Harrison G. Hong

Bad News Travels Slowly: Size, Analyst Coverage and the Profitability of Momentum Strategies

Various theories have been proposed to explain momentum in stock returns. We test the gradual-information-diffusion model of Hong and Stein ~1999! and establish three key results. First, once one moves past the very smallest stocks, the profitability of momentum strategies declines sharply with firm size. Second, holding size fixed, momentum strategies work better among stocks with low analyst coverage. Finally, the effect of analyst coverage is greater for stocks that are past losers than for past winners. These findings are consistent with the hypothesis that firm-specific information, especially negative information, diffuses only gradually across the investing public.

Does Fund Size Erode Mutual Fund Performance? The Role of Liquidity and Organization

We investigate the effect of scale on performance in the active money management industry. We first document that fund returns, both before and after fees and expenses, decline with lagged fund size, even after accounting for various performance benchmarks. We then explore a number of potential explanations for this relationship. This association is most pronounced among funds that have to invest in small and illiquid stocks, suggesting that these adverse scale effects are related to liquidity. Controlling for its size, a funds return does not deteriorate with the size of the family that it belongs to, indicating that scale need not be bad for performance depending on how the fund is organized. Finally, using data on whether funds are solo-managed or team-managed and the composition of fund investments, we explore the idea that scale erodes fund performance because of the interaction of liquidity and organizational diseconomies.

The Price of Sin: The Effects of Social Norms on Markets

We provide evidence for the effects of social norms on markets by studying “sin” stocks—publicly traded companies involved in producing alcohol, tobacco, and gaming. We hypothesize that there is a societal norm against funding operations that promote vice and that some investors, particularly institutions subject to norms, pay a financial cost in abstaining from these stocks. Consistent with this hypothesis, we find that sin stocks are less held by normconstrained institutions such as pension plans as compared to mutual or hedge funds that are natural arbitrageurs, and they receive less coverage from analysts than stocks of otherwise comparable characteristics. Sin stocks also have higher expected returns than otherwise comparable stocks, consistent with them being neglected by norm-constrained investors and facing greater litigation risk heightened by social norms. Evidence from corporate financing decisions and time variation in norms for tobacco also suggests that norms affect stock prices and returns. _____________________ We thank Murray Carlson, Douglas Diamond, Lorenzo Garlappi, Rob Heinkel, Narasimhan Jegadeesh, Lisa Kramer, Alan Kraus, Arvind Krishnamurthy, Jeffrey Kubik, Owen Lamont, Kai Li, Jose Scheinkman, Anna Scherbina, Jeremy Stein, Andrei Ukhov, Rossen Valkanov, Sunil Wahal, Jialin Yu, and seminar participants at Emory, McGill, Rutgers, Simon Fraser, Society of Quantitative Analysts, Swedish Institute for Financial Research, the European Finance Association Conference, the Financial Economics and Accounting Annual Conference, the NBER Behavioral Finance Conference, the Pacific Northwest Finance Conference, and the UBC Summer Conference for a number of helpful comments. Kacperczyk acknowledges research support from the Social Sciences and Humanities Research Council of Canada. Please address inquiries to hhong@princeton.edu and marcin.kacperczyk@sauder.ubc.ca.

Forecasting crashes: trading volume, past returns, and conditional skewness in stock prices

This paper is an investigation into the determinants of asymmetries in stock returns. We develop a series of cross-sectional regression specifications which attempt to forecast skewness in the daily returns of individual stocks. Negative skewness is most pronounced in stocks that have experienced: 1) an increase in trading volume relative to trend over the prior six months; and 2) positive returns over the prior thirty-six months. The first finding is consistent with the model of Hong and Stein (1999), which predicts that negative asymmetries are more likely to occur when there are large differences of opinion among investors. The latter finding fits with a number of theories, most notably Blanchard and Watsons (1982) rendition of stock-price bubbles. Analogous results also obtain when we attempt to forecast the skewness of the aggregate stock market, though our statistical power in this case is limited.

Simple forecasts and paradigm shifts

We study the asset pricing implications of learning in an environment in which the true model of the world is a multivariate one, but agents update only over the class of simple univariate models. Thus, if a particular simple model does a poor job of forecasting over a period of time, it is discarded in favor of an alternative simple model. The theory yields a number of distinctive predictions for stock returns, generating forecastable variation in the magnitude of the value-glamour return differential, in volatility, and in the skewness of returns. We validate several of these predictions empirically.

Talking up Liquidity: Insider Trading and Investor Relations

Managements (“insiders”) of many corporations, especially small or newly-public firms, invest considerable resources in investor relations. We develop a model to explore the incentives of insiders to undertake such costly investments. We point out that insiders may undertake such investments not necessarily to improve the share price, but to enhance the liquidity of their block of shares. This leads to a divergence of interest between insiders and dispersed outside shareholders regarding investor relations. Our model predicts that the demographics of insiders (e.g. liquidity needs, size of equity stakes) are important determinants of the extent of investor relations across firms.

What Does Futures Market Interest Tell Us about the Macroeconomy and Asset Prices

Economists have traditionally viewed futures prices as fully informative about future economic activity and asset prices. We argue that open interest could be more informative than futures prices in the presence of hedging demand and limited risk absorption capacity in futures markets. We find that movements in open interest are highly pro-cyclical, correlated with both macroeconomic activity and movements in asset prices. Movements in commodity market interest predict commodity returns, bond returns, and movements in the short rate even after controlling for other known predictors. To a lesser degree, movements in open interest predict returns in currency, bond, and stock markets.

A Model of Returns and Trading in Futures Markets

This paper develops an equilibrium model of a competitive futures market in which investors trade to hedge positions and to speculate on their private information. Equilibrium return and trading patterns are examined. (1) In markets where the information asymmetry among investors is small, the return volatility of a futures contract decreases with time-to-maturity (i.e., the Samuelson effect holds). (2) However, in markets where the information asymmetry among investors is large, the Samuelson effect need not hold. (3) Additionally, the model generates rich time-to-maturity patterns in open interest and spot price volatility that are consistent with empirical findings. Copyright The American Finance Association 2000.

Do Security Analysts Discipline Credit Rating Agencies

Earlier work exploiting brokerage house mergers identified that security analyst coverage leads to more competitive and less optimistically biased earnings forecasts. Since the earnings forecasts for a firm’s equity enter directly into the credit ratings of a firm’s debt, we test the hypothesis that security analyst coverage also disciplines credit rating agencies. We indeed find that a drop in analyst coverage due to these mergers leads to greater optimism-bias in credit ratings, especially for firms with little bond analyst coverage to begin with and for firms that are close to default. This coverage-induced shock leads to less informative ratings about future defaults and downgrades, and more subsequent bond security mispricings. Even though analysts do not directly compete with credit rating agencies, analyst reports about a firm’s equity nonetheless discipline what credit rating agencies can say about the firm’s debt.

Does Diversity Lead to Diverse Opinions? Evidence from Languages and Stock Markets

Diversity of opinions among investors plays a crucial role in models of financial market speculation and bubbles. Yet, little is known about the origins of investor disagreement. Using unique data from China, we identify an important cultural and linguistic factor. We show that investors living in linguistically diverse areas express more diverse opinions on stock message boards and trade stocks more actively. We use geographical isolation of an area due to hilly terrain as an instrument for linguistic diversity. We then discriminate in favor of a differential interpretations mechanism and against slow news diffusion due to language barriers.