Three Papers on Heterogeneous Investors and Their Financial Market Implications

Abstract

Financial market equilibrium is shaped by heterogeneous investors. Their distinct sophistication and incentive significantly influence market efficiency. This dissertation comprises three papers that examine the roles of distinct investors across different financial markets.

The first paper investigates how unsophisticated retail investors affect ETF price efficiency. Decomposing close-to-close ETF mid-quote returns into overnight and intraday components, we document a robust pattern: overnight returns are significantly positive, whereas intraday returns are negative. This return differential is pervasive across ETFs tracking diverse asset classes and regions and cannot be explained by differences in risk, macroeconomic news, or information asymmetry. Our evidence indicates that retail investor demand shocks, coupled with limited arbitrage supply, drive this pattern. These findings suggest that retail-driven demand generates abnormal price fluctuations, imposing a hidden cost on intraday ETF investors.

The second paper examines the impact of opportunistic "patent trolls" on firms' cash holdings. We construct a novel measure of patent troll litigation risk using the digital footprint of trolls viewing financial statements on the SEC EDGAR platform. Exploiting the staggered adoption of anti-troll laws, we find that firms facing greater litigation risk strategically reduce cash holdings to deter lawsuits. Cash flow analyses reveal that these adjustments are implemented primarily through financing activities, with operating and investing activities largely unaffected. Overall, our results highlight patent troll litigation risk as an important determinant of firms' cash and financing policies.

The third paper explores how active fund managers respond to incentive compensation reforms. Using China's mutual fund compensation reform, which introduced bonus deferral requirements, we find that while the reform successfully curbs excessive risk-taking, it also unintentionally reduces managerial effort, harming fund performance in some cases. Cross-sectional analyses show heterogeneous effects: for funds previously engaged in high-risk-low-return strategies, the benefits of reduced risk-taking dominate, improving investors' risk and return tradeoffs. In contrast, funds with high-risk-high-return strategies experience performance declines, as reduced effort outweighs the benefits of lower risk. These results underscore the importance of designing compensation policies that balance risk discipline with managerial incentives to value creation in the fund industry. Show more