Knowledge that Transforms

In 1982, Dimensional Fund Advisors launched a mutual fund intended to capture the returns of small-cap stocks. The ‘9–10 Fund’ is based on the CRSP 9–10 Index, an index of small-cap stocks constituting the ninth and tenth deciles of NYSE market capitalization, although the 9–10 Fund incorporates investment rules and a trading strategy that are aimed at minimizing the potentially excessive trade costs associated with such illiquid stocks. As a result, the 9–10 Fund provided a 2.2% annual premium over the 9–10 Index for the 1982–1995 period. We show that both the investment rules and the trade strategy components of the Fund’s design contribute significantly to this return difference.

This paper tests models of mutual fund market timing that allow the manager's payoff function to depend on returns in excess of a benchmark, and distinguish timing based on publicly available information from timing based on finer information. We simultaneously estimate parameters which describe the public information environment, the manager's risk aversion, and the precision of the fund's market-timing signal. Using a sample of more than 400 U.S. mutual funds for 1976–94, our findings suggest that mutual funds behave as highly risk averse, benchmark investors. Conditioning on public information improves the model specification. After controlling for the public information, we find no evidence that funds have significant market-timing ability.

We simulate standard tests of performance persistence using alternative return-generating processes, survival criteria, and test methodologies. When survival depends on performance over several periods, survivorship bias induces spurious reversals, despite the presence of cross-sectional heteroskedasticity in performance. Look-ahead biased methodologies and missing final returns typical of U.S. mutual fund datasets can also materially affect persistence measures. Our results reinforce previous findings that U.S. mutual fund performance is truly persistent. When fund performance is truly persistent, fund attrition affects persistence measures, even when the sample includes all nonsurvivor returns. We also examine the specification and power of the various persistence tests.

When a rate of return is regressed on a lagged stochastic regressor, such as a dividend yield, the regression disturbance is correlated with the regressor's innovation. The OLS estimator's finite-sample properties, derived here, can depart substantially from the standard regression setting. Bayesian posterior distributions for the regression parameters are obtained under specifications that differ with respect to (i) prior beliefs about the autocorrelation of the regressor and (ii) whether the initial observation of the regressor is specified as fixed or stochastic. The posteriors differ across such specifications, and asset allocations in the presence of estimation risk exhibit sensitivity to those differences.

We use a genetic algorithm to learn technical trading rules for the S&P 500 index using daily prices from 1928 to 1995. After transaction costs, the rules do not earn consistent excess returns over a simple buy-and-hold strategy in the out-of-sample test periods. The rules are able to identify periods to be in the index when daily returns are positive and volatility is low and out when the reverse is true. These latter results can largely be explained by low-order serial correlation in stock index returns.

This paper finds that discounts and premiums of closed-end funds reflect the market's assessment of anticipated managerial performance. Using single and multiple benchmarks, we present evidence that there is a significant and positive relation between stock fund premiums and future net asset value performance over the following year. The relation is not caused by the anticipation of future expenses. We also find that bond closed-end funds show no such relation between premium and asset value performance.

Commercial bank entry into securities underwriting can affect underwriter behavior because, unlike investment houses, banks also lend to firms. This raises several issues. Are banks better certifiers of firms’ securities than investment houses? If banks hold equity in firms rather than debt, does this make certification more credible? Would one type of underwriter drive out the other? This paper provides a model for analyzing such issues, and derives several interesting results. First, banks, as lenders to firms, can actually be better certifiers than investment houses. Second, equity holding can hinder banks’ certification ability. Finally, banks and investment houses can co-exist.

Deregulation provides a natural experiment for examining how governance adapts to structural changes in the business environment. We investigate the evolution of governance structure, characterized by ownership concentration, compensation policy, and board composition, in the U.S. airline industry during a 22-year period surrounding the Airline Deregulation Act of 1978. Consistent with theory, we find that after deregulation (i) equity ownership is more concentrated, (ii) CEO pay increases, (iii) stock option grants to CEOs increase, and (iv) board size decreases. Airlines’ governance structures gravitate toward the system of governance mechanisms used by unregulated firms. The adaptation process is gradual, however, suggesting that it is costly to alter organizational capital. We also present evidence on the relation between governance structure and firm survival.

To control risk-related incentive problems, equity holders are expected to manage both the convexity and slope of the relation between firm performance and managers’ wealth. I find stock options, but not common stockholdings, significantly increase the sensitivity of CEOs’ wealth to equity risk. Cross-sectionally, this sensitivity is positively related to firms’ investment opportunities. This result is consistent with managers receiving incentives to invest in risky projects when the potential loss from underinvestment in valuable risk-increasing projects is greatest. Firms’ stock-return volatility is positively related to the convexity provided to managers, suggesting convex incentive schemes influence investing and financing decisions.

This paper provides evidence on a previously unidentified source of managerial incentives: concerns about post-retirement board service. Both the likelihood that a retired CEO serves on his own board two years after departure, as well as the likelihood of serving as an outside director on other boards, are positively and strongly related to his performance while CEO. Retention on the CEO's own board depends primarily on stock returns, while service on outside boards is better explained by accounting returns. The evidence also suggests that firms consider ability in choosing board members.