Essays in Empirical Asset Pricing and Investments

Abstract

My thesis contains four essays on the pricing of financial assets and the role of non-professional investors. The first two essays describe the legal framework governing Exchange-Traded Funds (ETFs) and the liquidity transformation functions of ETFs. The third essay examines how trading by nine different types of market participants are related to characteristics that have previously documented to predict the cross-section of equity returns. The fourth and final essay examines whether and how orders originating from retail brokerages respond to analyst recommendations. In my first essay, I describe the legal framework that governs ETFs and theoretical benefits of the ETF security design relative to two other popular investment management security structures: open-end and close-end mutual funds. To do so, I briefly describe the history of the modern investment management industry. I describe the role of Authorized Participants (APs), the main security design innovation of ETFs, and highlight the key theoretical differences between the three classes of funds. Lastly, I describe SEC rulemaking that governs the behavior of ETF Managers and their APs. In the second essay, I document a hidden but substantial cost associated with the liquidity transformation that corporate bond exchange-traded funds (ETFs) provide. When creating new shares, authorized participants (APs) deliver a subset of the portfolio of bonds that underlie a corporate bond ETF. This subset contains bonds that realize low future returns, reducing ETF performance by 48 basis points per annum. This loss in performance cannot be attributed to forgone compensation for risk or illiquidity, but instead results from APs utilizing information regarding future changes in net asset values to strategically deliver bonds when those bonds are expected to realize poor performance in the near future. My third essay is joint work with Jeff Pontiff and David McLean. We provide the most comprehensive study of market participation to date. We assess the informativeness of 9 different participants’ trades, and how each participant’s trades relate to 130 different variables that together reflect the cross-section of expected stock returns. Firms and short sellers tend to be the smart money—both sell stocks with low expected returns, and their trades predict returns in the intended direction. Firms, however, also seem to possess private information, while short sellers do not. Retail investors buy (sell) stocks with low (high) expected returns and their trades predict returns opposite to the intended direction. All 6 types of institutional investors are weighted towards stocks with low expected returns, but none of their trades robustly predict returns. My fourth essay is joint work with Jeff Pontiff and David McLean. We ask whether retail investors are responsive to analysts’ revisions. We consider revisions in recommendations, price targets, and EPS forecasts, all of which predict returns. Revisions in recommendations and price targets portend greater retail trading in the direction of the revision. The effects are stronger for All-Star Analysts’ revisions, and retail investors also respond to All-Star’s revisions in EPS forecasts. Retail investors trade in anticipation of revisions in price targets and recommendations, consistent with analysts or brokers “tipping” some retail investors. Retail trades earn higher returns when aligned with analysts’ revision. The results show that retail investors are one channel through which analysts’ information gets into prices. Our findings also support the idea that spikes in retail trading reflect informed trading, some of which is informed by analysts.