My dissertation focuses on understanding the behavior of participants in financial markets and the cross-sectional variation in the returns of financial assets. In particular, I examine: a) how the interaction between managers and investors in the equity fund industry affects fund performance, b) how the behavioral biases of investors in the equity market are associated with stock returns that are not well captured by standard risk factor models.
Chapter one investigates the role of diseconomies of scale in mutual fund performance. I argue that there are two crucial aspects that are related to subsequent performance. In addition to the well-known metrics based on past returns (i.e., alpha and tracking errors), I demonstrate that managerial ability to overcome diseconomies of scale is also a key factor. I propose two new proxies for the degree of diseconomies of scale by contrasting two types of past success, namely, accumulated success in industry exploration (i.e., buying stocks from unknown industries) and accumulated success in industry exploitation (i.e., buying stocks from familiar industries). Accumulated success in industry exploration, representing low degree of diseconomies of scale, plays a significant positive role in absorbing fund inflows, leading to good and persistent benchmark-adjusted performance in the subsequent period. By sharp contrast,accumulated success in industry exploitation, representing high degree of diseconomies of scale, does exactly the opposite. Although these results suggest the importance of different degrees of diseconomies of scale in fund performance, I find that only investors in good performing funds realize their distinction.
Chapter two, coauthored with Jianfeng Yu, examines the profitability premium.
Previous studies show that the profitability-based factor can explain almost all asset pricing anomalies, highlighting the importance of firm profitability. This paper investigates both risk-based and behavioral-based explanations of
the profitability premium itself. First, we show that there is moderate support for risk-based structural models with shareholder advantage and investment flexibility. Second, the profitability premium exists primarily among firms with high arbitrage costs or high information uncertainty. Third, the majority of the profitability premium is derived from the negative alpha of low profitability firms, consistent with the notion that overpricing is more prevalent than underpricing due to greater impediments to short. Finally, portfolio return behavior around earnings announcements suggests that investor underreaction and limits-to-arbitrage are partially responsible for the profitability premium.
Chapter three, coauthored with Jinghua Yan and Jianfeng Yu, studies the cross-sectional risk-return tradeoff in the stock market. The fundamental principle in finance posits a positive relation between risk and expected return, whereas recent empirical evidence suggests that low-risk firms tend to earn higher average returns. We apply prospect theory to shed light on this violation of this fundamental principle. Prospect theory posits that when facing prior loss relative to a reference point, individuals tend to be risk-seeking, rather than risk-averse. Consequently, among stocks where investors face prior losses, there should be a negative risk-return relation. By contrast, among the stocks where investors face capital gains, the traditional positive risk-return relation should emerge since investors of these stocks are risk averse. Using several intuitive measures of risk, we provide empirical support for our hypotheses. The role of prospect theory in the idiosyncratic volatility puzzle is also discussed.