Two Essays on the Cross-Section of Stock Returns

dc.contributor.advisorGeorge, Thomas J.
dc.contributor.committeeMemberSusmel, Raul
dc.contributor.committeeMemberNardari, Federico
dc.creatorTan, Zhuo 1975- 2013 2013
dc.description.abstractThis dissertation consists of two essays that address issues related to the cross-section of stock returns. The first essay documents that actively managed mutual funds invest disproportionately in stocks with high historical risk-adjusted returns (alpha). This alpha-chasing behavior has a destabilizing effect on stock price. Specifically, low-alpha stocks earn higher subsequent returns than high-alpha stocks up to two months following portfolio formation—i.e. alpha is not persistent, but reverses. Consistent with liquidity-based price pressure, I find that low- (high)-alpha stocks that are heavily traded by mutual funds exhibit strong subsequent return reversals. Further analysis finds that trades from a few large funds are the primary source of this trading. However, there is no evidence to support the view that herding by fund managers explains fund managers’ preference for high-alpha stocks. The reason why managers of large mutual funds chase high-alpha stocks when alpha is not persistent remains a puzzle. The second essay shows that a better measure of mispricing confirms the primary prediction of the limits-of-arbitrage hypothesis that high levels of idiosyncratic risk prevent arbitrage activity. Rather than using returns to size, B/M and momentum portfolios, I construct a mispricing measure based on the difference between a stock’s price and its intrinsic value estimated using the residual income model of Ohlson (1995). I confirm that this measure explains future returns. I then use it and idiosyncratic return volatility to proxy for mispricing and arbitrage risk, respectively. I find that expected returns to undervalued (overvalued) stocks monotonically increase (decrease) with idiosyncratic risk. These findings support the limits-of-arbitrage hypothesis and that idiosyncratic risk is an impediment to arbitrage.
dc.description.departmentFinance, Department of
dc.format.digitalOriginborn digital
dc.rightsThe author of this work is the copyright owner. UH Libraries and the Texas Digital Library have their permission to store and provide access to this work. Further transmission, reproduction, or presentation of this work is prohibited except with permission of the author(s).
dc.subjectMutual funds
dc.subjectQuantitative stock selection
dc.subjectArbitrage risk
dc.subjectIdiosyncratic risk
dc.subjectLimits to arbitrage
dc.titleTwo Essays on the Cross-Section of Stock Returns
dc.type.genreThesis T. Bauer College of Business, Department of of Houston of Philosophy


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