Essays on gambling preference in January and timing ability of hedge fund managers

Abstract

This dissertation consists of one essay on hedge funds and two essays on a relation between financial anomalies and January gambling preference.

The first essay focuses on an unexplored dimension of fund managers’ timing ability: market-wide tail risk implied by information in options markets. Constructing the option-implied tail risk, I investigate whether hedge fund managers can strategically time the tail risk through adjusting their exposure to changes of it. Using an extensive sample of equity-oriented hedge funds, I find strong evidence of tail risk timing ability of hedge fund managers. Furthermore, tail risk timing ability brings significant economic value to investors. Top-ranked funds outperform bottom-ranked funds by 5–7% annually after adjusting for risk factors.

The second essay is empirical study on January seasonality of lottery-related anomalies. I find that in January lottery strategies persistently crash, delivering negative returns, but in non-January months they earn significant positive returns even after controlling for microcaps. This finding suggests that unconditional lottery-related anomalies are insignificant, but lottery-related anomalies conditional on the January seasonality are in fact strong and robust. The January crash of lottery strategies is driven by seasonality of investors’ preference for speculative stocks: stronger demand of lottery-type stocks in early January leads to price run-ups for these stocks.

The third essay documents that profitability premium, as well as profitability factors, becomes severely negative in January. This January negative profitability premium cannot be explained by current theories and is robust to other risk factors and firm characteristics related to January stock returns. Additionally, this negative premium is mostly driven by unusually high returns of unprofitable firms in January. Dissecting potential explanations, I find a New Year gambling mentality is strongly related to this phenomenon. Our empirical analysis provides new insight into profitability-related anomalies, in that they could be due to gambling demand–based overpricing in January and its correction in remaining months among unprofitable stocks.