ORCID

Jeremy Bertomeu, https://orcid.org/0000-0001-6746-5767

Language

English (en)

Publication Date

2017

Abstract

Asset pricing theory postulates that a risk factor correlates with individuals’ marginal utility of consumption. Hence, under plausible preferences, individuals should become more risk tolerant given favorable factor returns. We show that this wealth effect predicts a positive association be- tween performance pay and factor returns. Our results support the hypothesized relationship for the market, book-to-market and momentum factors. Factors constructed from bond prices are positively associated to incentives, incrementally to the Fama French factors, but we obtain mixed evidence for higher-order market factors, liquidity factors or factors constructed from national income accounts, including pricing kernels. This paper develops a non-conventional approach to test whether commonly-used empirical risk fac- tors capture individual consumption risks. A challenge in testing asset pricing theory is that individual consumption and wealth are difficult to measure. We bypass this measurement problem by testing the theory in the context of executive compensation, in which detailed data about incentives is available. Incentive contracts should allocate risk to states of the world in which the agent has lower absolute risk-aversion which, under standard asset pricing assumptions, are states with lower marginal utility of wealth and higher factor returns (Cochrane 2009). Under the joint hypothesis of market and contract efficiency, incentives in observed contracts will be positively associated with factor returns. A motivation for our approach is given by Harvey, Liu and Zhu (2014), who observe that standard test procedures for a new factor, which rely on the existence of unexplained returns, do not take into account the extensive statistical mining for factors. While Harvey, Liu and Zhu suggest to increase the desired significance level based on standard-errors adjusted for multiple hypotheses testing, we propose a closely related solution, that is, to combine existing empirical asset pricing tests with tests relying on observed real contracting decision. Under multiple hypothesis testing, the less correlated the noise in a test to noise in existing tests, the higher the joint significance of both tests. Because incentives in contracts need not be correlated to expected returns, evidence from contracts may increase confidence in a risk factor and should be read together with existing asset pricing tests — from which we borrow the set of factors under consideration. For our empirical tests, we use two datasets. The first dataset is the sensitivity of managerial wealth to stock price movements (Delta) for top executives from 1992-2014, as described in Coles, Daniel and Naveen (2013). Since this dataset contains the total delta but not its option and stock components, we ∗J. Bertomeu is an associate professor and E. Cheynel is an assistant professor both at Rady School of Management, University of California, San Diego, and M. Liu-Watts is an associate professor at Hunter College CUNY. Contact author: J. Bertomeu, 9500 Gilman Dr, La Jolla, CA 92093; email: [email protected]. †We received helpful comments from participants at workshops at Baruch College, the University of Paderborn and the University of Mannheim. also examine a second dataset using newly available data from the Execucomp compensation database in Compustat. Starting with the fiscal year-end 2006, this database collects detailed information about top management’s portfolio of equity and options, which allows us to estimate the sensitivity of managerial wealth to stock price movements for the stock option delta and stock delta. Because our test relies on a predicted characteristic of the contract, it does not require a measurement of other sources of managerial wealth separate from the firm. Hence, this approach offers an asset pricing test with limited knowledge of the manager’s consumption or wealth portfolio, as long as the researcher observes sensitivity to firm- specific risks. Overall, we find robust evidence that contracts treat the market, book-to-market (Fama and French 1993) and momentum factors (Carhart 1997) as risk, that is, factor returns are positively associated with incentives over various time periods and specifications. We also find evidence that the size factor is associated to incentives over the full sample 1992-2014, but the relationship no longer holds for the recent period 2006-2014 and in many supplementary tests. We test whether these associations may be tied to a positive association between pay and firm-level factorbetas, as documented by Garvey and Milbourn (2003). This problem is different from ours, in that we try to control for firm-specific determinants of incentives, which include firm-level betas, and our test variable is the factor return. In our main regression, we include firm fixed effects to control, among other things, for the time-invariant component of betas. In supplementary analyses, we include estimated factor betas in the main regression and, alternatively, run separate regressions by subsamples of firms within quintiles of size and book-to-market. In these specifications, we find similar results for the market, book-to-market and momentum factors but do not find a positive relationship between the size factor and incentives. Note that identification assumes efficient contracting and, therefore, we cannot distinguish between market and contract inefficiencies. To examine whether contracting inefficiencies may cause the relation- ship, we examine subsamples in which we would expect the contract to be more efficient. We conjecture that firms with poor governance may be less willing to contract on observable risk factors in order to conceal the nature of the compensation (Bebchuk and Fried 2003). In particular, if compensation ar- rangements tie incentives to changes in observable factors, it may be more difficult to justify unexplained reductions in incentives following negative firm performance (Bertrand and Mullainathan 2001; Garvey and Milbourn 2006).1However, we find similar results after partitioning the sample by various gover- nance variables suggesting that, when governance affects contract efficiency, this might occur through higher rents to managers rather than a distortion to the exposure of incentives to factors. Another source of contracting inefficiency may be imperfect knowledge of the manager’s preferred exposure to systematic risks by compensation committees. We conjecture that both the manager’s risk-aversion and the nature of the incentive scheme may take time to learn. We test this hypothesis in a subsample of firms whose management had at least two years in office, conducting the analysis separately for year 1 versus year 2. All factors except the size factor are significant in year 2, but only the momentum factor remains significant in year 1. We then broaden the scope of our analysis to test a larger universe of factors discussed in Harvey, Liu and Zhu (2014) and Berk and Van Binsbergen (2014). Specifically, we examine five classes of asset pricing factors: (i) higher-order market spanning factors, (ii) factors based on bond prices, (iii) national income accounts variables, (iv) liquidity factors and (v) factors based on theory-based kernels. 1For example, complex contract structures, which condition pay on risk factors unrelated to managerial actions, may cause special scrutiny by shareholders if they are viewed as a violation of relative performance evaluation (Abowd and Kaplan 1999; Core, Guay and Larcker 2003). 2

Document Type

Working Paper

Author's Department

Accounting

Author's School

Olin Business School

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