of Lo and Wang's (2000), which is based on mutual fund separation. Our results indicate that trading due to systematic risk in returns can account for as much as 73% of all systematic turnover variation in the weekly time-series and 76% in the cross-section. Thus, portfolio rebalancing due to systematic risk is a very important motive for stock trading. Finally, we demonstrate that several commonly used turnover measures may understate the impact of stock trading.

Abstract:
In this paper, we employ a Bayesian framework to test the CAPM while explicitly accounting for the unobservability of the true market portfolio. We derive the posterior model odds ratio for comparing the view that the proxy is perfect (exact efficiency) to the view that its correlation with the market portfolio is less than one (approximate efficiency). We also compare the prior and the posterior expected correlation between the proxy and the market portfolio using a new methodology to choose priors that is both analytically tractable and intuitive. In marked contrast to the existing literature, the main result is that, in general, the data do not provide clear evidence against the CAPM. Posterior correlations are generally high enough to suggest that a belief in approximate efficiency is reasonable. These new results illustrate the importance of carefully choosing priors, and they show that even apparently innocuous assumptions can have unforeseen consequences.

Abstract:
Standard Fama-French and Carhart models produce economically and statistically significant nonzero alphas even for passive benchmark indices such as the S&P 500 and Russell 2000. We find that these alphas primarily arise from the disproportionate weight the Fama-French factors place on small value stocks which have performed well, and from the CRSP value-weighted market index which is a downward-biased benchmark for U.S. stocks. We explore alternative ways to construct these factors and propose alternative models constructed from common and easily tradable benchmark indices. Such index-based models outperform the standard models both in terms of asset pricing tests and performance evaluation of mutual fund managers.

performance evaluation, benchmark index, factor model, Fama-French, Carhart

Abstract:
We study whether option-implied jump risk premia can explain the high observed level of credit spreads. We use a structural jump-diffusion firm value model to assess the level of credit spreads generated by option-implied jump risk premia. Prices and returns of equity index and individual options are used to estimate the jump parameters. We further calibrate the model to historical information on default risk and the equity premium. The results show that incorporating option-implied jump risk premia brings predicted credit spread levels much closer to observed levels. The introduction of jumps also helps to improve the fit of the volatility of credit spreads and equity returns.

G12, G13

Abstract:
Prices of equity index put options contain information on the price of systematic downward jump risk. We use a structural jump-diffusion firm value model to assess the level of credit spreads that is generated by option-implied jump risk premia. In our compound option pricing model, an equity index option is an option on a portfolio of call options on the underlying firm values. We calibrate the model parameters to historical information on default risk, the equity premium and equity return distribution, and S&P 500 index option prices. Our results show that a model without jumps fails to fit the equity return distribution and option prices, and generates a low out-of-sample prediction for credit spreads. Adding jumps and jump risk premia improves the fit of the model in terms of equity and option characteristics considerably and brings predicted credit spread levels much closer to observed levels.

Abstract:
Prices of equity index put options contain information on the price of systematic downward jump risk. We use a structural jump-diffusion firm value model to assess the level of credit spreads that is generated by option-implied jump risk premia. In our compound option pricing model, an equity index option is an option on a portfolio of call options on the underlying firm values. We calibrate the model parameters to historical information on default risk, the equity premium and equity return distribution, and S&P 500 index option prices. Our results show that a model without jumps fails to fit the equity return distribution and option prices, and generates a low out-of-sample prediction for credit spreads. Adding jumps and jump risk premia improves the fit of the model in terms of equity and option characteristics considerably and brings predicted credit spread levels much closer to observed levels.

Credit spreads, jump risk premium, firm value model

Abstract:
This paper studies the interaction between takeover defenses and product market competition. We find that firms in more competitive industries have more takeover defenses. This is the opposite result from what one would expect if takeover defenses always constitute an inefficient outcome that increases agency costs and managerial entrenchment. A novel explantion is provided by considering the nature of the relationship between the firm and the product (or labor) market. For firms in industries where a long-term relationship with customers and employees is vital, the disruption caused by takeovers could severely negatively impact the stakeholders. In particular, in a competitive environment, this could lead shareholders to optimally choose more takeover defenses to prevent such customers and employees from going to their closest competitor ex ante. We provide empirical evidence that stronger competition is linked to more defenses only in relationship industries, where the previously found negative relation between takeover defenses and firm performance is reversed. Our results cannot be explained by competition being a substitute for the market for corporate control. Finally, we discuss the implications of this framework for the design of various governance mechanisms. In conclusion, the paper provides a rationale for why shareholders themselves might want weak shareholder rights.

takeovers, shareholders, governance, shareholder rights

Abstract:
This paper introduces a dataset tracking approximately 1,000 firms’ G- and E-index scores, as well the individual corporate governance provisions constituting these indexes, over the 1978-1989 period. Combining this data with the 1990-2006 IRRC data, we are able to track firms’ corporate governance over a thirty year period. Most governance changes occurred during the 1980s (with relative stability thereafter). We find a robustly negative association between the G- and E-Index and Tobin’s Q for the 1978-2006 period, even when using firm fixed effects, and little direct evidence for reverse causation. The negative firm valuation effects of classified boards, poison pills and G-Index generally was significantly greater after the judicial approval of the poison pill in 1985, which can be considered as a largely unanticipated, exogenous shock to corporate governance. Moreover, G-Index changes have a much stronger negative association with firm valuation when a firm is in an industry experiencing “high” levels of M&A activity. Finally, we find a robust positive association between “good” corporate governance and abnormal returns for the 1978-2006 period. The abnormal returns association with governance was strongest in the beginning of our 1978-2006 time period and generally declining thereafter, consistent with an explanation of these returns based on the market learning the importance of good governance.

Abstract:
This paper explores the role played by multiple credit rating agencies (CRAs) in the market for corporate bonds. Moody's, S&P and Fitch operate in a competitive setting with market demand for both credit information and the certification value of a high rating. We empirically document the outcome of this competitive interaction over the period 2002 to 2007. Virtually all bonds in our sample are rated by both Moody's and Standard and Poors (S&P), and between 40% and 60% of the bonds are also rated by Fitch. This apparent redundancy in information production has long been a puzzle. We consider three explanations for why issuers apply for a third rating: 'information production,' 'adverse selection' and 'certification' with respect to regulatory and rules-based constraints. Using ratings and credit spread regressions, we find evidence in favor of Certification only. Additional evidence shows that the reported certification effects are consistent with an equilibrium outcome in a market with information-sensitive and insensitive bonds. In such a setting, ratings help to prevent market breakdowns.

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:
This paper explores the role played by multiple credit rating agencies (CRAs) in the market for corporate bonds. Moody’s, S&P and Fitch operate in a competitive setting with market demand for both credit information and the certification value of a high rating. We empirically document the outcome of this competitive interaction over the period 2002 to 2007. Virtually all bonds in our sample are rated by both Moody’s and Standard and Poors (S&P), and between 40% and 60% of the bonds are also rated by Fitch. This apparent redundancy in information production has long been a puzzle. We consider three explanations for why issuers apply for a third rating: ‘information production,’ ‘adverse selection’ and ‘certification’ with respect to regulatory and rules-based constraints. Using ratings and credit spread regressions, we find evidence in favor of Certification only. Additional evidence shows that the reported certification effects are consistent with an equilibrium outcome in a market with information-sensitive and insensitive bonds. In such a setting, ratings help to prevent market breakdowns.

Ratings, Credit Spreads

Abstract:
We study the market for CEO talent in public U.S. firms during the years 1993-2005. CEO talent pools are not homogenous across firms and industries. About 68% of new CEOs are former employees of their own firms (“insider CEOs”) and the rest come from outside the firm (“outsider CEOs”). We find wide disparities in talent pool structure across industries, with some industries having almost no outsider CEOs and other industries having a majority of outsider CEOs. Our central conjecture in this study is that, to the extent that the exogenous (to the firm) costs of hiring CEOs from outside the firm limit the potential outside options of the CEO and the firm, the compensation to the CEO should depend more on the compensation distribution within the pool rather than outside the pool. Consistent with this conjecture, industry talent pool structure helps explain several compensation practices: CEO compensation is benchmarked against other firms only in industries that have high percentage of outsider CEOs and pay-for¬luck is less prevalent when the industry has a low percentage of outsider CEOs. Finally, while CEO talent pools seem to explain cross-sectional variations in CEO compensation, they have little power in explaining the rise in CEO compensation in public U.S. firms in recent years.

CEO Compensation, talent, Skills, CEO Turnover

Abstract:
This paper introduces a recently developed consistent statistic by Bai and Ng (2002) to determine the number of factors in an approximate multifactor model. We use this new approach to study a recent work by Lo and Wang (2000), which shows that a multifactor asset-pricing model not only imposes factor restrictions on stock returns but on trading volume as well. We explicitly test their theoretical model restriction using individual stock and turnover data from NYSE and AMEX from 1962 to 1996.

While we find that the duo-factor model captures a great deal of common variation of return and trading volume, the data rejects a model restriction that excess return and turnover have the same number of systematic factors. We decompose excess return and turnover into systematic and idiosyncratic components. We discover a significant increase in the variation of idiosyncratic turnover through time, analogous to the finding of a notable increase in firm-specific volatility by Campbell, Lettau, Malkiel and Xu (2001). We also find significant co-movements between volatility and turnover at the systematic levels. Our findings support the view that trading volume is not purely random but driven by trading activities associated with macroeconomic and firm news.

Abstract:
This study looks inside a large retail-banking group to understand how influence within the group affects internal capital allocations and lending behavior at the member bank level. The group consists of 181 member banks that jointly own a headquarters. Influence is measured by the divergence from one-share-one-vote. We find that more influential member banks are allocated more capital from headquarters. They are less likely to decrease lending after negative deposit growth or to increase lending following positive deposit growth. These effects are stronger in situations in which information asymmetry between banks and the headquarters seems greater. The evidence suggests that influence can be useful in overcoming information asymmetry.

internal capital markets, capital markets, retail banking, corporate politics

Abstract:
This paper reinvestigates the performance of risk-based multifactor models. In particular, we generalize the Bayesian methodology of Shanken (1987b) and Kandel, McCulloch and Stambaugh (1995) from mean-variance efficiency to the ICAPM notion of multifactor efficiency. This methodology uses informative priors and provides a flexible framework to deal with the severe small sample problems that arise when estimating performance measures. We also introduce and theoretically justify a new inefficiency metric that measures the maximum correlation between the market portfolio and any multifactor efficient portfolio, which is used in conjunction with three other existing inefficiency measures. Finally, we present new empirical evidence that neither the two additional Fama-French (1992) factors nor the momentum factor move the market portfolio robustly closer to being multifactor efficient or robustly decrease pricing errors relative to the CAPM.

market measures, multifactor efficiency, market portfolios

Abstract:
The idea that uncertainty about a firm’s long-run profitability could increase its stock valuation has been proposed by Pastor and Veronesi (2003) to explain a number of phenomena in financial markets. We further examine this idea by analyzing a simple valuation model for both stocks and bonds, in contrast to the existing studies focusing on stocks only. Unless a firm is deeply in debt, our model implies that uncertainty about a firm’s profitability increases its stock valuation and decreases its bond valuation, where uncertainty’s impact is stronger if the firm’s leverage is higher. Using a number of existing uncertainty proxies in the literature and controlling for volatility, we empirically test these predictions. Consistent with the existing literature, our empirical evidence also supports the positive association of stock valuation and uncertainty for all uncertainty proxies. For only one proxy, our empirical evidence is also broadly consistent with uncertainty being negatively related to bond valuation and more so with greater leverage. However, the results based on all other uncertainty proxies generally (for example firm age) do not show a negative association with bond valuations. These results point to a number directions for further examination.

Uncertainty, convexity, valuation, technology bubble

Abstract:
This paper investigates the effect of shareholder control on bondholder wealth. While stronger shareholder control can benefit bondholders by disciplining managers, it also increases the likelihood of events that can hurt bondholders, e.g. hostile takeovers. We hypothesize that shareholder control can have contrasting effects on bond yields depending on the takeover vulnerability of a firm. Using the presence of an institutional blockholder to proxy for shareholder control and firm-level anti-takeover provisions to proxy for takeover vulnerability, we find that shareholder control is associated with lower yields if the firm is protected from takeovers. We also find that shareholder control is associated with higher yields if the firm is exposed to takeovers. The contrasting effects of shareholder control on yields are the strongest for firms that are small and have low leverage. In the presence of shareholder control, the difference in bond yields due to differences in takeover vulnerability can be as high as 93 basis points. Further, the results are insignificant for a sub-sample of firms where the bondholders are protected from takeovers through the poison put covenant. Bond ratings also appear to incorporate a similar effect of shareholder control on bondholders Finally, we find that a bond pricing model that does not account for shareholder control generates an annualized abnormal return of 1% to 1.4% for portfolios that long firms with both strong shareholder control and high takeover vulnerability and short firms without either shareholder control or takeover vulnerability. Combined, these results suggest that the use of different governance mechanisms, such as shareholder monitoring and takeover vulnerability, depends on a firm s capital structure and that bond-pricing models should account for shareholder control.

Abstract:
This paper considers the impact of the takeover channel on firm valuation. We usethe idea that takeover activity responds to investor expectations of future rate of return and hence to state variable(s) related to the time variation in risk premia. Thus firms with higher exposure to takeovers, due to higher expectations of receiving a takeover premium, have a higher exposure to the state variable that dictates time variation in risk premia. Consequently, the difference in the returns between firms that differ in their takeover vulnerabilities can be used to used to proxy these state variables. To do so, we create a takeover-spread portfolio that buys firms with low cash-adjusted-leverage(cheaper targets) and shorts firms with high cash-adjusted-leverage and show that sucha portfolio generates annualized abnormal returns of up to 11.20% between 1980 and2003. Also, abnormal returns associated with governance-spread portfolios (Gompers,Ishii and Metrick, 2003 and Cremers and Nair, 2004) decrease significantly once the assetpricing model includes this cash-adjusted-leverage factor. Finally, we propose a new takeover factor to proxy for the risk due to changes in these risk-premia related state variables, which is shown to be important in explaining cross-sectional differences in equity returns. The paper shows why investors require a higher rate of return on firms exposed to takeovers and yet value them higher than firms protected from takeovers.

Abstract:
This paper examines the effect of institutional investors‟ investment duration on the efficiency of stock prices. Using a new duration measure based on quarterly institutional investors‟ portfolio holdings, the presence of short-term institutional investors can help explain many of the best-known stock return anomalies, possibly because these investors are affected by behavioral biases like overconfidence. Specifically, we find that both momentum returns and subsequent returns reversal are much stronger for stocks with greater proportions of short-term institutional investors. The accruals and share issuance anomalies are also stronger for stocks held primarily by short-term institutional investors. Finally, short-term institutional investors do not seem to recognize the benefits of significant R&D increases, as they tend to under-react to these increases.

Abstract:
Recent theoretical work by Lo and Wang (2000) shows that a multi-factor assetpricingmodel not only imposes factor restrictions on stock returns but on trading volume as well. We explicitly test their theoretical result using individual stock return and turnover data from NYSE and AMEX from 1962 to 1996. We introduce a recently developed consistent statistic by Bai and Ng (2001a) to determine the number of factors in a duo approximate multi factor model for return and turnover. While we find that the duo-factor model captures a great deal of common variation of trading volume, the data rejects a model restriction that excess return and turnover should have the same number of systematic factors. Using the duo-factor-model, we decompose excess return and turnover into systematic and idiosyncratic components. Our empirical work discovers a significant increase in the variation of idiosyncratic turnover through time, analogous to the discovery of a noticeable increase in firm level volatility by Campbell, Lettau, Malkiel and Xu (2001). We also find significant co-movement between volatility and turnover at the systematic levels. Our findings support the view that trading volume is notpurely random but driven by trading activities associated with macroeconomic and firm news.

Abstract:
This paper examines the impact on shareholder voting of the mutual fund voting disclosure regulation adopted by the SEC in 2003, using a paired sample of management proposals on executive equity incentive compensation plans submitted before and after the rule change. While voting support for management has decreased over time, we find no evidence that mutual funds' support for management declined after the rule change, as expected by advocates of disclosure. In fact, we find evidence of increased support for management by mutual funds after the change. There is some evidence that firms sponsoring such proposals both before and after the rule change differ from those sponsoring a proposal only before the change. For example, firms are more likely to sponsor a proposal both before and after the rule change if they have higher mutual fund ownership. Such endogeneity could partly explain our findings of increased support after the rule.

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Abstract:
This paper considers the impact of the takeover likelihood on firm valuation. If firms are more likely to acquire when there is more free cash or lower required rates of return, the targets become more sensitive to shocks to cash flows or the price of risk. Ceteris paribus, firms exposed to takeovers have different rates of return than protected firms. Using takeover likelihood estimates, we create a “takeover factor,” buying (selling) firms with a high (low) takeover likelihood, which generates “abnormal” returns. Several tests confirm that the takeover factor helps explaining cross-sectional differences in equity returns and is related to takeover activity.

Abstract:
We introduce a new measure of active portfolio management, Active Share, which represents the share of portfolio holdings that differ from the benchmark index holdings. We compute Active Share for domestic equity mutual funds from 1980 to 2003. We relate Active Share to fund characteristics such as size, expenses, and turnover in the cross-section, and we also examine its evolution over time. Active Share predicts fund performance: funds with the highest Active Share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence. Nonindex funds with the lowest Active Share underperform their benchmarks.

G10, G14, G20, G23

Abstract:
This article applies the methodology of Bai and Ng (2002, 2004) for decomposing panel data into systematic and idiosyncratic components to both stock returns and turnover panels. This approach works well for both returns and turnover, despite the presence of severe heteroscedasticity and nonstationarity of individual stocks' turnover. We test the mutual fund separation model of Lo and Wang (2000). Trading due to systematic risk in returns can account for 66% of systematic turnover. Thus, portfolio rebalancing due to systematic risk is a very important motive for stock trading. Finally, several common turnover measures may understate the impact of stock trading.

Abstract:
We investigate the effects of shareholder governance mechanisms on bondholders and document two new findings. First, the impact of shareholder control (proxied by large institutional blockholders) on credit risk depends on takeover vulnerability. Shareholder control is associated with higher (lower) yields if the firm is exposed to (protected from) takeovers. In the presence of shareholder control, the difference in bond yields due to differences in takeover vulnerability can be as high as 66 basis points. Second, event risk covenants reduce the credit risk associated with strong shareholder governance. Therefore, without bond covenants, shareholder governance, and bondholder interests diverge.

G12, G34