Essays on Stock Return Anomalies, Sustainable Investing, and Bank Risk-Taking

Abstract

Chapter 1 studies the relationship between smart-beta investing and stock return anomalies. I document a novel fact that the expected returns of 7 anomaly factors are lower among stocks with higher ownership share by smart-beta institutional investors who trade according to these anomalies. The factor-oriented demand of smart-beta investors contributes to lower price-of-risk or mispricing for the anomaly factors in equilibrium; and stocks have different levels of smart-beta demand from their owners due to investor heterogeneity and market segmentation. As a result, anomaly factors have weaker return predictability among stocks with higher smart-beta institutional ownership. I provide robust empirical evidence for this relationship based on new measures of smart-beta factor demand at investor level. I further document that the market segmentation may be driven by idiosyncratic volatility, benchmarking, and strategic considerations in smart-beta investing. Chapter 2, co-authored with Ziang Li, studies banks’ deposit market power and risk-taking behavior. We document a novel fact that banks with high deposit market power take on significantly less credit risk. In particular, the loan portfolios of high- market-power banks are much safer than those of low-market-power banks. This persistent relationship is not driven by the size, funding structure, loan market power, or geography of banks. Consequently, high-market-power banks earn higher profits, are less exposed to business cycle fluctuations, and sustain smaller losses in recessions. We propose a model where deposit market power increases banks’ franchise value and induces them to take on less risk to avoid defaults. Chapter 3, co-authored with Don Noh and Sangmin Oh, investigates the het- erogeneity in investor demand for sustainable equity investing and studies its impli- cations. We measure firm-level sustainability across three dimensions: third-party environment scores, emissions, and green patents. Separately estimated institutional investor demands are sensitive to scores and emissions, but not to green patents. We then aggregate these heterogeneous demands in an equilibrium framework to draw implications for the effectiveness of sustainable investing: (i) price-elastic investors do not “undo” effects of sustainable investors, (ii) investor pressure for sustainability only weakly predicts future improvements in firm sustainability, and (iii) incorporat- ing green patents into ESG ratings can be a valuable adjustment.