Asset-Pricing Anomalies and Financial Distress

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Doron AvramovUniversity of Maryland
Tarun Chordia, Emory University
Gergana Jostova, George Washington University <
Alexander Philipov, George Mason University

Financial distress is crucial in explaining the profitability of prominent market anomalies. Price momentum, earnings momentum, credit risk, dispersion, and idiosyncratic volatility effects arise in periods of deteriorating credit conditions and are nonexistent in stable or improving credit conditions. These strategies target firms with deteriorated credit conditions that keep on deteriorating over the holding period. In contrast, the size and book-to-market anomalies are prominent in periods of improving or stable credit conditions and disappear or are attenuated otherwise. These strategies also target firms whose credit conditions have deteriorated but are profitable only if conditions subsequently improve.

Investment managers who trade on anomalies need to understand the origins of the anomalies so that they can best determine when to trade on them. The proposed research will identify how anomalies vary with credit conditions. The results should be of particular interest given the current credit problems that firms are experiencing.

Are Stocks Really Less Volatile in the Long Run?

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Lubos Pastor,University of Chicago
Robert F.Stambaugh, University of Chicago Pennsylvania

Stocks are more volatile over long horizons than over short horizons from an investor’s perspective. This perspective recognizes that observable predictors imperfectly deliver the conditional expected return and that parameters are uncertain, even with two centuries of data. Stocks are often considered less volatile over long horizons due to mean reversion induced by predictability. However, mean reversion’s negative contribution to long-horizon variance is more than offset by the combined effects of various uncertainties faced by the investor. Using a predictive system to capture these uncertainties, we find 30-year variance is 21 to 53 percent higher per year than 1-year variance.

Asset allocation decisions depend critically on the interaction between risk tolerance and characterizations of risk. The proposed study examines uncertainties associated with characterizing future return distributions. Including these uncertainties suggests that stocks may be more volatile in the future than they have been in the past.

A Comparison of Index Funds and ETF

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Ilan Guedj, University of Texas at Austin
Jennifer Huang, University of Texas at Austin

We develop an equilibrium model to compare the organizational structure of Open-End Index Funds (OEF) and Exchange-Traded Funds (ETF). We find that the OEF structure can be viewed as providing partial insurance against future liquidity needs and is ex-ante beneficial for risk averse investors. However, the insurance feature embedded in the OEF structure can cause moral hazard issues — e.g., excessive trading — and reduce the performance of the OEF. While higher-liquidity-need investors benefit more from the liquidity insurance and hence prefer to invest via the OEF, the concentration of high-liquidity-need investors in the OEF does not lead to higher flow-induced trading costs since individual liquidity needs cancel out at the fund level. As a result, OEFs and ETFs can coexist in equilibrium. Finally, guided by the theoretical prediction that ETFs are better suited for narrower and less liquid underlying indexes, we empirically confirm that the growth of ETFs is more concentrated in those indexes.

Exchange traded funds and open-end index funds compete with each other for investment dollars. Many investors now chose between them when implementing passive trading programs and also active trading problems. The proposed study examines how the valuation of liquidity and its pricing affects the relative attractiveness of these instruments to various types of traders.

Text Based Portfolio Choice

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Shimon Kogan, University of Texas at Austin
Bryan R. Routledge, Carnegie Mellon University
Jacob S Sagi,Vanderbilt University
Noah A. Smith,Carnegie Mellon Mellon

Portfolio optimization requires, as an input, a description of the assets’ joint return distribution. In estimating forward-looking distributional parameters from historical data, such as means, variances, and correlations, investors face a conundrum. Estimates with small measurement error require a long time-series, but a longer time-series necessarily contains less forward-looking information unless the distribution of returns is known to be static over time. We propose to investigate the usefulness of textual company-level materials in producing better estimates for firms’ return distributions. Our preliminary investigations shows that employing a novel text regression technique to annual reports we are able to predict, out of sample, firm return volatility.

Active trading strategies attempt to extract information from various sources about future return distributions. Most active portfolio managers undertake quantitative analyses of published financial data or qualitative analyses of soft textually based data. The proposed study will examine the value of tools designed to produce quantitative analyses of textual data.

Do Short Sellers Detect Overpriced Firms? Evidence from SEC Enforcement Actions

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Jonathan M.Karpoff, University of Washington
Xiaoxia Lou,University of Delaware

We examine short selling in the stocks of firms that subsequently are identified by the SEC as having misrepresented their financial statements. We first examine whether short selling anticipates the initial public revelation of financial misconduct, and whether the selling is sensitive to the misconduct’s severity. We then examine whether short selling conveys external benefits or harms to other investors, including the extent to which short selling: (i) helps uncover the misconduct, (ii) facilitates a downward price spiral when bad news is revealed to investors, or (iii) decreases the amount by which share prices are inflated by the misrepresentation.

Many investment management processes consider short selling, either as a source of information about values or as a trading strategy. The proposed research examines frauds identified by the SEC to determine whether short sellers anticipated them and to quantify the extent to which the short selling attenuated investor losses. The topic is of great current importance because the short selling is under attack as issuers and some investors pressure regulators to restrict short selling when security prices are uncertain.