Finance Dissertations

WHAT DRIVES FIRMS TO DIVERSITY? By RONG GUO Committee Chair: Dr. Omesh Kini Major Department: Finance This paper examines whether corporate governance structures, serving as proxies for agency costs, can explain firms’ decision to diversify. Specifically, it has been hypothesized that firms with worse corporate governance structures are more likely to diversify. The extant literature usually compares the governance characteristics of multi-segment firms to those of single segment firms to address this issue. However, different governance characteristics may simply reflect differences in firm characteristics of diversified firms and focused firms. Furthermore, industry factors may affect both the propensity of firms to diversify and their governance characteristics. To separate out the agency costs explanation of firms’ decision to diversify, I compare the corporate governance structures of single segment firms that choose to diversify with those of a matched sample of single segment firms in the same industry that choose to remain focused. I find that firms with a higher percentage of outsiders on the board and smaller board size are more likely to diversify. These findings are inconsistent with the agency costs explanation of why firms choose to diversify. In addition, the CEO pay-to-performance sensitivity of diversifying firms is also not significantly different from that of firms that stay focused. The corporate governance characteristics cannot explain the changes in excess value around diversification either. Although some of the governance characteristics are significantly related to the announcement effects of diversifying mergers, these relations are often inconsistent with the agency cost explanation. Taken together, my evidence indicates that diversifying firms do not systematically have worse governance structures than firms that stay focused and, therefore, higher agency costs do not appear to drive the decision to diversify.

Essay 1: The Determinants of the Convexity in the Flow-Performance Relationship There is substantial evidence that the flow-performance relationship of mutual funds is convex. In this work, I empirically investigate the determinants of such convexity. In particular, I study the impact that fund fees (marketing and non-marketing fees) and the uncertainty related to the replacement option of fund production factors (managerial ability and investment strategy) have on the convexity of the flow-performance relationship. I also analyze the impact of the priors about managerial ability and idiosyncratic risk on such convexity. The evidence suggests that marketing fees are positively related to the convexity of the flow-performance relationship. In addition, non-marketing fees do not have a negative impact on this convexity. The evidence associated with the value of the managerial and investment replacement option is mixed. Consistent with investment restrictions being relevant in explaining investors’ allocation decisions, sector, index, and hedge funds exhibit lower convexity in their flow-performance relationship than respectively diversified, non-index, and mutual funds. Finally, the dispersion of the priors about managerial ability and idiosyncratic risk are positively related to the convexity in the flow-performance relationship. Essay 2: Implicit Incentives and Tournament Behavior in the Mutual Fund Industry The convexity of the flow-performance relationship in the mutual fund industry produces implicit incentives for mutual fund managers to modify risk-taking behavior as a function of their prior performance (Brown, Harlow, and Starks (1996)). Rather than focusing only on tournament behavior, I investigate the link between the determinants of the convexity in the flow-performance relationship and the inter-temporal risk-shifting behavior of a fund’s manager. Hence, I examine how the sources of implicit compensation incentives shape tournament behavior. The evidence indicates that the relationship between changes in managers’ relative risk choices and mid-year performance is non-monotonic (U-shaped). Higher convexity in the flow-performance relationship increases the convexity of the U-shaped tournament behavior. For extreme performers, an increase in the convexity of the flow-performance relationship directly translates into higher risk-taking incentives. For average performers, the incentive to increase risk produced by the convexity in the compensation schedule is counterbalanced by an increase in the risk of termination. I find that the uncertainty about managerial ability, marketing efforts, and the size of family complexes affect the convexity of the U-shaped tournament behavior. These results are robust to the consideration of termination risks due to funds’ organizational form, investment objectives, or past performance. My results suggest that the risk strategies of younger funds, funds spending more on marketing, funds belonging to smaller families, sector funds, funds that are team-managed, or funds that have experienced consistent poor performance are more sensitive to intermediate performance.

ABSTRACT Deposit Insurance: Is it good for the development of Financial Markets? BY Kaysia Therese Campbell April 25, 2006 Committee Chair: Dr. Stephen Smith and Dr. James Owers Major Department: Finance The literature on deposit insurance has focused primarily on the role it plays in promoting banking sector stability and growth, while little attention has been placed on its possible effect on the development of other markets. Failure to examine the impact of deposit insurance on other markets could lead to premature conclusions about the full effect it has on total financial market development and, in turn, economic growth. Using panel data and cross sectional averages on 96 countries covering the time period 1975 – 2004 to distinguish between short run and long run effects, and including a host of controls, I find evidence that deposit insurance is associated with greater long run, total financial market development, as measured by the size and activity of banks, equity markets, bond markets and non-bank financial intermediaries. This indicates that it is able to accelerate banking sector development without necessarily retarding the development of other markets so that overall financial market development is improved. It is important to note that this is primarily evident for countries with a strong legal and contracting environment. The results also suggest that the immediate impact of deposit insurance is greatest for middle income economies but over time there is no clear evidence that this persists. Using design features thought to contribute to the generosity and ability of the scheme to curb moral hazard and provide a credible guarantee, I construct two indices to summarize the various design features and examine their impact on financial market development. I find that countries adopting more credible schemes appear to have smaller and less active markets over time. However the results also indicate that more credible and generous design features are better able to promote total market activity in the long run. The hopeful conclusion to be made from this study is that the positive influence of deposit insurance on the banking sector is translated into the entire financial market system over time and may be irrespective of a country’s particular stage of economic development.

ABSTRACT MANAGERIAL INCENTIVES AND TAKEOVER WEALTH GAINS By EBRU REIS DECEMBER 5, 2006 Committee Chair: Dr. Jayant R. Kale Major Department: Finance This study examines the relationship between managerial equity incentives and takeover wealth gains both for target and acquirer firms. Although there is some research about the effect of acquirer managers’ incentives on acquirer wealth gains, this paper is one of the first to investigate the effect of target managers’ incentives on the wealth effects of target firms in corporate takeovers. In addition, prior research has focused on the alignment effect of equity incentives in takeovers. However, takeovers provide an opportunity to liquidate personal equity portfolio for managers who hold an undiversified portfolio of their firms’ stock. In this study, I identify two hypotheses that potentially explain the effect of target managers’ incentives on wealth gains. While incentive alignment hypothesis predicts a positive relationship, diversification driven-liquidity hypothesis predicts a negative relationship between target managerial incentives and target wealth gains. I use a sample of 656 successful and 104 failed acquisitions over the period 1994-2003 to test these competing hypotheses. I find that for targets that are less (more) diversified, equity incentives are negatively (positively) related to wealth effects. I also find that the target managerial incentives increase the success probability of a takeover bid and this positive effect is less pronounced for diversified target managers. Based on these results, I conclude that incentive alignment argument is dominated by liquidity argument in less diversified target firms, however, holds in diversified firms. For acquirer managers, I do not find any evidence that supports incentive alignment or diversification arguments.

ABSTRACT TWO ESSAYS ON INVESTOR SENTIMENT AND EQUITY OFFERINGS BY HSIN-HUI CHIU May 2, 2006 Committee Chair: Dr. Jason T. Greene Major Department: Finance Using monthly open-end mutual fund flows as a proxy for investor sentiment, I am able to examine the impact of sentiment on IPO volume and underpricing. I find that issuers’ filing decisions are significantly affected by the predicted future sentiment around the expected IPO dates. Furthermore, sentiment has an impact on the final offer price setting and over-allotment options exercised. While previous research documents IPO cycles with respect to other proxies for investor sentiment, I am able to examine IPO cycles and underpricing with respect to sentiment along with investor risk preferences. I hypothesize that a going public firm will try to issue its IPO when investor risk preferences are favorable to the firm’s own risk characteristics. Empirical results based on 5,661 initial public offerings between 1986 and 2004 are consistent with my hypotheses that issuers not only time the market with sentiment in general, but also attempt to incorporate investor risk preferences into their going public decisions. Furthermore, underpricing is more severe when firms issue equity during months with large inflows into equity mutual funds. In my second essay, I find that SEO firms appear to time market efficiently because of the shorter filing periods compared to the average 2-3 months of the IPOs. Also, sentiment not only affects a SEO offer price setting but also affects the over-allotment options exercised. I examine two subgroups of the SEO samples: shelf registration and non-shelf SEOs. I find that shelf-registered SEOs incorporate investor sentiment into offering price to a greater degree compared to regular SEOs. Lastly I find that investor risk preference plays a role in firms’ decision to file prospectuses with the SEC. In other words, firms rationally decide the timing of filing based on the predicted investor preference and try to match firm characteristics with investor preference around the expected SEO date.

This paper provides novel evidence on the role of proximity in fund management subcontracting. I show that greater geographical proximity facilitates outsourced fund management. Specifically, increased availability of air travel leads to more subcontracting activities, improved performance of subcontracted funds, and lower subadvisory fees. I further show that air travel predicts the decision of fund management to outsource and reduces turnover of subadvisors. Finally, I find that higher air traffic helps subadvisors gain more fund management delegation from fund companies via reductions in information costs. Overall, my findings imply that air travel improves the efficiency of the fund sub-advising market.

This paper investigates the presence of self-attribution bias among mutual fund managers and evaluates its impacts on trading outcomes. I develop a novel GPT-based Natural Language Processing (NLP) architecture designed to extract attribution information from mutual funds' self-assessments of performance in their shareholder reports. On average, mutual fund managers exhibit a significant self-attribution bias—they are 40.6% more likely to attribute performance contributors versus performance detractors to internal factors. Funds displaying stronger self-attribution bias tend to engage in excessive trading and excessive risk-taking in the subsequent reporting period, which negatively impacts their performance. In addition, funds exhibit a higher self-attribution bias following higher performance, despite the fact that biased attribution only influences fund flows when funds perform poorly. Overall, these findings suggest that biased attribution likely stems from cognitive bias rather than strategic choices.

I test the impact of information acquisition (proxied by SEC EDGAR web traffic) on market informativeness about deal value creation in mergers and acquisitions (M&As). Information acquisition about merging firms, industry rivals, and supply-chain firms enhance short-term market reactions informativeness about long-term merger operating synergies. The effects are more pronounced among M&As with more sophisticated investors, new information, and pre-merger information asymmetry. Furthermore, information acquisition about merging firms improves the market’s assessment of financial synergies. In addition, non-deal related firms with more downloads experience an increase in subsequent takeover probability. The evidence from difference-in-differences analysis and instrumental approach analysis suggests potential casual effects of information acquisition on market reaction informativeness. Overall, this paper demonstrates that information acquisition improves the market’s assessment of value creation in M&As.

In this paper, I investigate the impact of diversified institutional ownership on firm innovation. I find that innovation productivity improves along with an increase in ownership by diversified institutions. This result is supported by a natural experiment design based on financial institution mergers. The results are consistent with the hypothesis that information complementarity drives the higher innovation productivity of firms held by institutional investors with diversified portfolios.

Essay 1: Climate-Induced Labor Risk: Labor Market Consequences, Firm Labor Adaptation Strategies, and Firm Performance

Abstract: This paper studies how physical climate risk affects corporations through the labor channel. By quantifying occupational climate exposure, I document that climate-exposed jobs have shorter working hours, lower productivity, and higher employment (especially of part-time workers) as workforce supplements. Firms with more climate-exposed workers adapt to unfavorable climate trends by retaining more employees, increasing insurance, and expanding offshore inputs. However, these firms have more workplace injuries and worse performance during climate surprises, indicating limitations of adaptation. I also explore various incentives and constraints for firms’ labor adaptation strategies and make further causal inferences by studying the implementation of the California Heat Standard.

Essay 2: Climate-Induced Labor Risk and Firm Investments in Automation

Abstract: This paper studies whether and how firms adapt to climate-induced labor risks through automation investments. Using textual analysis, I construct a measure of automation investment intensity at the firm-year level based on material news and events. I find that firms with more climate-exposed employees invest more in automation when they face adverse long-term climate conditions and are not financially constrained. The automation news of these firms is associated with higher stock returns during the announcement period. Moreover, after adopting automation, climate-exposed firms retain fewer employees, incur smaller employee insurance expenditures and decrease offshore inputs. These firms also exhibit better operating performance under short-term temperature shocks. Overall, these results imply that automation is a selective adaptation strategy that effectively helps mitigate climate-induced labor risk.

To correctly understand why companies make charitable donations, I utilize text-based machine learning technique on news articles to identify underlying topics on what is intended by the firm when making charitable donations. Using topic modeling machine learning technique on article text, I identify four topics of donation, Altruism, Managerial Benefit, Community, and Publicity, and test hypotheses on different possible motives for donations that could be distinguished through topics identified. With the test, I find that cover-up motive and business reputation motive are main drivers of corporate charitable donation. Moreover, I also find that corporate charitable donation is associated with higher profit, reduced information asymmetry, and lower risk. Evidences from tests reveal that corporate charitable donation is mainly motivated by reputation management and is highly strategic with its potential target audiences.

In this paper, we apply a state-of-the-art deep learning model to understand and predict dynamic patterns in mutual fund returns. A long-short portfolio based on the model’s prediction generates a 2.8% annualized Carhart 4-factor alpha. This abnormal performance is persistent for up to four years. The model improves the prediction of future fund alphas substantially by increasing the R-squared by more than 25% in a predictive regression that includes other fund skill measures as well as fund and time fixed effects. The model’s predictive power derives from its ability to capture fund skills embedded in dynamic strategies. We construct model-based conditional skill measures that depend on the inferred informativeness of macroeconomic and fundamental variables. Such measures are predictive of fund performance in future periods when the conditioning variables are highly informative. The conditional performance of these measures is also persistent. Overall, our results suggest that mutual funds have various specific skills that generate superior returns when the time is right.

This paper implements natural language processing (NLP) models and neural networks to predict mutual fund performance using the textual information disclosed in mutual fund shareholder letters. Informed funds identified by the prediction model deliver superior abnormal returns and are more likely to receive an upgrade in Morningstar ratings. Informed funds also attract greater flows in three days and up to 24 months after the disclosure of shareholder letters, especially when their disclosure has greater investor attention, suggesting that investors recognize the information from the qualitative disclosure. The machine learning model shows that informed funds tend to discuss sector specializations, portfolio risk taking, big picture of the financial market, and mixed strategies across assets. Collectively, this study shows that mutual fund disclosure contains rich, value-relevant textual information that can be analyzed by state-of-the-art machine learning models and help investors identify informed funds.

I find evidence of predictability in out-of-sample data for four risk premia using simple econometric models. Two factor return models are used, an APT model and the Wilshire Atlas. I demonstrate that investors can exploit conditioning information to manage their exposures to risk factors. The results suggest that the investment opportunities set changes in a large and an economically significant way. I show that the growth rate in money supply and trend in stock market valuations are the main drivers respectfully of the risk premia associated with the Book-to-Market and Size factors from the Wilshire model. The predictability results are mixed with respect to Business Cycle Theory. At times investors price business cycle risk while at other times they exhibit herding tendencies.

This paper examines the local labor spillover effect of mergers and acquisitions (M&As). By focusing on M&As in the manufacturing sector, I find that, in the metropolitan statistical areas (MSAs) where target firms reside, the negative effect of M&As on employment growth spills over from the manufacturing sector to the non-tradable sector through shrinking local consumer demand. Further tests with household-level data confirm this finding. The spillover effect is stronger when M&A transactions are horizontal and when an MSA relies more heavily on the manufacturing sector. Finally, lower minimum wage requirements may absorb the negative pressure from M&As on the non-tradable sector employment growth.

This paper investigates how the quality of financial disclosures impacts the portfolio choices of domestic and foreign investment companies. I implement an exogenous shock to the quality of financial reporting in European equity markets and examine the portfolio choices of global mutual funds in the pre and post periods. I find that when investing in the European equity market, non-European mutual funds significantly improve their stock-picking skills after the shock, in contrast to domestic ones whose skills deteriorate afterward. Besides, non-European mutual funds also increased their investments in the European market. The change in the portfolio choices between domestic and foreign investment companies is more profound in stocks with larger information asymmetry, proxied by return and earnings volatility. My results contribute to the positive accounting theory by showing that the aggregated information in financial disclosure could help investors make better investment decisions. However, to improve the disclosure quality may not make all investors better off. Instead, the role financial reporting serves is to level the playing field between different groups of investors.

Using a unique dataset of corporate directors with monitoring skills who serve on mutual fund boards, we find that the presence of intense monitors on a fund’s board has considerable influence on its governance. Mutual funds with intense monitors, defined as directors who have been involved in a corporate CEO turnover event; have served on a firm’s audit committee for at least three years; or have served on the board of a firm with high–quality governance, as measured by the GIM index, exhibit higher managerial turnover–performance sensitivity. Moreover, we find that the outflow from institutional investors becomes less sensitive to a mutual fund’s poor performance in the presence of an intense monitor, thereby suggesting a substitution effect between external and internal governance mechanisms. We find some evidence that mutual fund boards with intense monitors exhibit lower negative return gaps, lower window–dressing activity, and higher stock holding horizons compared to mutual funds without such directors. Finally, we find that mutual fund boards with intense monitors overemphasize recent performance and sub–optimally terminate their managers.

Board interlocks are pervasive: 68.20% of firms on average from 1991-2011 have at least one interlock. Since a firm's decisions are partly based on the board's information set, interlocked firms may show synchronized movements in their outputs. At the aggregate level, the structure of the board network will determine the information allocation across firms, which will have non-trivial effects on output in the economy. In this study, I theoretically examine the asset-pricing implications of firms’ connections across sectors through the board network. I show that changes in the network structure affects aggregate output, and thereby, consumption. Specifically, two attributes of network topology matter for asset prices - diversity and sparsity. In particular, I derive them from a production-based asset-pricing model in which firms act based on their information set, which is determined by the topology of board network. I then empirically compute the two factors using board network data. Consistent with the model's predictions, I find return spreads of -0.8582% and 0.9024% per month on diversity and sparsity beta-sorted portfolios, respectively.

Open-end mutual funds can use redemptions in kind to meet investor redemption requests by delivering securities held by the fund in lieu of cash. Such a tool can mitigate the need of asset fire sales while passing associated liquidation costs to the redeeming investor. Greater asset illiquidity, greater flow volatility, and younger funds are associated with a higher likelihood of funds utilizing redemptions in kind. Investors in illiquid funds with a greater likelihood of using redemptions in kind exhibit less run-like behavior. Redemptions in kind helps reduce the adverse effect of flow-induced pressure on stock performance and improve fund performance subsequent to extreme investor redemptions. Offsetting these benefits, redemptions in kind also reduces investors’ flow sensitivity to good performance. I find further evidence suggesting that, when redeeming in kind, funds deliver illiquid securities during periods when the market is illiquid and volatile.