1. "Not All Success is the Same: The Role of Exploration and Exploitation in Diseconomies of Scale in the Mutual Fund Industry"
(Job Market Paper)
This paper 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 and accumulated success in industry exploitation. 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.
2. "Dissecting the Profitability Premium"
(With Jianfeng Yu)
This paper investigates both risk- and mispricing-based explanations for the profitability premium, namely, the return spread (about 0.91% per month) between firms with high return-on-assets and those with low return-on-assets. Using 14 proxies for limits on arbitrage and information uncertainty, we find consistent evidence that the profitability premium exists primarily among firms with high information uncertainty or high arbitrage costs, suggesting that mispricing at least partly explains the profitability premium. On the other hand, although excess market returns on macro news announcement days are about 10 times larger than those on non-announcement days, suggesting a disproportionately large fraction of risk premium on macro news announcements, the profitability premium on announcement days and non-announcement days are similar. This finding suggests that macro risk is unlikely to be the source of the observed profitability premium. Further evidence from portfolio returns around earnings announcements provides additional support for the mispricing-based explanation.
3. "Prospect Theory and the Risk-Return Tradeoff"
(With Jinghua Yan and Jianfeng Yu)
This paper 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 the fundamental principle in finance. Prospect theory posits that when facing prior loss relative to a reference point, individuals tend to be risk-seeking, rather than risk-averse. In other words, when current stock prices are lower than their reference prices, average investors of these stocks tend to be risk-seeking. Consequently, among these stocks, there should be a negative risk-return relation. By contrast, among the stocks where most investors face capital gains, the traditional positive risk-return relation should emerge since average investors of these stocks are risk averse. Using several intuitive risk measures for layman investors, we provide strong empirical support for our hypotheses. The role of prospect theory in the idiosyncratic volatility puzzle is also discussed.
4. "An Empirical Assessment of Models of the Value Premium"
(With Jianfeng Yu)
This paper inspects leading explanations of the value premium, especially those based on structural models. Recent models of the value premium typically endogenously link B/M to firm-specific attributes. The value firms then earn higher subsequent returns because these firms command a higher risk premium due to a higher default probability, lower profitability, higher operating leverage, shorter cash flow duration, or higher cash flow risk. Using several moderators, we first sort the entire sample into several groups of firms, across which the value premium varies significantly. We find that among the groups in which the value premium is tiny and insignificant, there is indeed a significant desired relation between B/M and firm-specific attributes. In sharp contrast, among the groups in which the value premium is the most pronounced, there is no significant desired relation between B/M and firm-specific attributes. Moreover, in many cases, these relations are even opposite to the predictions of these theories. Given the above findings, we further explore potential sources for the value premium. Overall, we conclude that our understanding of the value premium is still very limited.