This conference is supported by Grant #NFI 2969-39117 from Norges Bank Investment Management
What are the capital market consequences of the presence of investors with very long investment horizons? Does standard investment theory capture the key tradeoffs facing these investors? The theory of intertemporal portfolio choice suggests that hedging against future deterioration in the investment opportunity set is more important for long- than for short-horizon investors. The extent to which such hedging translates into differences in asset allocation and portfolio holdings is an empirical question. An investor,s horizon also matters for the measurement of risk for a given asset category, and also potentially affects the investor's willingness to sacrifice returns for an asset's liquidity.
To spur research on both the theory and practice of long-term investing, in 2016, with the generous support of the Norwegian Finance Initiative, the NBER launched a Project on Long-Term Asset Management. The fourth annual research meeting of this project was held in Cambridge, MA, on May 9-10, 2019. The researchers presented papers on topics ranging from the changing ownership structure of equity markets, to the returns on real assets such as infrastructure investments, to the valuation of private equity investments. A keynote address was delivered by Harvard University Professor John Campbell, who discussed how introducing non-stationarity in the distribution of investment returns alters standard results on intertemporal portfolio choice as well as the selection of payout policies for long-horizon investors.
Pastor, Stambaugh, and Taylor derive equilibrium relations among active mutual funds' key characteristics: fund size, expense ratio, turnover, and portfolio liquidity. Portfolio liquidity, a concept introduced here, depends not only on the liquidity of the portfolio's holdings but also on the portfolio's diversification. As their model predicts, funds with smaller size, higher expense ratios, and lower turnover hold less-liquid portfolios. Additional model predictions are also supported empirically: Larger funds are cheaper. Larger and cheaper funds trade less and are less active, based on their novel measure of activeness. Better-diversified funds hold less-liquid stocks; they are also larger, cheaper, and trade more.
This paper was distributed as Working Paper 23670, where an updated version may be available.
What makes an asset institutional-quality? Ghent proposes that one reason is the existing concentration of delegated investors in a market through a liquidity channel. Consistent with this intuition, they document differences in investor composition across U.S. cities and shows that delegated investors concentrate investments in cities with higher turnover. Ghent then calibrates a search model showing how heterogeneity in liquidity preferences makes some markets more liquid even when assets have identical cash flows. The calibration indicates that commercial real estate commands an illiquidity premium of two percentage points annually relative to a perfectly liquid asset with similar credit risk.
This paper was distributed as Working Paper 25966, where an updated version may be available.
Greenwood and Vissing-Jorgensen document a strong effect of pension and insurance company (P&I) assets on the long end of the yield curve. Using data from 26 countries, the yield spread between 30-year and 10-year government bond yields is negatively related to the ratio of pension assets (in funded and private pension and life insurance arrangements) to GDP, suggesting that preferred-habitat demand by the P&I sector for long-dated assets drives the long end of the yield curve. The researchers draw on changes in regulations in several European countries between 2008 and 2013 to provide well-identified evidence on the effect of the P&I sector on yields and to show that P&I demand is in part driven by hedging linked to the regulatory discount curve. When regulators reduce the dependence of the regulatory discount curve on a particular security, P&I demand for the security falls and its yield increases. These effects extend beyond long government bonds. Greenwood and Vissing-Jorgensen's results suggest that pension discount rules can have a destabilizing impact on bond markets that reverses once rules are changed.
Andonov, Kräussl, and Rauh investigate the characteristics of infrastructure as an asset class from the perspective of a limited partner. The stream of cash flows and riskiness of performance delivered by private infrastructure funds to institutional investors is very similar to that delivered by other types of private equity, as reflected by the frequency and amounts of net cash flows as well as by the volatility of performance measures. Public investors, such as public pension funds, government agencies, and sovereign wealth funds perform worse than private institutional investors in their infrastructure fund investments, although they are exposed to underlying deals with very similar project stage, concession terms, ownership structure, industry, and geographical location. By selecting funds that invest in projects with poor financial performance, public investors have created an implicit subsidy to infrastructure as an asset class, which Andonov, Kräussl, and Rauh estimate at a minimum of $1.3-$1.5 billion per year if the alternative opportunity is the S&P 500 or real estate funds, $3.3 billion per year if compared to listed infrastructure funds, and $8.5 billion per year if compared to private equity buyout funds. The public subsidy is not primarily driven by local investments.
Kashyap, Kovrijnykh, Li, and Pavlova study the impact of evaluating the performance of asset managers relative to a benchmark portfolio on firms’ investment, merger and IPO decisions. The researchers introduce asset managers into an otherwise standard asset pricing model and show that firms that are part of the benchmark are effectively subsidized by the asset managers. This “benchmark inclusion subsidy” arises because asset managers have incentives to hold some of the equity of firms in the benchmark regardless of the risk characteristics of these firms. Contrary to what is usually taught in corporate finance, they show that the value of an investment project is not governed solely by its own cash-flow risk. Instead, because of the benchmark inclusion subsidy, a firm inside the benchmark would accept some projects that an identical one outside the benchmark would decline. The two types of firms’ incentives to undertake mergers or spinoffs also differ and the presence of the subsidy can alter a decision to take a firm public. Kashyap, Kovrijnykh, Li, and Pavlova show that the higher the cash-flow risk of an investment, the larger the benchmark inclusion subsidy; the subsidy is zero for safe projects. Benchmarking also leads fundamental firm-level cash-flow correlations to rise. The researchers review a host of empirical evidence that is consistent with the implications of the model.
When competing firms possess overlapping sets of investors, maximizing shareholder value may provide incentives that distort competitive behavior, affecting pricing, entry, contracting, and virtually all strategic interactions among firms. Backus, Conlon, and Sinkinson propose an approach to the measurement of this phenomenon for the universe of S&P 500 firms between 1980 and 2017. Over this period, the incentives implied by the common ownership hypothesis have grown dramatically. Contrary to popular intuition, this is not primarily associated with the rise of BlackRock, Vanguard, and State Street: instead, the trend in the time series is driven by a broader rise in diversified investment strategies, of which these firms are only the most recent incarnation. In the cross section, there is substantial variation that can be traced, both in the theory and the data, to observable firm characteristics - particularly the share of the firm held by retail investors. Finally, the researchers show how common ownership can theoretically give rise to incentives for expropriation of undiversified shareholders via tunneling, even in the Berle and Means (1932) world of the “widely held firm.”
This paper was distributed as Working Paper 25454, where an updated version may be available.
Chernov, Lochstoer, and Lundeby propose testing asset-pricing models using multi-horizon returns (MHR). MHR serve as powerful source of conditional information that is economically important and not data-mined. The researchers apply MHR-based testing to linear factor models. These models seek to construct the unconditionally mean-variance efficient portfolio. They reject many popular models that deliver high maximum Sharpe ratios in a single-horizon setting. Model misspecification manifests itself in strong intertemporal dynamics of the factor loadings in the SDF representation.
Gupta and Van Nieuwerburgh propose a new valuation method for private equity investments. First, they construct a cash-flow replicating portfolio for the private investment, using cash-flows on various listed equity and fixed income instruments. The second step values the replicating portfolio using a flexible asset pricing model that accurately prices the systematic risk in listed equity and fixed income instruments of different horizons. The method delivers a measure of the risk-adjusted profit earned on a PE investment, a time series for the expected return on PE fund categories, and a time series for the residual net asset value in a fund. The researchers apply the method to real estate, infrastructure, buyout, and venture capital funds, and find modestly positive average risk-adjusted profits with substantial cross-sectional variation, and declining expected returns in the later part of the sample.
It is common practice to decompose levels and variation in prices into expected future returns and fundamentals. However, it is unclear what information investors use for prices to be informative and how important different investors are for incorporating information into prices. Koijen, Richmond, and Yogo show that a small set of characteristics explains the majority of the variation in a panel of firm-level valuation ratios across countries. To measure how investors' demands respond to the characteristics and prices, they estimate a demand system in Great Britain and in the United States. The demand system allows the researchers to quantify the importance of different institutional types (e.g., mutual funds, broker dealers, ...) in the price formation process by computing counterfactual prices if a particular type were to follow a passive market indexing strategy.
This study examines whether increases in the personal income tax rate disincentivize hedge fund managers to exert effort. Using plausible exogenous variation in federal and state statutory tax rates, Agarwal, Chen, Shi, and Wang find that fund managers' marginal income tax rate is negatively associated with fund performance. The results are similar when they analyze the effect of a major U.S. federal income tax increase in 2013 and use non-U.S. fund managers as a control group. In response to a tax hike, fund managers hold stocks with lower information asymmetry. Finally, Agarwal, Chen, Shi, and Wang find that greater incentive fees are used to mitigate tax-induced effort shirking. Their study sheds light on the externality of taxing the affluent and informs the debate on tax system design.