Robert Stambaugh is the Miller Anderson & Sherrerd Professor of Finance at the Wharton School of the University of Pennsylvania. He is a Fellow and former President of the American Finance Association, a Fellow of the Financial Management Association, and a Research Associate of the National Bureau of Economic Research. Professor Stambaugh has been the editor of the Journal of Finance, an editor of the Review of Financial Studies, an associate editor of those journals as well as the Journal of Financial Economics, and a member of the first editorial committee of the Annual Review of Financial Economics. He has published articles on topics including return predictability, asset pricing tests, portfolio choice, parameter uncertainty, liquidity risk, volatility, performance evaluation, investor sentiment, and active-versus-passive investing. His research awards include a Smith-Breeden first prize for an article in the Journal of Finance as well as a Fama-DFA first prize and three second prizes for articles in the Journal of Financial Economics. Before joining Wharton in 1988, he was Professor of Finance at the University of Chicago, where he received his PhD in 1981. Professor Stambaugh visited Harvard University as a Marvin Bower Fellow in 1997-98.
Abstract: We construct optimal portfolios of mutual funds whose objectives include socially responsible investment (SRI). Comparing portfolios of these funds to those constructed from the broader fund universe reveals the cost of imposing the SRI constraint on investors seeking the highest Sharpe ratio. This SRI cost crucially depends on the investor’s views about asset pricing models and stock-picking skill by fund managers. To an investor who strongly believes in the CAPM and rules out managerial skill, that is, a market index investor, the cost of the SRI constraint is typically just a few basis points per month, measured in certainty-equivalent loss. To an investor who still disallows skill but instead believes to some degree in pricing models that associate higher returns with exposures to size, value, and momentum factors, the SRI constraint is much costlier, typically by at least 30 basis points per month. The SRI constraint imposes large costs on investors whose beliefs allow a substantial amount of fund-manager skill, that is, investors who heavily rely on individual funds’ track records to predict future performance. ( JEL G11, G12, C11) In 2005, when we released what ultimately proved to be the final version of this study, socially responsible investment (SRI) had already become a major presence on the investment landscape. In the years since, this approach, now often called “sustainable” investment, has grown even more rapidly and often encompasses a broad set of “ESG” (environmental, social, and governance) criteria. As evidence of the rapid growth, Morningstar (2020) notes, “one need look no further than the nearly fourfold increase in assets that flowed into sustainable funds in the United States in 2019.” Sustainable investing has also received increased attention in the academic literature, in subsequent studies too numerous to list. Some of the studies are especially related to ours in that they also examine mutual funds. In our study, mutual funds constitute an asset universe faced by an investor imposing an SRI/ESG constraint. A number of the subsequent studies use mutual funds to address other dimensions of sustainable investing. For example, Bollen (2007), Benson and Humphrey (2008), Renneboog, Ter Horst, and Zhang (2011), Bialkowski and Starks (2016) and Hartzmark and Sussman (2019) investigate determinants of mutual fund flows into sustainable funds versus other funds. Riedl and Smeets (2017) use survey and experimental data to explore investors’ preferences for sustainable funds. Madhavan et al. (2020) examine sustainable active equity mutual funds, relating factor loadings and residual returns to ESG characteristics. While we focus on mutual funds, our study also intends that the basic aspects of the SRI setting extend to other institutional investors. That intent is supported, for example, by the recent evidence of Bolton and Kacperczyk (forthcoming, 2020) providing broader perspectives on the SRI portfolio tilts of various types of institutional investors.One conclusion of our study is that an SRI/ESG constraint is especially binding for investors wishing to tilt toward value or small-cap funds. It seems reasonable to infer that such is still the case, though we have not updated our formal analysis. For example, Morningstar (2020) identifies, as of 2019, 99 sustainable U.S. equity funds categorized within its 3 × 3 style box that sorts along the dimensions of value/blend/growth and small/mid-cap/large. Of those 99 funds, only 8 are classified as value, versus 24 as growth and 67 as blend. Only 7 of the 99 are small-cap funds, versus 79 large-cap and 13 mid-cap. More generally, our 2005 study is early in noting meaningful differences in factor loadings between sustainable versus other funds, in both three- and four-factor models.An SRI/ESG constraint is also especially binding for investors who see much information in individual funds’ historical alphas. The basic reason we discuss in our study is seemingly still at work. That is, despite the rapid growth noted earlier, the number of sustainable funds is still well less than those in the total fund universe, so many of the highest track records appear among funds outside that subset. Not mentioned in our original study is that the case of an investor who sees much information in historical alpha confronts the argument of Berk and Green (2004): if fund flows rationally respond to historical alpha, an investor will not view historical alpha as being informative about future alpha. That argument relies on investors correctly assessing the degree of fund-level decreasing returns to scale. One might view an investor who sees historical alpha as informative about future alpha as also having beliefs that favor a lower degree of decreasing returns to scale, as compared to other investors. Moreover, the equilibrating effects of fund flows might interact with the nonpecuniary utility that SRI-conscious investors derive from their fund choices, as suggested by the evidence of Bollen (2007) that flows respond to returns differently for SRI funds versus conventional funds. In any event, when prior beliefs admit substantial information from historical alphas, Busse and Irvine (2006) find that Bayesian predictive alphas computed as in Pástor and Stambaugh (2002a, 2002b), as are the alphas in our study, do predict future performance.While not one we address, a question often asked is whether sustainable investments perform better or worse than other investments. A number of studies do pursue this question, obtaining a range of findings that include both higher and lower performance for sustainable investments. Pástor, Stambaugh, and Taylor (forthcoming) discuss the challenge in interpreting such findings’ implications about expected future performance. A wedge between ex ante and ex post performance of sustainable investments arises during any period that witnesses unanticipated shifts in either customers’ demands for sustainable products or investors’ demands for sustainable holdings.1 As those authors note, sorting out such effects is an important challenge for future research. Our study conducts its analysis under a variety of asset pricing models and prior beliefs. In each case, an investor conditions on funds’ past returns and thus takes account of any historical performance differences between the sustainable funds and other funds in our sample. We do not, however, include models in which expected asset returns depend on sustainability. In this respect, our study does not attempt to provide direct evidence about a potential relation between sustainability and expected investment performance.We are grateful to the Review of Asset Pricing Studies for the opportunity to publish our original study, which follows below with only the references updated to reflect subsequent publications. The study’s abstract is also unchanged from its original version.
Abstract: I analyze skill’s role in active management under general equilibrium with many assets and costly trading. More-skilled managers produce larger expected total investment profits, and their portfolio weights correlate more highly with assets' future returns. Becoming more skilled, however, can reduce a manager's expected profit if enough other managers also become more skilled. The greater skill allows those managers to identify profit opportunities more accurately, but active management in aggregate then corrects prices more, shrinking the profits those opportunities offer. The latter effect can dominate in a setting consistent with numerous empirical properties of active management and stock returns.
Abstract: We model investing that considers environmental, social, and governance (ESG) criteria. In equilibrium, green assets have low expected returns because investors enjoy holding them and because green assets hedge climate risk. Green assets nevertheless outperform when positive shocks hit the ESG factor, which captures shifts in customers' tastes for green products and investors' tastes for green holdings. The ESG factor and the market portfolio price assets in a two-factor model. The ESG investment industry is largest when investors' ESG preferences differ most. Sustainable investing produces positive social impact by making firms greener and by shifting real investment toward green firms.
Abstract: We construct size and value factors in China. The size factor excludes the smallest 30% of firms, which are companies valued significantly as potential shells in reverse mergers that circumvent tight IPO constraints. The value factor is based on the earnings-price ratio, which subsumes the book-to-market ratio in capturing all Chinese value effects. Our three-factor model strongly dominates a model formed by just replicating the Fama and French (1993) procedure in China. Unlike that model, which leaves a 17% annual alpha on the earnings-price factor, our model explains most reported Chinese anomalies, including profitability and volatility anomalies.
Abstract: We study tradeoffs among active mutual funds' characteristics. In both our equilibrium model and the data, funds with larger size, lower expense ratio, and higher turnover hold more-liquid portfolios. Portfolio liquidity, a concept introduced here, depends not only on the liquidity of the portfolio's holdings but also on the portfolio's diversification. We also confirm other model-predicted tradeoffs: Larger funds are cheaper. Larger and cheaper funds are less active, based on our new measure of activeness. Better-diversified funds hold less-liquid stocks; they are also larger, cheaper, and trade more. These tradeoffs provide novel evidence of diseconomies of scale in active management.
Abstract: The Critical Finance Review commissioned Li, Novy-Marx, and Velikov (2017) and Pontiff and Singla (2019) to replicate the results in Pastor and Stambaugh (2003). Both studies successfully replicate our market-wide liquidity measure and find similar estimates of the liquidity risk premium. In the sample period after our study, the liquidity risk premium estimates are even larger, and the liquidity measure displays sharp drops during the 2008 financial crisis. We respond to both replication studies and offer some related thoughts, such as when to use our traded versus non-traded liquidity factors and how to improve the precision of liquidity beta estimates.
Abstract: A pre-specified set of nine prominent U.S. equity return anomalies produce significant alphas in Canada, France, Germany, Japan, and the U.K. All of the anomalies are consistently significant across these five countries, whose developed stock markets afford the most extensive data. The anomalies remain significant even in a test that assumes their true alphas equal zero in the U.S. Consistent with the view that anomalies reflect mispricing, idiosyncratic volatility exhibits a strong negative relation to return among stocks that the anomalies collectively identify as overpriced, similar to results in the U.S.
Abstract: A four-factor model with two “mispricing” factors, in addition to market and size factors, accommodates a large set of anomalies better than notable four- and five-factor alternative models. Moreover, our size factor reveals a small-firm premium nearly twice usual estimates. The mispricing factors aggregate information across 11 prominent anomalies by averaging rankings within two clusters exhibiting the greatest co-movement in long-short returns. Investor sentiment predicts the mispricing factors, especially their short legs, consistent with a mispricing interpretation and the asymmetry in ease of buying versus shorting. Replacing book-to-market with a single composite mispricing factor produces a better-performing three-factor model.
Abstract: We find that active mutual funds perform better after trading more. This time-series relation between a fund's turnover and its subsequent benchmark-adjusted return is especially strong for small, high-fee funds. These results are consistent with high-fee funds having greater skill to identify time-varying profit opportunities and with small funds being more able to exploit those opportunities. In addition to this novel evidence of managerial skill and fund-level decreasing returns to scale, we find evidence of industry-level decreasing returns: The positive turnover-performance relation weakens when funds act more in concert. We also identify a common component of fund trading that is correlated with mispricing proxies and helps predict fund returns.
For hedge funds, poor performance, closures and large investor withdrawals are raising questions about their future. But don’t expect hedge funds to disappear anytime soon.Knowledge @ Wharton - 11/6/2015
For Jon Hartley, the power of economic forces and how they are applied has been an ongoing passion. Before he came to Wharton for his MBA, his interests led him to the Federal Reserve, investment management, Jeb Bush’s 2016 Presidential campaign, and even the NFL as a statistical analyst….Wharton Stories - 05/05/2017