Greetings!

Want to stay on top of cutting-edge finance research from Wharton? Every two months, the Rodney White Center highlights the latest studies by Wharton’s finance faculty. In this issue: 

• How does democracy impact the stock market? 
• Do growth stocks really have higher growth? 
• How does under-diversification affect the economy? 
• Who owns government debt? 
• How passive are passive ETFs?

We invite you to subscribe to this newsletter if you haven’t already. Click here to subscribe.

Best regards,
Itamar Drechsler and Luke Taylor

Ph.D. candidate Max Miller links democracy to stock-market performance

In the past 200 years, over half of all countries have transitioned to democracy. Democracies tend to reduce income inequality and increase taxes, so these transitions expose the rich to large redistribution risks. Those risks dampen wealthy households’ appetites for holding risky assets, reducing stock prices during democratizations. Ph.D. candidate Max Miller confirms these predictions using data on democratization events from 90 countries over 200 years. Democratizations and financial crises have similarly large effects.

Professor Sean Myers casts doubt on growth stocks’ growth

Conventional wisdom is that growth stocks have high price-earnings ratios because investors expect high growth in their corporate earnings. Professor Myers challenges this notion, showing that growth stocks have high P/E ratios mainly because they have low expected future returns. Over 70% of the cross-sectional variation stocks’ P/E ratios is explained by differences in future returns rather than future earnings growth. The lack of earnings predictability implies that stock returns are much more predictable than previously believed.

Professor Tim Landvoigt shows wide-ranging effects of investor under-diversification

It is well known that wealthy households hold undiversified portfolios, mainly due to their ownership of private businesses. Professor Landvoigt shows that this under-diversification reduces interest rates, increases risk premiums on both public stocks and private businesses, increases corporate investment and aggregate output, and increases wealth. Nevertheless, under-diversification reduces social welfare by exposing households to more risk. 

Professor Karen Lewis investigates who holds government debt and why it matters

Levels of government debt have risen in the wake of the Covid crisis. Who holds this debt, and does it matter to borrowers in this market? Professor Lewis answers these questions by collecting data on the sovereign debt of 95 countries over 20 years. Private non-bank investors have absorbed most of the increase in sovereign debt supply. Emerging-market sovereigns are highly vulnerable to losing their foreign non-bank investors.

Professor Yao Zeng studies the active management of passive ETFs

Exchange-traded funds (ETFs) are usually regarded as passive index trackers. In contrast, Professor Zeng shows that corporate bond ETFs actively manage their portfolios, trading off index tracking against liquidity transformation. ETFs optimally choose creation and redemption baskets that include cash and only a subset of index assets, especially if assets are illiquid. ETFs dynamically adjust their baskets to correct portfolio imbalances while facilitating ETF arbitrage.

Please share our research through social media and subscribe to this newsletter.

Visit our website at rodneywhitecenter.wharton.upenn.edu or contact us at rodneywhitecenter@wharton.upenn.edu.