Weekly Academic Digest 8/28/2011

Negative Alpha Research (Temporary Category)

Taxing Financial Transactions: An Assessment of Administrative Feasibility–ugg, just what we need…more taxes.

This paper considers how a tax on financial transactions could be applied to three broad and partially overlapping categories of financial instruments: (1) exchange-traded instruments; (2) over-the-counter instruments; and, (3) foreign exchange instruments. For each category, the paper examines the factors that would facilitate or complicate the administration of a financial transactions tax, the options for collecting the tax, the types of compliance risks that are likely to be encountered, and measures for mitigating these risks.

Alpha Research

The Asset Growth Anomaly and the Role of Limits to Arbitrage–questioning an anomaly we’ve talked about in the past.

Several studies have documented that companies that increase capital investments or grow their total assets subsequently earn substantially lower risk-adjusted returns. Some studies attribute this phenomenon to investors’ initial underreactions to firms’ overinvestments or overreactionsto changes in firms’ fundamentals. This paper examines the role of the limits to arbitrage in the negative effect of capital investment or asset growth on subsequent stock returns. We hypothesize that if the negative effect is due to investors’ initial mis-reactions, the effect should be more pronounced when there are more severe limits to arbitrage. Our empirical evidence supports the hypothesis. In addition, we find that the effect of the limits to arbitrage on the assetgrowth anomaly is not simply a manifestation of liquidity risk or trading costs consisted of bid ask spreads and trading commissions.

In Promises We Trust: Stock Returns and Annual Report Announcements–seasoned value investors will verify this effect via anecdotal evidence…never trust a CEO promise.

Firms making few promises in annual reports generate positive abnormal returns of up to 6% annually. These returns are not driven by microcaps or known anomalies and are not industry specific. Promises are measured by frequency of the verbs will, shall, and going to. Frequencies of the 100 other most common words (and their three-word combinations) in 10-K reports are unrelated to returns. Promises are costly informative signals, and the evidence favors a risk versus a mispricing explanation. Thus, as predicted by finance theories, firms about which there is less public information are riskier but offer higher returns.

 

Behavioral Finance

Do Psychological Shocks Affect Financial Risk Taking Behavior? A Study of U.S. Veterans–time to rename “shell shock” and call it “stock shock.”

Traditional economic theories assume that individuals are endowed with certain risk preferences that are unaltered by experiences. However, recent evidence indicates that macroeconomic shocks do have an effect on an individual’s willingness to take financial risks. In the context of investment decisions, we examine empirically whether individual’s risk preferences are affected by other types of traumatic life experiences. Using a unique proprietary data set, we investigate whether personal traumatic experiences – such as the combat experiences of veterans – have long-term effects on financial risk taking behavior. We find that having experienced combat decreases the probability of investing in risky assets. Key policy implications are noted.

Behavioral Corporate Finance: An Updated Survey–nice overview

We survey the theory and evidence of behavioral corporate finance, which generally takes one of two approaches. The market timing and catering approach views managerial financing and investment decisions as rational managerial responses to securities mispricing. The managerial biases approach studies the direct effects of managers’ biases and nonstandard preferences on their decisions. We review relevant psychology, economic theory and predictions, empirical challenges, empirical evidence, new directions such as behavioral signaling, and open questions.

General Interest

Do Private Equity Fund Managers Earn Their Fees? Compensation, Ownership, and Cash Flow Performance–think twice about funding your private equity manager’s yacht and Ferrari.

Using a new database of the compensation terms, ownership structures (capital commitments), and quarterly cash flows for a large sample of buyout and venture capital private equity funds from 1984-2010, we investigate the determinants of manager compensation and ownership and how these contract terms relate to the funds’ cash flow performance. Market conditions during fundraising are an important driver of compensation, as pay rises and shifts to fixed components during fundraising booms. We find no evidence that higher compensation or lower managerial ownership are associated with worse net-of-fee performance, in stark contrast to other asset management settings. Instead, compensation is largely unrelated to net cash flow performance. Our evidence is most consistent with an equilibrium in which compensation terms reflect agency concerns and the productivity of manager skills, and in which managers with higher compensation earn back their pay by delivering higher gross performance.

Quantitative Musings

How to be a successful car salesman–wow, the Farnam Street blog is fascinating!

Buy and hold is dead–didn’t we already know that?

 

 

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