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Sandy LaiSMU
1
The Role of Equity Funds in the Financial Crisis Propagation
Harald Hau
INSEADhttp://www.haraldhau.com
Chong Tze ChuaSMU
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Motivation and Key Findings
© Harald Hau, INSEAD 2
Subprime exposure was concentrated in financial stocks which account for only 15% of the US stock market in 2007
How could this lead to a 50% decline of the non-financial stocks?
This paper examine the role of mutual funds as a channel of asset contagions from financial to non-financial stocks
Document that the 27% stocks most exposed (via stock ownership) to distressed funds have an under-performance of 35% at the peak of the crisis
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Hypotheses
© Harald Hau, INSEAD 3
H1: Simple Fire Sale Hypothesis
Stocks owned by equity funds with high exposure to bank stocks in 2007/2 and 2008/1 face larger selling pressure and show poor crisis performance.
H2: Stock Performance Dependent Fire Sales Hypothesis
Distressed funds sell primarily better performing stocks when in distress
• Valuation Uncertainty makes over-performing stocks better sells
• Disposition Effect
H3: Fund Share Stability Hypothesis
Stocks with a large share of (non-distressed) fund owners perform better during the crisis
• Panic sales by direct retail investors• Self-selection of retail investors into fund and direct investors
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Literature I
What is contagion? Forbes and Rigobon (JF, 2001): Asset interdependence and
crisis specific effects are difficult to disentangle Need to think about contagion channel and its identification Example: Gelos and Reinhard (2006)
Equity fire sales Coval and Stafford (2007)
Limits to arbitrage more severe in crisis Caballero and Simsek (2009)
© Harald Hau, INSEAD 4
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Literature II
Recent contributions on the crisis contagion
Contagion from co-lateralized debt to corporate bonds (Manconi, Massa, and Yasuda (2010))
Channel: demand collapse, credit collapse or asset fire sales? (Calomiris, Love, and Peria (2010))
Contagion from the ABX subprime index to bonds and financial stocks (Longstaff (2010))
[...]
© Harald Hau, INSEAD 5
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Identification
Use stock and fund/investor level data to separate contagion effect from other linkages and macro crisis channels
Procedure: Step 1: Measure fund exposure to financial stocks Step 2: Measure stock exposure to exposed
(distressed) funds Stock exposure is a stock specific measure of fire sale
pressure which differs across stocks in the same country and industry; control for macro exposure via industry fixed effects
© Harald Hau, INSEAD 6
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Data
Fund holding data: 27,274 equity funds in 69 countries Reported holding concern approximately 30,000
stocks
After data filtering: Work with 20,477 funds Report 16,045 billion in assets under management in
June 2007
© Harald Hau, INSEAD 7
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Summary Statistics
© Harald Hau, INSEAD 8
[...]
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From Fund Exposure to Stock Exposure
© Harald Hau, INSEAD 9
Fund exposure: Return loss (if larger than 1%) due to financial stock investments in 2007/2 and 2008/1
Stock exposure: Aggregate fund exposure of all funds holding a stock weighted by fund ownership relative to capitalization
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Exposed versus Non-Exposed Stocks
Define exposure dummy DExp for 15% most exposed stocks worldwide
We find that exposed stocks are concentrated in the U.S. market (27%) are spread over all industries are on average larger than non-exposed stocks show a drastic reduction of their fund holdings relative
to non-exposed stocks
No evidence that exposed funds are different Same average pre-crisis return on assets
© Harald Hau, INSEAD 10
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Fund Redemption
© Harald Hau, INSEAD 11
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Fund Holding Changes During Crisis
© Harald Hau, INSEAD 12
0.1
.2.3
0.1
.2.3
-30 -20 -10 0 10
Exposed Stock
Non-Exposed Stock
Den
sity
Percentage Aggregate Fund Holding Change
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Factor model for risk adjustment of returns estimated for July 2003 to July 2007:
Excess returns for crisis period
Cumulative excess return
Calculation of Excess Returns
© Harald Hau, INSEAD 13
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Relative Underperformance of Exposed Stocks
© Harald Hau, INSEAD 14
-.5
-.4
-.3
-.2
-.1
0C
um
ula
tive
Re
turn
s
Fire Sales Effects for All Exposed Stocks
-.5
-.4
-.3
-.2
-.1
0C
um
ula
tive
Re
turn
s
Fire Sales Effects for Exposed U.S. Stocks
Feb 27, 2009:
-36%
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H1: Evidence on Fire Sale Hypothesis
Stocks owned by distressed funds dramatically underperform during the crisis relative to industry peers
Return shortfall of 36% on February 27, 2009 for the 27% most exposed U.S. Stocks
Also large effects for non-U.S. stocks Fire sale discounts are transitory
Contagion channel through fund ownership can account for at least 10% of the downturn in non-financial stocks
© Harald Hau, INSEAD 15
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H2: Stock Performance Dependent Fire Sales?
© Harald Hau, INSEAD 16
Non-Exposed Stocks
Exposed Stocks
-10
12
3
Cu
mu
lativ
e R
etu
rns
0 .2 .4 .6 .8 1
Return Quantiles
Non-Exposed vs. Exposed U.S. Stocks27/2/2009
-2-1
.5-1
-.5
0
Cu
mu
lativ
e R
etu
rns
0 .2 .4 .6 .8 1
Return Quantiles
Fire Sales Effects by Return Quantiles27/2/2009
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H3: Are Stocks with high Fund Share more stable?
© Harald Hau, INSEAD 17
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Are Direct Investors more Panic-Prone?
Retail investors with direct investments might be more prone to panic than those investing through mutual funds; hence a high fund share increases a stock’s crisis resilience
Fund ownership share and NYSE retail trading volume have correlation of - 0.58
Define two long-short portfolio loading on stocks with
(i) high direct ownership share (DMF = direct minus fund)
(ii) high retail trading (RMI = retail minus institutional) VAR structure:
© Harald Hau, INSEAD 18
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Impulse Response of DMF Portfolio to Index Return Shock
© Harald Hau, INSEAD 19
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Summary of VAR Evidence
Evidence of Granger causality from index returns to the DMF portfolio return
Find Granger Causality during the two crisis periods, but not before the crisis
Spill-over occurs (mostly) with a one-day lag It is economically large: A 1% index shock causes a
DMF return of 0.41% for the DMF portfolio
© Harald Hau, INSEAD 20
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Conclusions
Equity funds were a very important channel for asset contagion from bank stocks to non-financial stocks
Paradoxically, fire sales are concentrated in the best performing stocks
(Non-distressed) fund ownership increases a stock’s crisis resilience
Evidence of more “flight to quality” (retail investor panic) among direct than indirect (fund) investors
© Harald Hau, INSEAD 21
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Next Project
What were the consequences of stock mispricing for the company’s real decision: Investment behaviour? Employment? Capital structure: Share buybacks?
Is the stock market a side-show? Does it matter for bank financing?
© Harald Hau, INSEAD 22