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Sandy Lai SMU 1 The Role of Equity Funds in the Financial Crisis Propagation Harald Hau INSEAD http://www.haraldhau.com Chong Tze Chua SMU
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
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
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
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
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
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
Summary Statistics © Harald Hau, INSEAD 8 [...]
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
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
Fund Redemption © Harald Hau, INSEAD 11
Fund Holding Changes During Crisis © Harald Hau, INSEAD 12
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
Relative Underperformance of Exposed Stocks © Harald Hau, INSEAD 14 Feb 27, 2009: -36%
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
H2: Stock Performance Dependent Fire Sales? © Harald Hau, INSEAD 16
H3: Are Stocks with high Fund Share more stable? © Harald Hau, INSEAD 17
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 stocks 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
Impulse Response of DMF Portfolio to Index Return Shock © Harald Hau, INSEAD 19
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
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 stocks crisis resilience Evidence of more flight to quality (retail investor panic) among direct than indirect (fund) investors © Harald Hau, INSEAD 21
Next Project What were the consequences of stock mispricing for the companys 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
Sandy Lai SMU 1 The Role of Equity Funds in the Financial Crisis Propagation Harald Hau INSEAD Chong Tze Chua SMU.
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