Menu Jack Treynor Prize Winners 2020 In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis Xavier Gabaix, Harvard Ralph Koijen, University of Chicago This thought-provoking paper models the effects of stock-bond mandate ratios. For example, certain investment vehicles may have a mandate to maintain close to an 80:20 stock:bond ratio. The authors show that under such mandates, flows between bonds and stocks will cause startling price changes in the overall value of stocks. In a stylized model with one 80:20 mixed stock-bond fund and one bond fund, a $1 flow from bonds to stocks will cause stock prices overall to go up by $5. The authors then use market data to test the presence of this effect empirically, and find that indeed overall markets do react as if there is an 80:20 mandate. The authors are aware of the unorthodox nature of this result; they have thoughtfully explored many possible objections but find that their hypothesis continues to hold up. Reconsidering Returns Samuel Hartzmark, University of Chicago David Solomon, Boston College The authors document a widespread reporting phenomenon whereby stock market results are usually reported on a price basis rather than on a total return basis. Leaving out dividends and other distributions causes under-reporting of true returns to investors, leading to more negative market sentiment commentary. While institutional investors know that returns should include distributions, market movements suggest that the adjustment to total returns is not fully incorporated in prices. The authors conjecture that price-based reporting can explain part of the equity risk premium. Regulatory Limits to Risk Management Ishita Sen, Harvard This paper looks at the difference between regulatory requirements for risk-based capital in insurance companies, and the actual hedging that would be needed to fully offset risk exposures to equities and interest rates. Firms’ actual hedging positions for VA (variable annuities) are carefully examined. The conclusion is that regulatory requirements encourage suboptimal hedging. These requirements can lead to offloading of risk into off-balance-sheet entities, which puts the stability of the broader financial system at risk. 2019 Expected Correlation and Future Market Returns Adrian Buss, INSEAD and CEPR Lorenzo Schönleber, Frankfurt School of Finance & Management Grigory Vilkov, Frankfurt School of Finance & Management Implied correlation, jointly extracted from index and stock options, is a robust predictor of long-term market returns. Its predictive power stems from its role as a leading pro-cyclical state variable that predicts future investment opportunities, financial-market risks, and macroeconomic conditions for up to 18 months ahead. The predictability is inherited from the interplay between its three main components: implied market variance, implied idiosyncratic variance, and the implied dispersion of market betas. The predictability is not subsumed by measures of tail risk. Out-of-sample evidence suggests that that the predictability can produce substantial economic gains for market-timing strategies. Factor Momentum and the Momentum Factor Sina Ehsani, Northern Illinois University Juhani Linnainmaa, Dartmouth College Momentum in individual stock returns comes from momentum in factor returns. Most factors are positively autocorrelated: the average factor earns a monthly return of 1 basis point following a year of losses and 53 basis points following a positive year. Factor momentum explains all forms of individual stock momentum. Stock momentum strategies indirectly time factors: they profit when the factors remain autocorrelated, and crash when these autocorrelations break down. Momentum is not a distinct risk factor; it aggregates the autocorrelations found in all other factors. Molecular Genetics, Risk Aversion, Return Perceptions, and Stock Market Participation Richard Sias, University of Arizona Laura T. Starks, University of Texas at Austin H. J. Turtle, Colorado State University Molecular variation in DNA related to cognition, personality, health, and body shape predicts an individual’s equity market participation, risk aversion, and beliefs regarding the distribution of expected equity returns. Molecular genetic endowments also are strongly associated with many of the investor characteristics (e.g., trust, sociability, wealth) shown to explain heterogeneity in equity market participation. This analysis helps explain why financial choices are heritable and how these genetic endowments can help explain the links between financial choices, risk aversion, beliefs, and other variables known to predict stock market participation. 2018 The Economics of Factor Timing Valentin Haddad, UCLA & NBER Serhiy Kozak, University of Michigan Shrihari Santosh, University of Maryland The authors use economic restrictions implied by asset pricing theory to empirically identify and characterize optimal factor timing portfolios. They find that long-short equity factors are strongly and robustly predictable. Several of these portfolios have small average risk prices. These small prices suggest that the economic risks investors worry about conditionally are often different from those that they worry about on average. For bonds and foreign exchange, long-short portfolios sorted on maturity or interest rate differential also are predictable. How Alternative Are Private Markets? William N. Goetzmann, Yale School of Management and NBER Elise Gourier, Queen Mary University of London and CEPR Ludovic Phalippou, University of Oxford The authors estimate a parsimonious set of factor portfolios using returns from a comprehensive panel of private market funds. They then determine whether commonly used public equity factors span these private market factors, and whether the private market factors are priced in the cross-section of private market funds. Four main private market factors explain returns in the cross-section. One factor, dominated by large leveraged buyout funds, generated a significant positive premium. A second factor, dominated by venture capital funds, also was priced over the past thirty years. The pricing of the other two factors, related to real assets and private debt funds, was smaller but has been increasing over time. Labor Market Competitor Network and the Transmission of Shocks Yukun Liu, Yale University Sissi Xi Wu, New York University Using online job postings, the authors determine the extent to which firms in different industries compete for similar workers. They show that the overlap between firms’ labor market competitors and their product market rivals is less than 20 percent. The authors then show that a firm’s stock returns can be partially predicted by the lagged stock returns of its labor market competitors as news about labor market conditions propagates across industries. A long-short strategy based on this observation generates an annualized alpha of 9.36 percent. 2017 Performance Isn’t Everything: Personal Characteristics and Career Outcomes of Mutual Fund Managers Brad Barber, University of California, Davis Anna Scherbina, University of California, Davis Bernd Schlusche, Board of Governors of the Federal Reserve System Past performance—measured by returns and fund flows—largely determine mutual fund managers’ career outcomes. Managers’ personal attributes also matter. All else equal, female fund managers are less likely to be promoted than male managers, and they have shorter tenures. Furthermore, managers from elite schools and those holding advanced degrees have better career outcomes, while older managers face significantly worse career prospects, possibly by choice. Sensation-Seeking Hedge Funds Stephen Brown, NYU Stern School of Business and Monash Business School Yan Lu, College of Business, University of Central Florida Sugata Ray, Culverhouse College of Commerce, University of Alabama Melvyn Teo, Lee Kong Chian School of Business, Singapore Management University The authors collect data on hedge fund manager automobile purchases and show that managers who own powerful sports cars take on more investment risk than do other managers but do not deliver higher returns. Moreover, funds managed by performance car owners exhibit higher operational risk and are more likely to fail. Performance car owners demonstrate other attributes associated with sensation seeking, such as a preference for lottery-like stocks, unconventional strategies, and active trading. Trading on Talent: Human Capital and Firm Performance Anastassia Fedyk, Harvard University James Hodson, Jožef Stefan Institute Using a novel dataset with information about 37 million employees of U.S. public companies, the authors show that human capital affects firm performance. Firms with low employee turnover perform better in the market than firms with higher turnover. Also, firms with disproportionately more employees with sales-oriented skills perform better than others, whereas firms with more employees with administrative skills underperform. The effects of skill are heterogeneous across industries. Web development skills are more valuable in information industries, but sales-oriented skills are not notably more valuable in Finance. 2016 Credit-Implied Volatility Bryan Kelly, University of Chicago Gerardo Manzo, University of Chicago Diogo Palhares, AQR The pricing of corporate credit can be succinctly understood via the credit-implied volatility (CIV) surface. Using a method analogous to the estimation of implied volatility from options contracts, the authors compute credit-implied volatility each month from the firm-by-maturity panel of CDS spreads using the Merton model. The process transforms CDS spreads into units of asset volatility. The CIV surface facilitates direct comparison of credit spreads at different “moneyness” (firm leverage) and time to maturity. The authors use this framework to characterize the behavior of corporate credit markets. They examine moneyness (leverage); they show that of credit spreads dynamics can be parsimoniously described with three clearly interpretable factors; and they examine the cross section of CDS risk premia. Extrapolation Bias and the Predictability of Stock Returns by Price-Scaled Variables Stefano Cassella, Krannert School of Management, Purdue University Huseyin Gulen, Krannert School of Management, Purdue University Using survey data on expectations of future stock returns, the authors estimate the degree of extrapolation bias (DOX)—the belief that what has happened recently will continue to happen—in investor expectations. Considerable time-series variation exists in the DOX, evidence shows that it can predicted to a meaningful extent. The authors show that the ability of the dividend-price ratio to predict the equity premium is contingent on the DOX. There is Predictability is when the DOX is high and weak otherwise. These results help answer a critical question: when will an overvalued asset, or even a bubble, experience a correction?. Lazy Prices Lauren Cohen, Harvard Business School Christopher Malloy, Harvard Business School Quoc Nguyen, University of Illinois at Chicago When making required regulatory financial reports, firms very often repeat the same MD&A texts that they most recently used. Changes in these texts can be quite informative. Using the complete history of regular quarterly and annual filings by U.S. corporations from 1995-2014, the authors show that changes to the language and construction of financial reports have strong implications for firms’ future returns: a portfolio that shorts “changers” and buys “non-changers” earns up to 188 basis points per month (over 22% per year) in abnormal returns in the future. Changes in language referring to the executive (CEO and CFO) team, or regarding litigation, are especially informative for future returns. 2015 The Credit Spread Puzzle in the Merton Model—Myth or Reality? Peter Feldhutter, London Business School Stephen Schaefer, London Business School The Merton model links bond values to stock values through option pricing theory. Past tests of the model have been unsatisfactory because they depend on default rates which are hard to estimate. This paper shows that when default rates are measured over long periods, the model explains the average level of investment grade spreads and captures the time series variation of the BBB-AAA spread well. The paper further shows that using data on individual firms—rather than a representative firm—is important for matching the slope of the term structure of credit spread. Low Risk Anomalies? Paul Schneider, University of Lugano and Swiss Finance Institute Christian Wagner, Copenhagen Business School Josef Zechner, CEPR and ECGI, WU Vienna The stocks of low risk firms have performed surprisingly well when compared to the predictions of standard asset pricing models. This study shows that their performance can be explained by return skewness—the tendency for large negative returns to be more common than large positive returns. Such returns generally are associated with financial distress and the risk of default. With increasing downside risk, the standard capital asset pricing model (CAPM) increasingly overestimates expected equity returns relative to firms’ true (skew-adjusted) market risk. A Protocol for Factor Identification Kuntara Pukthuanthong, University of Missouri Richard Roll, California Institute of Technology Asset pricing models generally examine various factors for their ability to predict average returns. Several hundred factors have been suggested in the literature. This study proposes a protocol for determining which factors are related to risks and which are related to mean returns. The results will allow quantitative investors to better construct portfolios and to understand the risk and expected returns associated with their portfolios. 2014 Betting Against Beta or Demand for Lottery Turan G. Bali, Georgetown University Stephen J. Brown, New York University and University of Melbourne Scott Murray, University of Nebraska-Lincoln Yi Tang, Fordham University Recent academic research has shown that stocks with high betas have worse performance than low beta stocks, which violates conventional finance theory. Beta is the tendency for a stock to rise or fall with the broader market. The evidence in this paper suggests that high beta stocks also or fall with the broader market. The evidence in this paper suggests that high beta stocks also tend to provide lottery-like returns and investors seeking these lottery-like payoffs push up the prices of high beta stocks, causing them to subsequently under perform. The Shorting Premium and Asset Pricing Anomalies Itamar Drechsler, New York University and NBER Qingyi (Freda) Drechsler, Wharton Research Data Service Academics and practitioners have identified several asset-pricing anomalies that can be associated with seemingly profitable trading strategies. This paper shows that many of these anomalies occur in stocks for which there are a limited supply of shares that can be shorted, or where the costs of shorting are high. Thus, some of the apparent profits available to shorting these stocks don’t exist because either they cannot be shorted or it is too expensive to do so. X-CAPM: An Extrapolative Capital Asset Pricing Model Nicholas Barberis, Yale School of Management Robin Greenwood, Harvard Business School Lawrence Jin, Yale School of Management Andrei Shleifer, Harvard University The Capital Asset Pricing Model (CAPM) is the most important model practitioners and academics use to understand the relation between expected returns and risk. However, empirical studies suggest that it does not work well in practice. This paper argues that asset pricing is the result of a tension between rational investors whose behavior is consistent with the CAPM and other rational investors who extrapolate future investment returns from recent investment returns. JOIN THE Q GROUP CALL FOR WORKING PAPERS FALL 2021 SEMINAR