Essays in financial economics

Abstract

This thesis consists of three essays in corporate finance and capital markets. The first chapter estimates the effect of competition from low-cost index funds on fees in the money management industry. A difference-in-differences analysis exploiting the staggered entry of index funds finds that while actively managed funds sold directly to retail investors reduce fees by six percent, those sold through brokers increase fees by four percent. Additionally, actively managed funds, especially closet indexers, shift away from holding the index portfolio. The paper proposes a price-discrimination model to illustrate that the effect of low-cost passive fund competition depends on market segmentation. Beyond the price competition effect, the entry creates a selection effect that isolates the least-price-sensitive investors in the broker channel and results in a price increase for this group. Repeating the study using the entry of exchange-traded funds reveals similar but stronger finding. Overall, the results shed light on why aggregate mutual fund fees decline slowly despite increased competition from lower-cost passive alternatives. The second chapter, joint with Jean-Noel Barrot, examines the effects of imperfect investor risk adjustment on the behavior of mutual fund managers. We exploit a natural experiment when a major fund rating company changed its rating methodology. While in the old system, all equity funds were compared with one another in one pool, in the new algorithm, funds become compared within narrow peer groups. This algorithm revision increases the ability of retail investor to compare funds based on risk-adjusted returns, and it has an important impact on the fund mangers' compensation. The sensitivity of retail fund flows to systematic returns is eliminated. Using institutional funds as a control for retail funds in a difference-in-differences analysis, we find that this revision reduces fund managers risk taking behavior, in particular for funds in the categories that had biased low ratings ex-ante. The third chapter, joint with Carola Frydman and Eric Hilt, documents the dividend policy of firms in the United States during the first three decades of the twentieth century. This period features severe information asymmetry between insiders and outsiders, while other factors that could affect the payout policy were relatively muted. In the years surrounding World War I, industrial firms increased their payout ratios and dividends became less sticky. The new industrial firms listed on the NYSE in the 1920s had the best fit with the Lintner (1956) model and these firms refrained from committing to sticky dividend policy. Consistent with the asymmetric information theory, the market reacted positively to dividend increase announcements, especially to those made by the new industrials, and reacted negatively to dividend cuts.