Gregory B. Kadlec

An empirical examination of the amortized spread

Abstract Theories of asset pricing suggest that the amortized cost of the spread is relevant to investors required returns. The amortized spread measures the spreads cost over investors holding periods and is approximately equal to the spread times share turnover. We examine amortized spreads for Amex and NYSE stocks over the period 1983–1992. We find that stocks with similar spreads can have vastly different share turnover, and thus, a stocks amortized spread cannot be predicted reliably by its spread alone. Consistent with theories of transaction costs, we find stronger evidence that amortized spreads are priced than we find for unamortized spreads.

The pricing of equity offerings

Examination of 1,600 seasoned equity offerings reveals little evidence that underwriters systematically set offer prices below the market price on the major exchanges, though they may do so for NASDAQ issues. Quick round-trip transactions in seasoned offerings are not profitable, but subscribing to an offering and holding the stock for 30 days seems to be very profitable, especially in the NASDAQ market. In addition to seasoned offerings, we analyze 250 issues of new classes of preferred stock. These issues are not underpriced.

Issuer surplus and the partial adjustment of IPO prices to public information

This study develops a model in which rational issuers maximize the expected surplus from going public by choosing an offer price that weighs the benefit of higher proceeds if the offer is completed against the cost of foregone surplus if the offer fails. Increases in the market valuation of comparable firms during the waiting period imply higher surplus associated with going public; issuers respond with a partial revision in the offer price to elevate the probability of completion. The model offers insights into many facts associated with initial public offering pricing, including partial adjustment to market returns, the inverse relation between withdrawal and market returns, the asymmetric price adjustment to up versus down market returns, hot-issue markets, and unconditional underpricing. r 2005 Published by Elsevier B.V.

On the Perils of Financial Intermediaries Setting Security Prices: The Mutual Fund Wild Card Option

Economic distortions can arise when financial claims trade at prices set by an intermediary rather than direct negotiation between principals. We demonstrate the problem in a specific context, the exchange of open-end mutual fund shares. Mutual funds typically set fund share price (NAV) using an algorithm that fails to account for nonsynchronous trading in the funds underlying securities. This results in predictable changes in NAV, which lead to exploitable trading opportunities. A modification to the pricing algorithm that corrects for nonsynchronous trading eliminates much of the predictability. However, there are many other potential sources of distortion when intermediaries set prices. Copyright The American Finance Association 2001.

Scale Effects in Mutual Fund Performance: The Role of Trading Costs

Berk and Green (2004) argue that investment inflow at high-performing mutual funds eliminates return persistence because fund managers face diminishing returns to scale. Our study examines the role of trading costs as a source of diseconomies of scale for mutual funds. We estimate annual trading costs for a large sample of equity funds and find that they are comparable in magnitude to the expense ratio; that they have higher cross-sectional variation that is related to fund trade size; and that they have an increasingly detrimental impact on performance as the funds relative trade size increases. Moreover, relative trade size subsumes fund size in regressions of fund returns, which suggests that trading costs are the primary source of diseconomies of scale for funds.

Institutional Investors and Stock Return Anomalies

We examine institutional investor demand for stocks that are categorized as mispriced according to twelve well-known pricing anomalies. We find that institutional demand during the year prior to anomaly portfolio formation is typically on the wrong side of the anomalies’ implied mispricing. That is, we find increases in institutional ownership for overvalued stocks and decreases in institutional ownership for undervalued stocks. Moreover, abnormal returns for all twelve anomalies are concentrated almost entirely in stocks with institutional demand on the wrong side. We consider several competing explanations for these puzzling results.

Agency Costs of Institutional Trading

Under the typical institutional trading arrangement a portfolio manager makes the trade decision and a trading desk executes the trade, with execution performance evaluated against a benchmark such as the volume weighted average price (VWAP). We show that this trading arrangement provides incentives to the trader that are at odds with the objectives of the portfolio manager. Specifically, traders maintain a relatively low ask quote during rising markets to expedite sell trades and a relatively high bid quote during falling markets to expedite buy trades. This process inhibits the securitys natural tendency to rise (or fall) with the market. We provide empirical evidence of several properties of price-adjustment delays that are consistent with this model.

Post-SEO Performance and Institutional Investors

We document a strong link between institutional investors and long-run stock return and operating performance following seasoned equity offerings (SEOs). Virtually all of the underperformance is confined to the top two quintiles of stocks with the largest increase in number of institutional investors prior to the post-issue underperformance. Moreover, non-SEO stocks with matching changes in institutional investors exhibit similar long-run underperformance to that of SEO stocks. Thus, we conclude that post-SEO underperformance is not due to the SEO per se but rather is a manifestation of more general effects associated with changes in institutional interest in a firm’s stock.

Downside Risk and Long-Horizon Stock Return Reversals

We argue that long-horizon return reversals [Debondt and Thaler (1985)] reflect a premium for downside risk. Consistent with this, we find that downside betas of past losers are significantly greater than downside betas of past winners, and the inclusion of downside beta in Fama-Macbeth regressions subsumes the reversal effect. We note that downside risk offers a theoretical justification for the “distress risk” explanation for long-horizon return reversals of Fama and French (1996). Consistent with this view, we find that downside beta is more highly correlated with firm characteristics associated with distress (dividend reductions and delisting) and explains long-horizon return reversals better than SMB/HML and other proxies for distress risk in the literature.

Information and Implementation: Assessing the Net Impact of Trading on Mutual Funds

Studies examine the relation between mutual fund performance and trading cost using a variety of proxies - the most common being portfolio turnover. Overall, the evidence is consistent with informational equilibrium, i.e., trading has zero net impact on performance. We offer an alternative explanation, that common trade cost proxies lack statistical power. We show that a necessary condition for statistical power that common trading cost proxies such as turnover fail to satisfy: the proxy must jointly reflect both the volume and per unit cost of trading. Using this observation we develop a simple proxy for trading cost that sorts performance differences of 233 bps per year across fund quartiles, and forecasts fund returns better than past performance, fund size, expense ratios, or other proxies for trading cost.