Friends or foes? Target selection decisions of sovereign wealth funds and their consequences

This paper examines investment strategies of sovereign wealth funds (SWFs), their effect on target firm valuation, and how both of these are related to SWF transparency. We find that SWFs prefer large and poorly performing firms facing financial difficulties. Their investments have a positive effect on target firms' stock prices around the announcement date but no substantial effect on firm performance and governance in the long run. We also find that transparent SWFs are more likely to invest in financially constrained firms and have a greater impact on target firm value than opaque SWFs. Overall, SWFs are similar to passive institutional investors in their preference for target characteristics and in their effect on target performance, and SWF transparency influences SWFs' investment activities and their impact on target firm value.     

Firm values and sovereign wealth fund investments

We analyze the impact of sovereign wealth fund (SWF) investments on firm values and provide evidence consistent with the tradeoff between the monitoring and lobbying benefits versus tunneling and expropriation costs of SWFs as blockholders. The data show significant positive (negative) returns to announcements of SWF investments (divestments). The returns are non-monotonic, first rising (falling) and then falling (rising) with the share sought (sold) for investments (divestments). Moreover, we find that SWFs are often active investors. Slightly more than half of the target firms experience one or more events indicative of SWF monitoring activity or influence.     

Do FOMC minutes matter to markets? An intraday analysis of FOMC minutes releases on individual equity volatility and returns

This paper examines the 2006 to 2007 time period to determine the extent to which the release of the Federal Reserve minutes affects equity volatility and returns for 2832 individual firms. Using intraday data, we find that equity returns are essentially unaffected by FOMC minutes releases. We do find evidence of volatility effects, in that conditional volatility is lower prior to the minutes release and higher after the minutes release on release days, relative to a “control” day one week prior to the release date. These differences manifest at the 2:00–2:05 pm interval, and generally dissipate within 15 min. Consistent with previous literature, we also find evidence of both industry-specific and firm size effects in our data. Finally, we see that volatility is higher (lower) when the minutes are released after the Federal Reserve engages in restrictive (expansionary) monetary policy. Our results are robust to a variety of different definitions of the “control” dates, as well as differing industry definitions.     

Determinants of Sovereign Wealth Fund Cross‐Border Investments

Using a sample of 1,590 purchases of stock by sovereign wealth funds (SWFs) in listed firms in 78 target countries between 1985 and 2011, we study the country‐level determinants of SWF cross‐border investment. We find that SWFs from countries with high levels of openness and economic development, but with less developed local capital markets, will make more cross‐country transactions, while target countries with higher levels of investor protection and more developed capital markets will attract more SWF investment. Our findings support the investment facilitation hypothesis, suggesting that SWFs act purely or principally as commercial investors facilitating cross‐border corporate investment.     

Evidence on the Trade-Off between Risk and Return for IPO and SEO Firms

Do the low long‐run average returns of equity issuers reflect underperformance due to mispricing or the risk characteristics of the issuing firms? We shed new light on this question by examining how institutional lenders price loans of equity issuing firms. Accounting for standard risk factors, we find that equity issuing firms' expected debt return is equivalent to the expected debt return of nonissuing firms, implying that institutional lenders perceive equity issuers to be as risky as similar nonissuing firms. In general, institutional lenders perceive small and high book‐to‐market borrowers as systematically riskier than larger borrowers with low book‐to‐market ratios, consistent with the asset pricing approach in Fama and French (1993) . Finally, we find that firms' expected debt returns decline after equity offerings, consistent with recent theoretical arguments suggesting that firm risk should decline following an equity offering. Overall, our analysis provides novel evidence consistent with risk‐based explanations for the observed equity returns following IPOs and SEOs.     

Bilateral political relations and sovereign wealth fund investment

We examine the role of bilateral political relations in sovereign wealth fund (SWF) investment decisions. Our empirical results suggest that political relations play a role in SWF decision making. Contrary to predictions based on the FDI and political relations literature, we find that relative to nations in which they do not invest, SWFs prefer to invest in nations with which they have weaker political relations. Using a two-stage Cragg model, we find that political relations are an important factor in where SWFs invest but matter less in determining how much to invest. Inconsistent with the FDI and political relations literature, these results suggest that SWFs behave differently than rational investors who maximize return while minimizing risk. Consistent with the trade and political relations literature, we find that SWF investment has a positive (negative) impact for relatively closed (open) countries. Our results suggest that SWFs use—at least partially—non-financial motives in investment decisions.     

The effect of sovereign wealth funds on the credit risk of their portfolio companies

We study how sovereign wealth fund (SWF) investments affect the credit risk of target companies as measured by the change in their credit default swap (CDS) spreads around the investment announcement. We find that the CDS spread of target companies decreases, on average, following an SWF investment. The reduction in the CDS spread is higher when the SWF is established by a politically stable non-democratic country that has a neutral political relationship with the host country of the target company. Our results suggest that creditors expect SWFs to protect target companies from bankruptcy when it is in the interest of their home country to build political goodwill in the host country of the company.     

Predicting firms' corporate governance choices: Evidence from Korea

This paper contributes to a new literature on the factors that affect firms' corporate governance practices. We find that regulatory factors are highly important, largely because Korean rules impose special governance requirements on large firms (assets > 2 trillion won). Industry factors, firm size, and firm risk are also important. Other firm-specific factors only modestly affect governance even when they are statistically significant. This suggests that many Korean firms do not choose their governance to maximize share price. Among firm-specific factors, the most significant are size (larger firms are better governed) and firm risk (riskier firms are better governed). Long-term averages of profitability and equity finance need are significant, where short-term averages are not. This is consistent with “sticky governance”, in which firms alter their governance slowly in response to economic factors.     

Investor sentiment and stock returns: Wenchuan Earthquake

This paper exploits a natural experiment (the Wenchuan Earthquake in China) to study the effects of investor sentiment on stock returns. We find that during the 12 months following the earthquake, stock returns are significantly lower for firms headquartered nearer the epicenter than for firms further away. Further analyses indicate that this pattern of stock returns does not exist before or long after the earthquake, and cannot be explained by actual economic losses or a change in systematic risk. Overall, our evidence is consistent with the interaction of local bias and investor sentiment affecting stock returns.     

Frequency of observation and the estimation of integrated volatility in deep and liquid financial markets

Using two newly available ultrahigh-frequency datasets, we investigate empirically how frequently one can sample certain foreign exchange and U.S. Treasury security returns without contaminating estimates of their integrated volatility with market microstructure noise. Using the standard realized volatility estimator, we find that one can sample dollar/euro returns as frequently as once every 15 to 20 s without contaminating estimates of integrated volatility; 10-year Treasury note returns may be sampled as frequently as once every 2 to 3 min on days without U.S. macroeconomic announcements, and as frequently as once every 40 s on announcement days. Using a simple realized kernel estimator, this sampling frequency can be increased to once every 2 to 5 s for dollar/euro returns and to about once every 30 to 40 s for T-note returns. These sampling frequencies, especially in the case of dollar/euro returns, are much higher than those that are generally recommended in the empirical literature on realized volatility in equity markets. The higher sampling frequencies for dollar/euro and T-note returns likely reflect the superior depth and liquidity of these markets.     

The state of research on sovereign wealth funds

The new global economic and political environment brings new challenges to sovereign wealth funds (SWFs) and forces them to adopt new strategies to adapt to the environmental changes. This study is a sequel to Fotak, Gao, and Megginson (2017). We focus on the newly produced research on SWFs and confirm the impact of new environmental changes on SWFs' asset allocations and decision-making process. Recent studies on cross-border SWF investments show that SWFs are different from other private institutional investors although no evidence explicitly proves that SWFs have exerted political influence on recipient countries through their cross-border deals. SWFs are improving their transparency. However, the variations in transparency and institutionalization are attributed to the disparities in national culture, political regime, and internal political dynamics. We re-examine the long-term impact of SWF investments on target firms and industries and affirm the necessity to consider the heterogeneity among SWFs. We also survey the research investigating the government's motivations to establish new SWFs.     

External monitoring and returns to hedge fund activist campaigns

Firms targeted by hedge fund activists experience significantly higher returns when there are fewer external monitors in place at the target firm. Using analyst coverage and institutional ownership as measures of external monitoring presence, we find that low‐monitored activist targets experience abnormal returns 17.52% above that of high‐monitored targets in the 2‐year period following the initial campaign start date. The significant effect of external monitoring remains after controlling for target firm and activist characteristics. We also document improved operating performance and an increased monitoring presence at low‐monitored target firms across the same 2‐year period, consistent with the observed market performance.     

On the suboptimality of single-factor exercise strategies for Bermudan swaptions

This paper examines the interaction between momentum in the returns of equities and corporate bonds. We find that investment grade corporate bonds do not exhibit momentum at the three- to 12-month horizons. Instead, the evidence suggests that they exhibit reversals. However, significant evidence exists of a momentum spillover from equities to investment grade corporate bonds of the same firm. Firms earning high (low) equity returns over the previous year earn high (low) bond returns the following year. The spillover results are stronger among firms with lower-grade debt and higher equity trading volume, seem robust to various risk and liquidity controls, and hold even after controlling for past earnings surprises. In examining the source of the spillover, we find that the bond ratings of firms with positive (negative) equity momentum continue to improve (deteriorate) in the future, suggesting underreaction to the information in past equity prices about changing default risk is a likely source of the spillover effect. Overall, our results suggest that both equity and debt underreact to firm fundamentals, but past equity returns is a better proxy of firm fundamentals than past bond returns.     

The risk level discriminatory power of mutual fund investment objectives: Additional evidence

We reexamine the information content of mutual fund investment objectives to learn whether investors can use them to infer risk. For investment objectives to properly convey risk, risk must be heterogeneous between investment objective groups and homogeneous within them. The present study differs from earlier work in two important ways: (1) it reaches a generally different conclusion about within-objective class fund risk, and (2) it is being done against a backdrop of industry-wide incentive compensation structures that rely on these classifications as proxies for fund volatility. Empirical testing suggests that risk is heterogeneous within groups.     

CEO risk incentives and firm performance following R&D increases

In this study we analyze how CEO risk incentives affect the efficiency of research and development (R&D) investments. We examine a sample of 843 cases in which firms increase their R&D investments by an economically significant amount over the period of 1995–2006. We find that firms with higher sensitivity of CEO compensation portfolio value to stock volatility (vega) are more likely to have large increases in R&D investments. More importantly, we find that high-vega firms experience lower abnormal stock returns and lower operating performance compared to their low-vega counterparts following the R&D increases. Our main results hold in a variety of robustness tests. The results are consistent with the conjecture that high-vega compensation portfolios may induce managers to overinvest in inefficient R&D projects and therefore hurt firm performance.     

Earnings quality and the heterogeneous relation between earnings and stock returns

We adopt a heterogeneous regime switching method to examine the informativeness of accounting earnings for stock returns. We identify two distinct time-series regimes in terms of the relation between earnings and returns. In the low volatility regime (typical of bull markets), earnings are moderately informative for stock returns. But in high volatility market conditions (typical of financial crisis), earnings are strongly related to returns. Our evidence suggests that earnings are more informative to investors when uncertainty and risk is high which is consistent with the idea that during market downturns investors rely more on fundamental information about the firm. Next, we identify groups of firms that follow similar regime dynamics. We find that the importance of accounting earnings for returns in each of the market regimes varies across firms: certain firms spend more time in a regime where their earnings are highly relevant to returns, and other firms spend more time in a regime where earnings are moderately relevant to returns. We also show that firms with poorer accrual quality have a greater probability of belonging to the high volatility regime.     

A note on foreigners’ trading and price effects across firms

We study the investment behavior of foreign investors in association with an equity market liberalization, and find a strong link between foreigners’ trading and local market returns. In the period following the liberalization, net purchases by foreign investors induced a permanent increase in stock prices, suggesting that local firms reduced their cost of equity capital. We also find a strong link between a firm’s fraction of foreign ownership and the magnitude of the cost reduction. Foreign investors seem to prefer large and well-known firms, and these firms realize the largest reduction in capital cost. Furthermore, our analysis suggests that foreigners increase their net holding in firms that have recently performed well. Analyzing foreigners’ performance, we find very little evidence of informed trading, suggesting that risk sharing is the most plausible explanation for the reduction of the cost of equity capital.     

The importance of the volatility risk premium for volatility forecasting

In this paper, we study the role of the volatility risk premium for the forecasting performance of implied volatility. We introduce a non-parametric and parsimonious approach to adjust the model-free implied volatility for the volatility risk premium and implement this methodology using more than 20 years of options and futures data on three major energy markets. Using regression models and statistical loss functions, we find compelling evidence to suggest that the risk premium adjusted implied volatility significantly outperforms other models, including its unadjusted counterpart. Our main finding holds for different choices of volatility estimators and competing time-series models, underlying the robustness of our results.     

Individual and institutional herding and the impact on stock returns: Evidence from Taiwan stock market

Using high frequency intraday data, this paper investigates the herding behavior of institutional and individual investors in the Taiwan stock market. The study finds evidence of herding by both investors but a stronger herding tendency among institutional than among individual investors. Institutional investors herd more on firms with small capitalizations and lower turnovers and they follow positive feedback strategies. The portfolios that institutional investors herd buy outperform those they sell by an average of 1.009% during the 20 days after intense trading episodes. By contrast, individual investors herd more on firms with small sizes and higher turnovers, and they crowd to buy (sell) stocks with negative (positive) past returns. The portfolios that individual investors herd buy underperform those they sell by an average of − 0.829% during the following 20 days. Moreover, these return differences of both investors are more pronounced under a market with higher pressure and among small stocks. These findings suggest that the herding of institutional investors speeds up the price-adjustment process and is more likely to be driven by correlated private information, while individual herding is most likely to be driven by behavior and emotions.     

ON STOCK RETURN SEASONALITY AND CONDITIONAL HETEROSKEDASTICITY

We model the seasonal volatility of stock returns using GARCH specifications and size-sorted portfolios. Estimation results indicate that there are volatility differences between months and that these seasonal volatility patterns are conditional on firm size. Additionally, we find that seasonal volatility does not explain seasonal returns when the reward for risk is held constant over the sample period. Specifically, our results indicate that much of the abnormal return in January for small firms cannot be entirely attributed to either higher systematic risk or a higher risk premium in January.