Essays in Investments

In the first essay, I show that the inflow of capital to mutual funds reduces their future returns, and the outflow of capital improves future returns. I do this by showing that the Carhart alphas of funds are decreasing in their past raw returns (which proxy for unexpected flow), and increasing in their past alphas (which proxy for manager skill). The high-alpha low-raw-return fund portfolio has an alpha, net of fees, of 2.65% over the next year. I construct an extension of the model of Berk and Green (2004), in which investors learn about fund manager ability from raw return, which predicts this pattern. I then determine the mechanism through which flow affects performance. I find the same pattern in alphas when I track the portfolios held by the funds on the date at which they are ranked by performance through the subsequent year. A decomposition of fund alphas attributes the majority of the pattern observed during the holding year to the portfolio held by the fund at the beginning of the holding year. I argue that the proximate cause of the lack of persistence in performance of funds with high returns is that the prices of the securities they hold have been bid up to fundamental value by the end of the ranking year.;In the second essay, which is based on a paper written jointly with Anthony Lynch and Jessica Wachter, I use conditional factor models to study whether the performance of mutual funds varies over the business cycle. Conditional factor models allow both risk loadings and performance over a period to be a function of information available at the start of the period. Much of the literature to date has allowed risk loadings to be time-varying while assuming either that performance is not conditional or that conditional betas are linear in the information. We develop a new methodology that allows for conditional performance but does not make assumptions about the behavior of the conditional betas. This methodology uses the Euler equation restriction that comes out of the factor model rather than the beta pricing formula itself. It assumes that the stochastic discount factor (SDF) parameters are linear in the information. We use econometric techniques developed by Lynch and Wachter (2007) to estimate the Euler equation restrictions, which produce efficiency gains by using all available data, even though the factor data and the mutual fund data do not start on the same date. Using dividend yield and term spread to track the business cycle, we find that conditional mutual fund performance relative to conditional versions of the Fama-French and Carhart pricing models moves with the business cycle, and this business cycle variation in performance differs across large-NAV and small-NAV funds within at least one equity fund category. This result is robust to considering performance in excess of a matched Fama-French size/book-to-market portfolio, where the matching is done on the basis of the fund portfolio's factor loadings.;In the third essay, I study how mutual fund families vote in the shareholder meetings of a company whose shares they own. Fund families which hold more debt than equity in that company vote differently on certain types of propositions than families which hold relatively more equity. I conclude that these classes of propositions do not affect bondholders and stockholders in the same way, and infer how bondholders would vote on these propositions if they had the vote. I find that there are three types of propositions which affect bondholders differently from equityholders: the authorization of new common and preferred stock, the approval of pay-for-performance schemes, and the removal of anti-takeover defences.