Murray Carlson

Why Constrain Your Mutual Fund Manager

We examine the form, adoption rates, and economic rationale for the investment restrictions found in the contracts between mutual fund investors and managers. Based on a sample of U.S. domestic equity funds from 1994 to 2000, we find systematic patterns in the use of policy constraints that are consistent with an optimal contracting view of the fund industry. In particular, restrictions are more frequently present when it is relatively less beneficial to use direct methods to monitor manager behavior, including when (i) boards contain a higher proportion of inside directors, (ii) the portfolio manager is more experienced, (iii) the fund is managed by a team rather than an individual, and (iv) the fund does not belong to a large organizational complex. We find no evidence that low- and high-constraint funds produce different risk-adjusted returns, which is also consistent with the existence of a contracting equilibrium.

Leaders, Followers, and Risk Dynamics in Industry Equilibrium

We study the distinct impacts of own and rival actions on risk and return when firms strategically compete in the product market. Contrary to simple intuition, a competitor’s options to adjust capacity reduce own-firm risk. For example, if a rival possesses a growth option, an increase in industry demand directly enhances profits but also encourages value-reducing competitor expansion. The rival option thus acts as a natural hedge. Within the industry, we obtain endogenous differences in expected returns. In a leader-follower equilibrium, own-firm and competitor risks and required returns move together through contractions and oppositely during expansions, providing testable new predictions.

Leverage and the Limits of Arbitrage Pricing: Implications for Dividend Strips and the Term Structure of Equity Risk Premia

Negligible pricing frictions in underlying asset markets can become greatly magnified when using no-arbitrage arguments to price derivative claims. Amplification occurs when a replicating portfolio contains partially offsetting positions that lever up exposures to primary market frictions, and can cause arbitrarily large biases in synthetic return moments. We show theoretically and empirically how synthetic dividend strips, which shed light on the pricing of risks at different horizons, are impacted by this phenomenon. Dividend strips are claims to dividends paid over future time intervals, and can be replicated by highly levered long-short positions in futures contracts written on the same underlying index, but with different maturities. We show that tiny pricing frictions can help to reproduce a downward-sloping term structure of equity risk premia, excess volatility, return predictability, and a market beta substantially below one, consistent with empirical evidence. Using more robust return measures we find smaller point estimates of the returns to short-term dividend claims, and little support for a statistical or economic difference between the returns to short- versus long-term dividend claims.

Asset Return Predictability in a Heterogeneous Agent Equilibrium Model

We use a general equilibrium model as a laboratory for generating predictable excess returns and for assessing the properties of the estimated consumption/portfolio rules, under both the empirical and the true dynamics of excess returns. The advantage of this approach, relative to the existing literature, is that the equilibrium model delineates the precise nature of the risk/return trade-off within an optimizing setting that endogenizes return predictability. In the experiments that we consider, the estimation issues are so severe that simple unconditional consumption and portfolio rules actually outperform (in a utility cost sense) both simple and bias-corrected empirical estimates of conditionally optimal policies.

Specification Error, Estimation Risk, and Conditional Portfolio Rules*

In characterizing the data-generating process for excess returns, an investor faces both parameter uncertainty (or “estimation risk”) and specification error. We examine the trade-off between these two effects, in the context of an optimal consumption/portfolio decision problem, by considering a minimal extension of the standard assumption of a linear vector autoregression for excess returns. The key additional assumption in our data-generating process is a positive linear relationship between market volatility and lagged market dividend yields. This simple specification is consistent with a long sample of U.S. data. We show that volatility adjusted rules are substantially less sensitive to variation in dividend yields, and volatility-related specification error is economically significant – even when the decisions are based on sample estimates from data sets of a realistic size.

Household Wealth and Portfolio Choice When Tail Events Are Salient

Robust experimental evidence of violations of expected utility (EU) establishes that individuals overweight utility from low probability gains and losses. These findings motivated development of rank dependent utility (RDU). We provide novel solutions for optimal portfolios of such investors facing dynamic, binomial returns. Our calibrated model shows optimal terminal wealth has significant downside protection, upside exposure, and a lottery component. We calculate that RDU investors would pay 5% of their initial wealth to trade away from an optimal EU wealth allocation. The optimal dynamic trading strategy requires higher risky share after good returns and, possibly, nonparticipation when returns are poor.

An Equlibrium Analysis of Exhaustible Resource Investments

We develop a general equilibrium model of an exhaustible resource market where both the prices and extraction choices are determined endogenously. The model generates price dynamics that are roughly consistent with observed oil and gas forward and option prices as well as with the two-factor price processes that were calibrated in Schwartz and Smith (2000). However, the subtle differences between the endogenous price process determined within our general equilibrium model and the exogenous processes considered in earlier papers can generate significant differences in both financial and real option values.