Investment-Based Asset Pricing and Its Applications.

Abstract

Investment-based asset pricing (Cochrane (1991, 1996)) is a useful approach to understanding the cross-section of asset prices and returns. The first chapter incorporates its insights into mutual fund performance evaluation. Motivated by the investment model, I show that investment and profitability convey useful information about future fund returns. However, such information is not taken into account by the standard benchmarks that build exclusively on the size, value, and momentum effects. As a result, funds favoring low investment or high profitability stocks tend to outperform, while funds favoring high investment or low profitability stocks tend to underperform. Accounting for investment and profitability changes performance estimates significantly and helps explain the good performance of growth-oriented funds, high activeness funds, or small funds. I propose new performance benchmarks that incorporate investment and profitability. The results show that a new comprehensive benchmark accounts for the cross-section of stock returns better and tracks mutual fund returns much more closely. The second chapter shows that the investment model matches cross-sectional asset prices both in first differences and in levels. With ten book-to-market deciles as the testing portfolios, the investment model largely matches the Tobin's Q spread, while maintaining a good fit for the average return spread across the extreme deciles. The model's fit results from three aspects of our econometric strategy: (i) We test the model at the portfolio level to alleviate the impact of measurement errors; (ii) we match the first moment to mitigate the impact of temporal misalignment between asset prices and investment; and (iii) we allow for nonlinear marginal costs of investment. The model also does a good job in matching asset price levels within each industry, allowing technological heterogeneity across industries. Our evidence suggests that any differences between the intrinsic value and the market value of equity tend to dissipate in the long run.