Thesis advisor: Jeffrey Pontiff / My thesis contains four essays on the pricing of financial assets and the role of non-professional investors. The first two essays describe the legal framework governing Exchange-Traded Funds (ETFs) and the liquidity transformation functions of ETFs. The third essay examines how trading by nine different types of market participants are related to characteristics that have previously documented to predict the cross-section of equity returns. The fourth and final essay examines whether and how orders originating from retail brokerages respond to analyst recommendations. In my first essay, I describe the legal framework that governs ETFs and theoretical benefits of the ETF security design relative to two other popular investment management security structures: open-end and close-end mutual funds. To do so, I briefly describe the history of the modern investment management industry. I describe the role of Authorized Participants (APs), the main security design innovation of ETFs, and highlight the key theoretical differences between the three classes of funds. Lastly, I describe SEC rulemaking that governs the behavior of ETF Managers and their APs. In the second essay, I document a hidden but substantial cost associated with the liquidity transformation that corporate bond exchange-traded funds (ETFs) provide. When creating new shares, authorized participants (APs) deliver a subset of the portfolio of bonds that underlie a corporate bond ETF. This subset contains bonds that realize low future returns, reducing ETF performance by 48 basis points per annum. This loss in performance cannot be attributed to forgone compensation for risk or illiquidity, but instead results from APs utilizing information regarding future changes in net asset values to strategically deliver bonds when those bonds are expected to realize poor performance in the near future. My third essay is joint work with Jeff Pontiff and David McLean. We provide the most comprehensive study of market participation to date. We assess the informativeness of 9 different participants’ trades, and how each participant’s trades relate to 130 different variables that together reflect the cross-section of expected stock returns. Firms and short sellers tend to be the smart money—both sell stocks with low expected returns, and their trades predict returns in the intended direction. Firms, however, also seem to possess private information, while short sellers do not. Retail investors buy (sell) stocks with low (high) expected returns and their trades predict returns opposite to the intended direction. All 6 types of institutional investors are weighted towards stocks with low expected returns, but none of their trades robustly predict returns. My fourth essay is joint work with Jeff Pontiff and David McLean. We ask whether retail investors are responsive to analysts’ revisions. We consider revisions in recommendations, price targets, and EPS forecasts, all of which predict returns. Revisions in recommendations and price targets portend greater retail trading in the direction of the revision. The effects are stronger for All-Star Analysts’ revisions, and retail investors also respond to All-Star’s revisions in EPS forecasts. Retail investors trade in anticipation of revisions in price targets and recommendations, consistent with analysts or brokers “tipping” some retail investors. Retail trades earn higher returns when aligned with analysts’ revision. The results show that retail investors are one channel through which analysts’ information gets into prices. Our findings also support the idea that spikes in retail trading reflect informed trading, some of which is informed by analysts. / Thesis (PhD) — Boston College, 2022. / Submitted to: Boston College. Carroll School of Management. / Discipline: Finance.

In the seven decades following the Investment Company Act of 1940 coming into force in the United States, the mutual fund industry has undergone dramatic changes including, some argue, a transition from stewardship to salesmanship with asset-gathering becoming the industry’s driving force. As fund managers incrementally assumed a more pronounced role in the investment fund industry, an emerging strand of finance literature focused on their characteristics and their potential impact on investment performance. While a large body of academic research concurs that fund managers cannot outperform systematically better than chance, there are also a significant number of studies that link the psychological characteristics of investors to their investment performance. Importantly, we know that fund managers, as a representative sample of professional investors, often have to operate under enormous anxiety and associated psychic pressures. In their effort to cope with these pressures and make sense of an immensely unpredictable and complex work environment, a wide range of psychic defences and behavioural biases may be triggered. The purpose of this research is to investigate, on the one hand, to what extent mutual fund managers are prone to overconfidence and associated behavioural biases such as self-serving attribution. On the other hand, the extent to which overconfidence, proxied by a wide range of variables including overoptimism, excessive certainty and excessive self-reference, may have any bearing on fund performance is of interest. The fundamental question is why, how, and through which mechanisms does overconfidence affect performance. The underlying research questions are motivated by three large areas of research: studies of mutual fund performance and persistence, studies of financial accounting narratives, and studies of professional investor psychology. I also explore how overconfidence is fundamentally generated and, in a sense, resorted to by fund managers as a defence mechanism against the psychic pressures of having to work in a highly intangible, complex and uncertain environment. Drawing on evidence from fund manager reports written for investors, I explain how they use the medium of narratives, and in particular stories, to make sense of what they do as fund managers and their added value for clients. I demonstrate how analysing fund manager commentaries, both through computer-assisted corpus-linguistic approaches and through the “close reading” method, sheds light on the link between fund manager psychology and investment performance. In particular, from the perspective of narrative analysis, I explain how fund managers write their reports in distinguishably different genres depending, among others, on their past performance record, fund size and investment style. In addition, I establish in a longitudinal study that the overall economic environment in which fund managers operate does influence the rhetoric of fund manager reports as well as the evidence for the Pollyanna hypothesis. My findings also suggest that excessive overconfidence is associated, to a large extent, with diminished future investment returns. While superior past returns are expected to increase fund manager confidence which, in turn, may introduce the overconfidence bias in the investment decision-making process and thus diminish returns (through inefficient stock selection, suboptimal market timing and other possible mechanisms), this is not a simple regression towards the mean. The asset pricing model employed in my empirical analysis, the Carhart four-factor model, controls for the effect of previous-year momentum, and my overconfidence measures are only slightly correlated with the momentum figures. Hence, one is led to the conclusion that the narrative-based variables used in this study indeed capture some aspect of the professional investor psychology, and are capable of enhancing the explanatory power of conventional asset-pricing models such as Carhart’s. In investigating the dynamic relationship between fund manager overconfidence and investment performance, the cross-sectional variations in my study demonstrate that superior past performance boosts overconfidence as measured by all proxies employed. In addition, there appears to be an inverted-U relationship between overconfidence and subsequent investment performance. In particular, a hedging strategy based on shorting funds with extremely overconfident managers and going long in funds with normally (over)confident managers, yields positive average returns. The impact of overconfidence on subsequent returns is robust across different investment styles, although it is stronger among growth-oriented funds. Incorporating average scores for fund manager overconfidence over longer periods yields similar results. In addition, fund manager duration appears to correlate with managerial overconfidence in the long term.

During the last decade, there has been severe critique directed at the auditing profession regarding its necessity and accuracy. Auditors have been accused of neglecting their duty to the public interest, which is overshadowed by their financial dependence on the audited companies. In light on several large audit failures, the users of the audit report have demanded more information be released regarding the company and the audit process. In response to this, several standard setting bodies have released new regulatory suggestions regarding the audit report. Among the revised regulations that are relevant to Sweden are the ISA 700 (revised) and the newly created ISA 701, both of which become effective starting December 2016. FAR, the Swedish Professional Institution for Authorized Accountants and Auditors, have expressed concerns regarding the effect of the implementation of the Key Audit Matters in combination with the Swedish confidentiality clause, by which auditors must abide. These revisions are meant to increase the informative value of the audit report for the users, where the main users of the audit report are non-professional investors. Due to this, along with lacking research on the topic of Swedish non-professional investors in this context, we have chosen to focus our thesis on the effects of the changes to the audit report in relation to the investment behavior of this specific group. Research Question: How is the Swedish adaptation of ISA 700 (revised) and ISA 701 likely to impact the perceived value of the new audit report to young Swedish nonprofessional investors? We have conducted an online questionnaire with an attached case, derived from a listed British company that has already made similar changes to their audit report format. Based on the responses of 100 young Swedish non-professional investors, we found that the new changes to the audit report, as we presented them, had positive effect on the young non-professional investors perception on the audit report. Of the respondents, 64% viewed the new audit report as significantly more informative than the current Swedish audit report. Both new information, in the form of the audit resolution paragraph, and useful information, in the form of the Key Audit Matters paragraph, statement of the audit firm, and movement of the audit opinion, was perceive by the respondents. In addition to this, we found that 63% of our sample would read the audit report in the future, as compared to 49% today. However, we are unsure of whether these positive effects will be observe following the Swedish implementation of the changes, due to FAR and Swedish auditors hesitation toward the Key Audit Matters.

Ökning av bedrägerier i den finansiella rapporteringen anses ha skadat förtroendet för bolagsledningar och revisorer vilket i sin tur har lett till ett ökat krav på ansvarstagande för bolag. Svag bolagsstyrning anses vara en av de bakomliggande orsakerna till det förtroendeproblem som uppstått inom det svenska näringslivet. För att försöka återfå investerarnas förtroende har ett antal åtgärder vidtagits. Svensk Kod för bolagsstyrning uppkom delvis med syftet att stärka förtroendet för de svenska börsbolagen. Styrelsen är ansvarig för transparens och upprättandet av intern kontroll och i ett försök till att höja dess kvalitét skall styrelsen inrätta ett revisionsutskott.Som ett i led i att försöka stärka allmänhetens förtroende för bolagsledningar och revision skall revisionsutskotten säkerställa den interna och externa rapporteringen i bolagen. Detta har fört oss till vår forskningsfråga: Hur har de professionella investerarnas förtroende för de publika bolagen påverkats av införandet av revisionsutskott?För att försöka besvara vår frågeställning har vi genomfört intervjuer med professionella investerare och professionella aktörer, vilka på olika sätt har en relation till revisionsutskott. Vår empiri visar att revisionsutskotten inte har någon direkt påverkan på förtroendet eftersom revisionsutskotten inte har en direkt kommunikation ut till marknaden. Däremot kan vi genom empirin utläsa att revisionsutskotten har en positiv påverkan på den interna kontrollen inom bolagen. Således kan vi dra vår slutsats om att revisionsutskotten har en indirekt påverkan på investerarnas förtroende. / Program: Civilekonomprogrammet