Change is Good or the Disposition Effect Among Mutual Fund Managers by Anna Scherbina, Li Jin

Previous research has shown that individual investors often hold on to losing stocks for too long. It has largely been assumed that this is because individuals are reluctant to admit their mistakes. Empirically this has been shown by many including Odean 1998.

There is some, although less persuasive evidence that professional money managers are less likely to make this financial error.

Short Version:
Scherbina and Jin examine whether Mutual Fund managers exhibit such reluctance. Their finding? The managers, like the individual investors, hold on to losers too long. Their evidence? When new fund managers take over, they are more apt to sell off the losers and start fresh.

Longer Version:
SSRN-Change is Good or the Disposition Effect Among Mutual Fund Managers by Anna Scherbina, Li Jin:

"We document that mutual fund managers exhibit the disposition bias, or the tendency to hold on too long to poorly performing stocks. This bias arises because of the psychological unwillingness to admit past mistakes. We show that new fund managers, who are emotionally unattached to their predecessors' decisions, sell the momentum losers they have inherited more readily than continuing fund managers."

Some key factoids:

• The authors only look at those funds where the complete manager team is replaced.
• The sample is amazing! It goes from 1924 to the present and covers over 30,000 managerial changes.
• "Consistent with the hypothesis of the disposition effect, in the quarter immediately after the new manager takes over, the median sale of the stocks in the losing decile is -100%, while the median stock sale (averaged over the continuing managers) is only -16.75%."

Their conclusion?

"mutual fund managers, much like individual investors are subject to the disposition bias. In order to document the effect, we go to the root of the bias and show that new managers, who are not likely to be attached to past portfolio decisions, make more rationaltrading choices."

While I think this is sort of what would have been expected, it is a victory for behavioral finance.

And interesting to boot! ;)

Cite:
Scherbina, Anna and Jin, Li, "Change is Good or the Disposition Effect Among Mutual Fund Managers" (February 25, 2005). EFA 2005 Moscow Meetings Paper. http://ssrn.com/abstract=676970

Mmm, I wonder if the same happens when teams make coaching changes?

ISLAMIC MORTGAGES: Faith, finance forge new path

Kim Norris of the Detroit Free Press presents an interesting look at Islamic Mortgages. Islamic mortgages are different than traditional mortgages since many Muslims believe interest is wrong.

ISLAMIC MORTGAGES: Faith, finance forge new path: "In Islamic mortgages, an intermediary such as a bank buys the property, and the homeowner eventually obtains the home through a lease-to-own arrangement."

A few interesting tidbits from the article:

"The biggest barrier to developing so-called Islamic financing in the United States is the absence of a secondary market for these products. Typically when banks loan money for houses, they sell those loans to investors who profit by collecting the principle and interest.

Ranzini said University Bank must hang onto the Islamic mortgages it writes as well as title to the homes. That limits the volume of loans a bank can make."

Home insurance can also a be problem for the "borrowers" since they technically do not own the home. In the article Norris writes of a Muslim couple who experienced this problem:

"some problems when they tried to buy homeowners insurance -- something necessary to obtain a mortgage. Insurers would not recognize the Islamic mortgage as a standard mortgage. Instead, they insisted that since the trust owned the house, Solaiman and Metzger were only eligible for renters' insurance."

This may be changing however since in Michigan at least, the "Office of Financial and Insurance Services...OFIS issued a clarification saying that Islamic mortgages qualified for homeowners insurance just as a traditional mortgage does."

Ironically, what the article does not say is that the mere presence of insurance can be problematic for the most fundamentalist of Muslims. From Islam.org:

"Our scholars are not in agreement whether insurance is permissible (Halal) or prohibited (Haram). Since insurance as it is being practised now did not exist during the Prophet's time, Ijtihad is used to determine whether it is permissible or otherwise. As the scholars are not in agreement as to whether insurance is permissible or prohibited, they are also not in agreement as to reasons for its prohibition."

Total disclosure here. I was consulted by Kim Norris for her article. Among the topics we discussed were that the idea of that interest being bad is not new or unique to Islam. Christians had the same debate about 900 years ago.

From Newschool.edu (I highly recommend reading it!!!):

"Although clerics had been prohibited from lending at interest at least since the 4th Century, the ban was not extended to laymen until much later. In 1139, the Second Lateran Council denied all sacraments to unrepentant usurers and, in an 1142 decree, condemnedany payment greater than the capital that was lent."

Interestingly (no pun intended) Christians decided that interest was fine so long as it was not punitive (hence the term usury). It will be interesting to see (and unfortunately it will probably be after any of our lifetimes) whether Muslims decide likewise.

I have tried to understand why any religion would not allow any interest and I can not. I realize there are scripture readings (in many religions--see Wikipedia) against it, but I confess I do not understand the logic behind them. The ability to borrow (i.e. access to capital) can be amazingly beneficial and while equity might be better in some regards, limiting supply seems an interesting way of making helping the poor. Indeed, it could be said that religions would want to increase this access to money to help lift the poor from poverty.

The only explanation that makes sense to me is that debt can become a burden (too much of a good thing) and can lead to short-term thinking. But that is more an indictment of excessive debt. So maybe we should be against predatory lending and not all lending.

I would love some help on this one.

BTW Don't forget to check out the Detroit Free Press' article!

Also one of the best articles I have ever found on current trends in Islamic Finance is still available at Dinar Standard. A Great read!

Optimism and Economic Choice by Manju Puri, David Robinson

Puri and Robinson give us a new look at the old idea that optimism matters.

They identify optimists by looking at people's self-reported life expectancy. The findings are that not only do optimists work harder, but they buy more individual stock than their more pessimistic peers. .

SSRN-Optimism and Economic Choice by Manju Puri, David Robinson:

Short version:

"Optimists are more likely to believe that future economic conditions will improve. Self-employed respondents are more optimistic than regular wage earners. In general, more optimistic people work harder and anticipate longer age-adjusted work careers. They are more likely to remarry, conditional on divorce. In addition, they tilt their investment portfolios more toward individual stocks"

Longer version:

While I am usually quite interested in optimism research both in finance (e.g. Barber and O'Dean's work on excessive confidence leading to increased trading) and outside of finance (e.g. recovery from surgery etc), I confess I had not much seen much of the work cited. For instance:

"Gervais and Goldstein (2004) model how overconfidence in one's own ability leads to excessive effort, resolving moral hazard problems in teams. Rigotti, Ryan, and Vaithianathan(2004) develop a model in which optimists are more likely to embrace occupations with ambiguous returns, leading optimists to naturally choose entrepreneurship."

Puri and Robertson use self-reported life expectancy to proxy for optimism. That is, if the person expects to live for a longer time than actuarial tables suggest, that person is labeled an optimist. This rather simple labeling proves to be quite powerful.

For instance the authors report that:

"Our measure of optimism correlates with beliefs about future economic conditions. Respondents who report that they think economic conditions will improve over the next five years are statistically much more optimistic according to our measure than respondents who think conditions will stay the same or deteriorate."

And later:

"we findthat more optimistic people (regardless of their employment status) seem to view work more favorably: they work longer hours, they anticipate longer age-adjusted work careers, and they are more likely to think that they will never retire."

Which is all interesting, but I am not sure if I could include it in a FinanceProfessor blog (it would probably need to show up on my RandomTopics2 blog) but there is some pure finance in the paper:

"Optimists are more likely to own individual stocks, and they own a larger fraction of their equity wealth in individual stocks. Thus, they appear to be stock-pickers. This suggests that our measure of optimism captures the idea that optimists place greater weight on more positive outcomes than pessimists do. However, there is no evidence that more optimistic people tilt their portfolios more toward equity per se."

Very interesting.

Cite:
Puri, Manju and Robinson, David T., "Optimism and Economic Choice" (May 2005). http://ssrn.com/abstract=686240

Do Investors Reinvest Dividends and Tender Offer Proceeds? by Elias Rantapuska

SSRN-Do Investors Reinvest Dividends and Tender Offer Proceeds? by Elias Rantapuska

Short answer: Not really.

Rantapuska asks two interesting questions:

1. Are dividends and the proceeds from tender offers really reinvested?
2. Are the proceeds from cash flows from tender offers treated differently than those from dividends.

Using data from Finland, the author finds that a relatively small percentage of the proceeds are immediately reinvested and that investors do appear to treat dividends differently from tender proceeds.

In Rantapuska's own words:

"analyses show that households reinvest probably less than 1% and under no circumstances more than 8.1% of the dividends within two weeks of the payment. Institutions other than mutual funds are not reinvesting either. There is also strong evidence on investors being more likely to reinvest proceeds from tender offers than dividends. This result holds even when I control for the identity of the investor, size of the cash flow, and the extraordinary nature of tender offer proceeds payment. This result can be understood in terms of mental accounting: investors label corporate cash-disbursements to mental accounts of capital assets and dividend income and are more prone to reinvest the former."

Pretty interesting. And yet more evidence that DRIP programs (both for mutual funds and individual stocks) are probably a good idea.

The mental accounting idea is also intriguing. Purely economic investors would treat cash as cash regardless of its source.


Cite:
Rantapuska, Elias Henrikki, "Do Investors Reinvest Dividends and Tender Offer Proceeds?" (July 25, 2005). EFA 2005 Moscow Meetings, Forthcoming http://ssrn.com/abstract=675981

Socially Responsible Investors

I hate it when the WSJ "scoops" me, but that is where I found out about this paper. It is by Bollen and Cohen.

Socially Responsible Investing has been studied a great deal. Most of the work has looks at whether investors receive lower returns as a result of the SR criteria. Financial theory suggests that the more constraints placed on a portfolio, the lower the returns should be. (To put it another way, the addition of a constraint should make investors worse off when measure by risk and return). Somewhat surprisingly, the research on this has been very mixed.

Bollen and Cohen might have a partial explanation. They examine the behavior of SR investors. The results? SR investors appear to be more patient. This trait reduces transactions and (if theory is correct) should increase returns.

From the paper:

"following negative returns, cash outflows from SR funds are indeed smaller than cash outflows from a matched set of conventional funds, suggesting that investors derive utility from the SR attribute. Following positive returns, however, cash inflows to SR mutual unds are larger than cash inflows to conventional funds. An explanation for this asymmetry is that SR investors perceive the SR attribute as a luxury good which is more affordable when their level of wealth is sufficient."

Two quick points:

1. It is possible that the reason previous researchers have not been able to find a SRI penalty is that the lower returns due to the self-imposed constraint is offset by the higher net returns stemming from lower transaction costs and greater planning horizon provided by the higher cash flow predictability.

2. That SRI is seen as a luxury good is a cool finding. If pushed this is consistent with the view that improving economies could be expected to improve the same aspects that SRI investors are concerned with. (for instance firms in trouble worry less about the environment than firms "doing well").

Cite:

Bollen and Cohen, Working paper, Vanderbilt University. Downloaded 8/8/05

SSRN-Options and the Bubble by Robert Battalio, Paul Schultz

Time to rewrite my class notes.....Like many people I have been telling my classes that at least a portion of the reason that Internet stocks were allowed to get so overpriced during the so-called bubble was that short-sale restrictions prevented investors from shorting the shares to drive down prices.

However, in their Options and the Bubble paper Robert Battalio and Paul Schultz show that even if there were short sale restrictions, the option market was efficient enough to allow investors to circumvent the short restrictions.

Unlike Ofek and Richardson (2003), Battalio and Schultz

"find few cases when synthetic and actual share prices diverge enough to appear to create arbitrage profits from short-selling. Indeed, the option and stock prices track each other so closely that we conclude short sale restrictions did not seem to have an important impact on Internet stocks." [emphasis mine]

They do this by showing that

"short sales of synthetic shares, formed by buying puts and writing
calls, are a viable alternative to selling actual shares short. For Internet stocks during the sample period, the expected proceeds from a synthetic short sale averaged about 99.5% of the expected proceeds from the short sale of actual shares. Even the hard-to-borrow stocks in our sample could be easily sold short synthetically, yielding proceeds that were on average only 0.6% less than the proceeds of an actual short-sale...."

Additionally, the option market was not just along for the ride, but a significant amount of information was being discovered via option markets. In the authors' words:

"We find that price discovery did take place in the options market during our
sample period. Moreover, we find that a larger portion of price discovery took place in the options market on days when the stock price declined."

So if we can't blame short sales restrictions, what caused the bubble? The authors conclude that investors simply did not know that the prices were too high:

"it was not obvious to them that Internet stocks were too high. They were trying to value companies in a new industry with unprecedented levels of recent growth. We academics, along with reporters and regulators, have the unfair advantage of hindsight."

Yet another very cool paper!!!

Cite:
Battalio, Robert H. and Schultz, Paul H., "Options and the Bubble" (March 2004). AFA 2005 Philadelphia Meetings; EFA 2004 Maastricht Meetings Paper No. 3081. http://ssrn.com/abstract=558543

BTW Yes I realize this is not the newest paper, but I just found it when doing class notes for the upcoming semester. So I decided that since I had not seen it before, maybe some of you had not either.

Reputation Effects in Trading on the New York Stock Exchange by Andrew Ellul, Robert Jennings, Robert Battalio

Reputation matters. Once again we see that reputation and relationships matter. This papers presents evidence that trading costs on the NYSE are, in part, a function of the interpersonal relationships of floor traders.

SSRN-Reputation Effects in Trading on the New York Stock Exchange by Andrew Ellul, Robert Jennings, Robert Battalio: "reputation plays an important role in the liquidity provision process on the floor of the NYSE."

How cool of a study is this? Ellul, Jennings, and Battalio investigate trading costs on the NYSE following relocation of the specialist's post.

As the authors state, they have identified a "natural experiment". This occurs when specialists are moved but are not followed by the floor brokers who trade with the specialist. If relationships and reputation matter, then trading costs should increase (at least temporarily) following the move.

And the results? Sure enough, following the specialists' moves, trading costs increased. Interestingly, since the parties often knew of a pending move prior to the actual move, the importance of the relationship decreased before the actual move (consider game theory predictions as you get closer to the end of the game).

A few brief "look-ins":

*"we find evidence of statistically increased relative effective spreads for
relocating stocks versus their controls starting around event day -35 and ending after event day +45" p16.

* "With few exceptions, starting 45 days before the switch and continuing 35 days after the switch, the relocating stocks with high adverse selection have relative effective spreads that are higher than their controls"


In most cases the floor brokers did not follow the specialists to the new location. However, in some cases the brokers did move. Using regression analysis the authors find that "moving brokers enjoy significantly lower (statistically and economically) effective spreads than non-moving brokers. This advantage is particularly strong in stocks where the adverse selection problem is more severe." p. 26.

Which again suggests that repuation and relationships do impact trading costs. Why? The most logical explanation is that trust lowers the adverse selection cost of trading.


Very cool!


Cite:
Ellul, Andrew, Jennings, Robert H. and Battalio, Robert H., "Reputation Effects in Trading on the New York Stock Exchange" (March 2005). http://ssrn.com/abstract=684091

Do Managers Influence their Pay? Evidence from Stock Price Reversals Around Executive Option Grants by M.P. Narayanan, Hasan Seyhun

SSRN-Do Managers Influence their Pay? Evidence from Stock Price Reversals Around Executive Option Grants by M.P. Narayanan, Hasan Seyhun: "Consistent with the hypothesis that managers influence their pay, the reversals are positively related to grant size and the seniority of the manager, and negatively related to the firm size. "

The size of this reversal is staggering.

"The market-adjusted return for the 90 days preceding the grant date is about −3.6% and the return for the 90 days following the grant date is about 9.4%. In small firms, the 90-day post-grant date average abnormal rise in stock price is about 17%. These patterns are significantly larger than any that has been documented in previous literature."

I saw this and, while surprised by the size, held off reading the rest of the article because I feared it was the same old thing on the topic: namely that managers do influence their pay by issuing bad news prior to option grant dates and good news after (see Yermack 1997). Well, that part was found again. BUT, what is cool about this paper is that the Narayanan and Seyhun propose that the price reversals that are found around option grant dates might not be merely because of the timing of news releases, but the selection of historic dates to use as the option grant date.

From the paper:

"consistent with the back-date method of influencing the grant date stock price comes from the relationship between stock price reversals on the grant date and reporting lags....for most of our sample period, Section 16(a) of the Securities and Exchange Act requires that option grants be disclosed within 10 days of the month following the month of the grant. About two-thirds of the awards in our database are reported after this deadline. We define the number of days elapsed between the grant date and the reporting date the “reporting lag.” If indeed in some cases the grant date is set on a back-date basis, the reporting period is extended automatically by an amount equal to the elapsed time between the reported grant date and the date on which the grant decision was made. Therefore, if the stock return reversals of Figure 1 are caused partly by awards being given on a back-date basis, the reversals should be more pronounced (i.e., the drop before and the rise after the grant date should both be steeper) in those cases where the reporting lag is greater. This is exactly what we find."

Why the interpretation of back-dating? Because of the striking change of direction around the date is almost too much to believe:

"if managers attempt to drive the share price down before the grant date by selling shares of the firm that they own and then release favorable earnings information after the grant date, it will be most likely in violation of the anti-fraud provisions of the Securities and Exchange Act of 1934 [Section 10(b)-5]. For these reasons, it appears farfetched that managers are influencing the stock price with such precision to obtain options at a reduced exercise price."

With that in mind, the authors look for (and find) evidence that is consistent with backdating. For instance, the reversal is greater for larger grants, grants to more senior management, and that there is no abnormal return when the actual grant is announced.

Interesting stuff!

Cite:
Narayanan, M.P. and Seyhun, Hasan Nejat, "Do Managers Influence their Pay? Evidence from Stock Price Reversals Around Executive Option Grants" (January 2005). http://ssrn.com/abstract=649804

They're back!

The US Treasury announced that the 30-year T bond will be making a return. (get it? I couldn't resist ;) )

"Treasury is re-introducing regular semi-annual auctions of the 30-year nominal security beginning with a bond that will mature on February 15, 2036." Treasury Press Release

From the Seattle Times:

"It is good because it will help the U.S. government finance its huge deficit and debt at longer terms, even as the baby boom prepares to retire. It is good because it would offer investors, such as big pension funds and insurance companies in particular, a safe, longer-run option in which to park their large portfolios.

It is bad because it means that there is much a bigger deficit, and debt, to finance even as the baby boom prepares to retire."

Don't Worry About China. Learn From It. - New York Times

Don't Worry About China. Learn From It. - New York Times: While there is a debate about the actual size of the Chinese economy, very few really have a grasp on the actual size.

From the article:

"range of estimates, but generally the gross domestic product of China in the year 2004 is estimated to be substantially less than $2 trillion. That would roughly make it one-sixth the size of the United States economy. Yet China has nearly five times the population of the United States. That means the per capita G.D.P. of China is about one-thirtieth the per capita G.D.P. of the United States"

This is totally not meant as a cut against anyone, but it is always useful to keep relative positions in mind. While China's economy is growing very quickly, don't forget it has a long ways to go. As the author Ben Stein points out, it is something often forgotten in the media.

The McKinsey Quarterly: Sizing the emerging global labor market

Thomas Friedman's Flat World meet academia. McKinsey Quarterly reports on the impact outsourcing will have on the global economy.

Short Version:
Outsourcing is here to stay, will continue to grow as more jobs can be digitized, this will increase per capita income in developing economies without "major discontinuities in overall levels of employment and wages in developed countries."

Of course that last statement is both macro in view (i.e. overall levels may not be impacted, but there will be individual winners and losers) and slightly optimistic.

Interesting!!!

The McKinsey Quarterly: Sizing the emerging global labor market

FinanceProfessor.com trivia

I had a request for my old trivia page that had been taken off the website. So here it is. I had not looked at it in years. Some are pretty interesting.
FinanceProfessor.com trivia

For instance:
#34. Ronald Reagan was the first president to visit the NYSE
#36. Arnold Schwarzenegger was a finance major
#41. The Founder of Merrill Lynch (Charles Merrill) played semi-pro baseball prior to coming to Wall Street. The Lynch in the name is from Edward Lynch who was a soda fountain salesman
#68. The slowest day is NYSE history was March 16, 1830, when only 31 shares changed hands


some of them are really dated, but still interesting.

Low-Carb Pioneer Atkins Files Chapter 11

Projecting sales is difficult. Indeed, it is probably the hardest part of valuation and it can have large implications if we are wrong. Therefore, it is covered in virtually all investment and corporate finance classes at least to some degree. Well we now there is a new example to use: Atkins Nutritionals.

As the low carb diet fad cooled, not only have grocery stores left with unsold product, but Atkins Nutritionals itself has found itself in financial trouble. Atkins Nutritionals after having projected the sales to grow significantly had increased their capacity in part with increased debt. When sales suffered, so did the firm's financial health and has now lead to Atkins filing for bankruptcy.

AOL News - Low-Carb Pioneer Atkins Files Chapter 11: "The company started by the late nutrition guru Dr. Robert C. Atkins to promote a low-carb lifestyle has filed for bankruptcy court protection, a further sign of the waning popularity of the diet"

I know this will be used as in class example in my classes. It should spur an interesting discussion as many students will have experience with the diet and therefore better understand the difficulty in predicting sales. With luck, the discussion will also include coverage of why firms facing greater business uncertainty opt for less debt in their capital structure.

Other links: CNN, Bloomberg (which also has a useful timeline), and the NY Times

RadioEconomics interview

As I warned/promised you last week, here is the RadioEconomics' interview I did. I just listened to it. I definitely did not break any new ground, but it does give a background on FinanceProfessor.com as well as some of the synergy between the site, the blogs, my research, and my classes.

Radio Economics

be sure to listen to some of the other interviews as well. Especially the Becker and Posner one!