R. David McLean

Idiosyncratic Risk, Long-Term Reversal, and Momentum

This paper tests whether the persistence of the momentum and reversal effects is the result of idiosyncratic risk limiting arbitrage. Idiosyncratic risk deters arbitrage, regardless of the arbitrageur’s diversification. Reversal is prevalent only in high idiosyncratic risk stocks, suggesting that idiosyncratic risk limits arbitrage in reversal mispricing. This finding is robust to controls for transaction costs, informed trading, and systematic relations between idiosyncratic risk and subsequent returns. Momentum is not related to idiosyncratic risk. Momentum generates a smaller aggregate return than reversal, so the findings along with those in related studies suggest that transaction costs are sufficient to prevent arbitrageurs from eliminating momentum mispricing.

When Is Stock Picking Likely to Be Successful? Evidence from Mutual Funds

Consistent with a costly arbitrage equilibrium in which arbitrage costs insulate mispricing, this study finds that mutual fund managers have stock-picking ability for stocks with high idiosyncratic volatility but not for stocks with low idiosyncratic volatility. These findings suggest that fund managers and other investors may want to pay special attention to high-idiosyncratic-volatility stocks because they provide fertile ground for stock picking. The study also finds that the stock-picking ability of the average mutual fund manager declined after the extreme growth in the number of both mutual funds and hedge funds in the late 1990s. Whether mutual fund managers have stock-picking ability is an important question for both practitioners and mutual fund investors. The empirical evidence is mixed. In this article, we try to answer this question from a fresh angle: If mutual fund managers do possess stock-picking ability, when are they most likely to be successful? We found that mutual fund managers have stock-picking ability in stocks with high idiosyncratic volatility but not in stocks with low idiosyncratic volatility. This finding is consistent with a costly arbitrage equilibrium in which unhedgeable volatility prevents risk-averse arbitrageurs from taking large positions in mispriced securities, and thus, mispricing persists. An alternative explanation for this finding is that high-idiosyncratic-volatility stocks have large streams of company-specific information, thereby providing opportunities for company-specific information production and stock picking. One practical implication of this finding is that fund managers and other investors may want to pay special attention to high-idiosyncratic-volatility stocks because they provide fertile ground for stock picking. We also found little evidence of stock-picking ability among mutual fund managers in the later part of our sample (after the mid-1990s), although fund managers do seem to make better trades in high-idiosyncratic-volatility stocks. One explanation for this finding could be the large increase in the number of both mutual funds and hedge funds that occurred in the late 1990s. Increased competition among managers may have caused a decrease in the number of profitable trading opportunities, and the large increase in the number of managers may have caused the quality of the average mutual fund manager to decline.

Anomalies and News

Using a sample of 97 stock return anomalies documented in published studies, we find that anomaly returns are 7 times higher on earnings announcement days and 2 times higher on corporate news days. The effects are similar on both the long and short sides, and they survive adjustments for risk exposure and data mining. Moreover, anomaly signals predict errors in analysts’ earnings forecasts — analysts’ forecasts are systematically too low for anomaly-longs and too high for anomaly-shorts. Taken together, our results support the view that anomaly returns are the result of biased expectations, which are at least partially corrected upon news arrival.

Fooled by Compounding

Compounding can make things appear to be larger than they really are. This confusion can arise when the return from an event is compounded over a long holding period, and the return from compounding is described as the return from the event. In this article, McLean reviews several examples of this common mistake, which are found in a popular book on rare events, newspaper articles, investment advisors’ research reports, and finance journal articles. He also shows how compounding can distort inference in event studies and in the measurement of mutual fund performance. McLean describes alternative methods of return measurement that are not affected by compounding and shows that these methods can lead to different inferences than do measures that include compounding.

Innovation and Productivity Growth: Evidence from Global Patents

We explore the relation between a country’s patents and its economic and productivity growth. Consistent with patents reflecting important innovations, a one standard deviation increase in patent stock leads to a 1.58% (1.52%) elevation in GDP (TFP) growth. Patent stock has a stronger impact on growth than other previously documented determinants, including human capital and capital stock. The effect of private firms’ patents on both GDP and TFP growth are double that of public firms. These results support a growing innovation literature, which uses various patent variables as proxies for firm-level innovation, and contends that private firms are more innovative.

Investor Protection and Choice of Share Issuance Mechanism

Legal investor protection is associated with how firms choose to issue shares. The likelihood of private placements relative to rights offerings increases with investor protection, as does the likelihood of public offerings relative to both private placements and rights offerings. These findings are consistent with investor protection benefitting minority investors and reducing the benefits of control. Commonly used measures of equity market development are not associated with how shares are issued, nor are measures of market inefficiency. Our study helps shed light on several current issues in the literature, including choice of share issuance mechanism, how investor protection promotes finance, whether investor protection reduces ownership concentration, and the rights offering paradox.

Precautionary Finance: Evidence from the Timing and Size of Debt and Equity Issues

The precautionary motive for finance predicts that firms make large issues to build financial liquidity when capital market conditions are favorable, and issue less or not at all when conditions are unfavorable. The liquidity squeeze framework predicts that firms issue to fund liquidity squeezes, regardless of market conditions. We find that both frameworks help explain the timing of issuance decisions, but only the precautionary framework explains issue size. With respect to timing, the majority of firms facing ex-ante liquidity squeezes do not issue. Squeezed firms issue if capital market conditions are favorable, but cut spending otherwise. With respect to size, large issues are not associated with large liquidity squeezes. Instead, firms raise more capital when issuance conditions are favorable, and use the majority of the proceeds to build financial liquidity, both by increasing cash and by refinancing debt to extend maturity.

Debt Issue Motives and Earnings Optimism

The precautionary motive for finance predicts that firms make large issues to build financial liquidity when capital market conditions are favorable, and issue less or not at all when conditions are unfavorable. The liquidity squeeze framework predicts that firms issue to fund liquidity squeezes, regardless of market conditions. We find that both frameworks help explain the timing of issuance decisions, but only the precautionary framework explains issue size. With respect to timing, the majority of firms facing ex-ante liquidity squeezes do not issue. Squeezed firms issue if capital market conditions are favorable, but cut spending otherwise. With respect to size, large issues are not associated with large liquidity squeezes. Instead, firms raise more capital when issuance conditions are favorable, and use the majority of the proceeds to build financial liquidity, both by increasing cash and by refinancing debt to extend maturity.

Cash Savings and Capital Markets

A growing literature argues that firms plan their cash policies while considering dynamics in the supply of capital. Evidence from the U.S. shows firms making large equity issues when stock prices are high for the purpose of building precautionary cash savings. We confirm this U.S. evidence, and find these effects internationally in countries like the U.S. where external finance is more accessible. In these countries, the relation between precautionary motives and cash savings disappears if the proceeds from net equity issues are removed from cash. In contrast, high precautionary motive firms do not build cash with equity issues in countries where external finance is costlier, suggesting the benefits of holding cash are outweighed by issuance costs. Our findings show that access to equity finance has a first order impact on cash policy.

The Motives and Limits of Long-Term Debt Issues

The precautionary motive for finance predicts that firms make large issues to build financial liquidity when capital market conditions are favorable, and issue less or not at all when conditions are unfavorable. The liquidity squeeze framework predicts that firms issue to fund liquidity squeezes, regardless of market conditions. We find that both frameworks help explain the timing of issuance decisions, but only the precautionary framework explains issue size. With respect to timing, the majority of firms facing ex-ante liquidity squeezes do not issue. Squeezed firms issue if capital market conditions are favorable, but cut spending otherwise. With respect to size, large issues are not associated with large liquidity squeezes. Instead, firms raise more capital when issuance conditions are favorable, and use the majority of the proceeds to build financial liquidity, both by increasing cash and by refinancing debt to extend maturity.