Lubos Pastor

Stock Valuation and Learning About Profitability

We develop a simple approach to valuing stocks in the presence of learning about average profitability. The market-to-book ratio (M/B) increases with uncertainty about average profitability, especially for firms that pay no dividends. M/B is predicted to decline over a firms lifetime due to learning, with steeper decline when the firm is young. These predictions are confirmed empirically. Data also support the predictions that younger stocks and stocks that pay no dividends have more volatile returns. Firm profitability has become more volatile recently, helping explain the puzzling increase in average idiosyncratic return volatility observed over the past few decades.

Investing in equity mutual funds

We construct optimal portfolios of equity funds by combining historical returns on funds and passive indexes with prior views about asset pricing and skill. By including both benchmark and nonbenchmark indexes, we distinguish pricing-model inaccuracy from managerial skill. Even modest confidence in a pricing model helps construct portfolios with high Sharpe ratios. Investing in active mutual funds can be optimal even for investors who believe active managers cannot outperform passive indexes. Optimal portfolios exclude hot-hand funds even for investors who believe momentum is priced. Our large universe of funds offers no close substitutes for the Fama-French and momentum benchmarks.

Mutual fund performance and seemingly unrelated assets

Estimates of standard performance measures can be improved by using returns on assets not used to de?ne those measures. Alpha, the intercept in a regression of a funds return on passive benchmark returns, can be estimated more precisely by using information in returns on non-benchmark passive assets, whether or not one believes those assets are priced by the benchmarks. A funds Sharpe ratio can be estimated more precisely by using returns on other assets as well as the fund. New estimates of these performance measures for a large universe of equity mutual funds exhibit substantial dierences from the usual estimates.

Rational IPO Waves

We argue that the number of firms going public changes over time in response to time variation in market conditions. We develop a model of optimal IPO timing in which IPO waves are caused by declines in expected market return, increases in expected aggregate profitability, or increases in prior uncertainty about the average future profitability of IPOs. We test and find support for the models empirical predictions. For example, we find that IPO waves tend to be preceded by high market returns and followed by low market returns.

On the Size of the Active Management Industry

We argue that active management’s popularity is not puzzling despite the industry’s poor track record. Our explanation features decreasing returns to scale: As the industry’s size increases, every manager’s ability to outperform passive benchmarks declines. The poor track record occurred before the growth of indexing modestly reduced the share of active management to its current size. At this size, better performance is expected by investors who believe in decreasing returns to scale. Such beliefs persist because persistence in industry size causes learning about returns to scale to be slow. The industry should shrink only moderately if its underperformance continues.

Uncertainty and Valuations: A Comment

Cremers and Yan (2016) aim to provide “an additional litmus test for the uncertainty-convexity argument in PAistor and Veronesi (2003).†We challenge this view, as well as the authors’ related thoughts on the technology “bubble†of the late 1990s. Nonetheless, we agree with Cremers and Yan that our profession needs to think harder about the measurement of parameter uncertainty.

The Capital Markets Union: Key Challenges

In September 2015, the European Commission announced the first actions of its plan to build a Capital Markets Union in Europe. We describe the key features of the Commissions plan and discuss the economic rationale behind it. The plan has many strengths but also some weaknesses, such as limited ambition in the supervision and enforcement of securities regulations. Other challenges to the development of European capital markets include the financial transactions tax, the low-interest-rate environment, cultural reasons, and potential political opposition.