Sentiment, Beta Herding, and Cross-sectional Asset Returns

Soosung Hwang* School of Economics, Sungkyunkwan University, Seoul, Korea Mark Salmon Department of Economics, University of Cambridge
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Abstract We investigate the effects of asymmetric bias in betas on cross-sectional asset returns. The asymmetric bias in betas incorporates the interaction between sentiment and herding in linear factor models. Contrary to common belief that herding is significant when a market is under stress, we demonstrate that beta herding is more likely to arise when investors expectations are more homogeneous, whether it be rising or falling, and investors are in consequence, most probably, more confident regarding the future rather than when the market is in crisis. Our empirical evidence indicates that crises appear to lead investors to seek out the fundamental risk-return relationship rather than to herd. In terms of cross-sectional asset returns, we find that beta matters conditioning on beta herding though it does not unconditionally: high beta stocks are priced higher than low beta stocks after adverse beta herding. Keywords: Herding, Sentiment, Market Crises, Cross-sectional Asset Returns. JEL Classifications: C12,C31,G12,G14

Corresponding author. School of Economics, Sungkyunkwan University, 53 Myeongnyun-Dong 3-Ga, Jongno-Gu, Seoul 110-745, Korea. , Tel: +82 (0)2 760 0489, Fax: +82 (0)2 744 5717, Email: shwang@skku.edu. We would like to thank the seminar participants at the International Conference on the Econometrics of Financial Markets, the PACAP/FMA Finance Conference, University of New South Wales, the Bank of England, Said Business School, Oxford, University of Copenhagen, Imperial College, London, Australian Conference of Economists, Perth for their comments on this paper. Faculty of Economics, Austin Robinson Building, Sidgwick Avenue, Cambridge CB3 9DD, UK. Tel: +44 (0)207, Fax: +44 (0)24 76523779, Email: mhs39@cam.ac.uk
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1. Introduction
Herding is widely believed to be an important element of behavior in financial markets and yet the weight of empirical evidence remains inconclusive. The majority of studies have failed to find strong evidence of herding, and only in a few particular cases, for example, herding by market experts such as analysts and forecasters or individual traders does the empirical evidence appear to be convincing (see Hirshleifer and Teoh, 2003; Barber, Odean, and Zhu, 2009). One difficulty in the study of herding lies in the problem of differentiating between a rational reaction to changes in fundamentals and irrational herding behavior.1 It is critical to discriminate empirically between these two forces, since the former simply reflects an efficient reallocation of assets, whereas the latter potentially leads to market inefficiency.2 In this paper we propose a new approach to measuring herding and examine the evidence of the impact of herding on asset prices, explicitly recognizing the existence of systematic rational rebalancing to news. Therefore, we introduce the concept of herding in terms of collective deviations from the equilibrium risk and return relationship in a market where rational and quasi-rational investors co-exist (Russell and Thaler, 1985) and asset returns are affected by psychological biases such as over- or under-reaction and sentiment (Lakonishok, Shleifer, and Vishny, 1994; Barberis, Schleifer, and Vishny, 1998; Daniel, Hirshleifer and Subrahmanyam, 1998, 2001; Hong and Stein, 1999; and Baker and Wurgler, 2006). Our notion of herding measures the behavior of investors who irrationally follow or herd behind the performance of specific drivers which could be the market index itself or particular sectors, styles, or macroeconomic signals, and buy or sell individual assets while disregarding their underlying equilibrium risk-return relationship. Although this measure can be easily applied to specific factors, we focus here on herding toward the market portfolio, which we call beta herding. Beta herding is different from other herd measures in the literature. First, it measures how betas in the popular CAPM are biased when investors asymmetrically react to the overall market outlook or are affected by sentiment. Thus it measures deviation from the equilibrium risk-return relationship. Secondly, it directly measures the impact of herding on asset returns by capturing market-wide herding rather than herding within a small group of investors. For example, the herd measures proposed by Lakonishok, Shleifer, and Vishny (1992) or Wermers (1999) are for psychological bias by a small group of investors and need detailed records of individual trading activities which may not be readily available in many cases. Moreover, these measures do not necessarily show if asset prices are biased due to herding even if these measures suggest evidence of herding. Finally, the cross-sectional variability of returns (Christie and Huang, 1995) is not necessarily indicative of irrational pricing in the
1

The use of irrational here refers to the market, as opposed to individual irrationality. We recognize that there will be situations in which it may be myopically rational for an individual to follow the herd and hence our use of irrational may seem inappropriate. However, given that such behavior may lead to inefficient asset prices and irrational behavior for the market as a whole, we will throughout this paper refer to herding simply as irrational. See Hirshleifer and Teoh (2009) 2 We implicitly assume that herding should be viewed in a relative sense rather than as an absolute and that no market can ever be completely free of some element of herding. Therefore, we argue that there is either more or less herding in a market at some particular time and herding is a matter of degree. It appears to us conceptually difficult, if not impossible, to define rigorously a statistic that could measure an absolute level of herding. However, many herd measures that have been proposed, such as those of Lakonishok, Shleifer, and Vishny (1992), Wermers (1995), and Chang, Cheng and Khorana (2000), have explicitly attempted to identify and describe herding in absolute terms.

market, as it may just reflect fundamental changes in common factors. On the other hand, the cross-sectional variability of betas, from their equilibrium values, can, more clearly, be interpreted as irrational pricing theoretically. We show that the measure of beta herding is robust to business cycle and stock market movements, but is heavily affected by the advent of crises. Contrary to the common belief that herding is only significant when the market is in stress (Kim and Wei, 1999; and Choe, Kho, and Stulz, 1999), we find that beta herding becomes more apparent when investors are likely to be relatively more confident regarding the future direction of the stock market. Once a crisis appears, beta herding weakens, as investors become more concerned with fundamentals than movements in the overall market. These results suggest that herding occurs more readily when investors expectations regarding the market are more homogeneous regardless of whether it be a bull or a bear market. The results obtained from portfolios formed on size and book-to-market or industry portfolios are not different from those we find from using individual stocks. As expected, market-wide sentiment increases beta herding. When market-wide positive sentiment exists, individual asset returns tend to increase regardless of their systematic risk, and beta herding increases. On the other hand, negative sentiment will reduce beta herding. Our empirical results using individual stocks from the US equity market support the fact that beta herding exhibits a significant positive relationship with sentiment; however, sentiment explains only 10% of beta herding. For the effects of beta herding on cross-sectional asset returns, we find evidence that beta herding matters. As in Fama and French (1992), beta unconditionally does not explain cross-sectional asset returns. However, beta forecasts cross-sectional returns conditioning on the level of herding. The positive coefficients on the herd measure confirm that betas become less priced when investors have confidence in the direction toward which the market is heading. On the other hand, sentiment does not conditionally explain beta sorted portfolio returns. However, beta herding has restricted ability for the cross-sectional asset returns through other channels, i.e., firm characteristics. Our analysis to those tested by Baker and Wurgler (2006) shows limited evidence that beta herding drives subsequent returns of portfolios sorted on these firm characteristics. These results confirm that although sentiment can explain firm characteristics sorted portfolio returns but it does not explain beta sorted portfolio returns in cross-section. It is beta herding that explains beta sorted portfolio returns. In the next section, we model beta herding considering sentiment and the implications for asset pricing. A method is developed to estimate herd behavior based on the cross-sectional variance of the -statistics of the estimated betas in a linear factor model. In section 3, we apply this measure to the US equity market. The empirical properties of the beta herd measure, its relationship to economic events and sentiment, and its robustness to fundamentals are assessed. We then analyze the implication of beta herding in cross-sectional asset pricing in section 4. Finally, we draw some conclusions in section 5.

2.

Cross-sectional mispricing, sentiment, and beta herding

We investigate the effects of a form of behavioral bias on asset pricing that induces a cross-sectional distortion in betas where both rational and quasi-rational investors populate. As shown in Russell and Thaler (1985), the existence of rational investors who revise their expectations according to Bayes rule does not guarantee an efficient equilibrium. A number of studies have subsequently investigated the consequences of the interaction between rational and quasi-rational investors and shown why quasi-rational investors do not 2

necessarily die out; see for instance, DeLong, Shliefer, Summers and Waldman (1990), Kirman (1995), and Kozhan and Salmon (2009). In such a market, over- or under-reaction to unexpected events is common for a variety of reasons; due to the misinterpretation of information by the quasi-rational investors. Various models have been proposed to explain the effects of various behavioral biases on asset pricing; see Lakonishok, Shleifer, and Vishny (1994), Barberis, Schleifer, and Vishny (1998), Daniel, Hirshleifer and Subrahmanyam (1998, 2001), and Hong and Stein (1999). In this study we develop a model that leads to biases in beta induced by both cross-sectional herding and market wide sentiment; the combined effect of which we refer to as beta herding. We define a measure and provide a statistical framework to examine the empirical impact of beta herding on asset prices. Although the concept of beta herding is developed here in the context of the standard market model for simplicity, it would equally hold for the market beta in multifactor models insofar as the additional factors are orthogonal to the market factor. 2.1. Cross-sectional herding How bias in betas arises from cross sectional herding can be better understood with an example. Suppose that investors are, for some reason, optimistic and expect the market as a whole to increase by 20%. Their optimistic view may reflect changes in fundamentals or simply market-wide sentiment. For quasi-rational investors who do not know the true betas of the individual assets nor forecast the betas with any accuracy, it is not easy to identify which assets should show higher or lower returns than the market return. Instead they may overreact to the optimistic view and expect similar returns for the individual assets regardless of the assets true betas. When investors succumb to this form of behavioral bias and have a strongly homogenous outlook across assets, we would expect bias in cross-sectional asset returns. As the consequence of the cross-sectional herding in valuation towards the market movement, the betas on assets move away from their equilibrium values and towards the market beta. The response to these market movements is cross-sectionally asymmetric as low beta assets overreact compared to the market as their biased betas become larger than their equilibrium values (positively biased), whereas high beta assets underreact compared to their equilibrium values and their betas become biased downward. This herding toward the market beta (whose value is obviously one) indicates that cross-sectional asymmetric reactions, i.e., overreaction and under-reaction, can occur at the same time for low and high beta stocks, respectively. In addition, at some stage a reversal must follow in order for equilibrium to be regained. During this correction phase, betas return towards their equilibrium levels (i.e., high betas increase whereas low betas decrease) and thus the cross-sectional dispersion of individual betas increases. The asymmetric bias in betas (and expected returns) can be observed in the ex post returns. In the above example, the quasi-rational investors may buy assets whose returns increase by less than the market, since these would appear relatively cheap. Likewise, they may sell assets whose returns increase more than the market because these assets would seem to be relatively expensive and the opportunity for taking apparent profit might be hard to resist (Shefrin and Statman, 1985). Similar trading patterns may be observed in bear markets; where high beta assets may appear relatively cheap compared to low beta assets. This type of bias in betas is closely related to investor overconfidence and biased self-attribution discussed by Daniel, Hirshleifer and Subrahmanyam (1998, 2001). When investors are overconfident on the market outlook, they ignore the underlying equilibrium relationships and respond asymmetrically to the market outlook; they respond too much with 3

low beta stocks and too little with high beta stocks. 2.2. Sentiment and the cross-sectional bias in betas The asymmetric response to market movements at times of strong cross-sectional herding is closely associated with sentiment. In this subsection, we discuss how individual betas behave in the presence of sentiment and how these biases are related to the asymmetric bias in betas. While sentiment will affect the entire return distribution, we follow the majority of the literature and define sentiment with reference to its effect on the mean of quasi-rational investors subjective returns: if it is relatively high (or low), we say that an optimistic (or pessimistic) sentiment exists.3 Let !" and !" denote the impact of sentiment on beliefs regarding the expected returns on the market portfolio and asset , respectively. Then, the investors biased expectation in the presence of sentiment can be found as the sum of two components; one due to fundamentals and the other due to sentiment, !! !" = ! !" + !" , (1) ! ! (!" ) = ! (!" ) + !" , where !" and !" are the excess returns on asset and the market at time , respectively, ! (. ) is the conditional expectation based on the information available at time , the superscript reflects the bias due to sentiment. For consistency we require !" = ! (!" ) and ! (. ) represents the cross-sectional expectation. As beta represents the ratio of expected excess return to expected excess market return, the effects of sentiment on beta can be shown as follows;
! ! !"# = ! ! (! !" ) ! ! (! )

= ! (! =
!

! !" !! (!!" )!!!"

(2)

! !" )!!!" !!"# !!!"

!!!!"

!" ! where !"# is the systematic risk in the presence of sentiment, and !" = ! (! !

!" )

and

!" = ! (!!"
!

of sentiment on the market portfolio and asset with respect to the expected excess market return, respectively. Several previous studies, such as Brown and Cliff (2004), report empirical evidence that asset returns are positively associated with sentiment. Therefore, positive values of !" and !" are generally expected in bull markets, whereas negative values are expected during bear markets. We explore several specific cases to demonstrate how beta is biased in the presence of sentiment in individual assets and/or the market and thus how the observed beta would differ from its equilibrium value. Consider the following cases;
!!"# !!!!"

!" )

represent the degree of optimism or pessimism given by measuring the impact

when !" = 0 and !" 0, (3) when !" 0 and !" 0.

! !"# = !"# + !" when !" 0 and !" = 0, !!"# !!!" !!!!"

The first case in equation (3) arises when there is market-wide sentiment but no
3

Several different approaches to defining sentiment have been proposed; see De Long, Shleifer, Summers, and Waldmann (1990), Barberis, Shleifer, and Vishny (1998) and Daniel, Hirshleifer, and Subrahmanyan (1998). Essentially we follow Shefrin (2005) and regard sentiment as an aggregate belief that affects the market as a whole.

sentiment impact for a specific asset. It is worth noting that even if there is no specific sentiment effect for the asset, its beta is still biased due to the market-wide sentiment. If there is positive market-wide sentiment, its beta is biased downward, and vice versa. Obviously, for the market as a whole, there would need to be other individual assets whose sentiment contributes to the non-zero market-wide sentiment. The second case, where !" = ! (!" ) = 0 (or !" = ! (!" ) = 0), assumes that no aggregate market-wide sentiment exists, although non-zero sentiment exists for the individual asset; positive sentiment in some assets must be accompanied by negative sentiment in others. In this case the asymmetric biases in betas discussed above may well occur. For example, for given ! (!" ) , when !" < 0 for stocks with !"# > 1 and !" > 0 for stocks with !"# < 1, these cross-sectional asymmetric beliefs increase cross-sectional homogeneity. Hwang and Salmon (2004) (henceforth HS) propose the following equation to capture this type of herding;
! !! (!!" )

where !" represents the level of cross-sectional herding. Comparing equations (3) and (4), we obtain HS herding by setting !" = !" (!"# 1). A positive value of !" suggests negative sentiment for high beta assets and positive sentiment for low beta assets. The HS analysis, however, assumes that ! (!" ) is given, and thus is a special case. The last and more general case arises when both individual and market sentiment are ! non-zero. Only when !" = !"# !" will we find !"# = !"# . That is, the observed beta will be equivalent to the equilibrium beta only when the individual sentiment is related to the market-wide sentiment through the equilibrium relationship. However, this may not arise, since in a market where strong (either positive or negative) sentiment exists, asset pricing based on fundamentals is likely to be suppressed by sentiment regardless of betas. In general, when investors have strong positive sentiment, a similar level of sentiment is likely to be expected for individual assets regardless of the equilibrium relationship. In an extreme case, when sentiment is strong and the same for all assets in the market, i.e., ! ! !" = !" > 0 for all , !"# moves toward 1; 1 > !"# > !"# for assets with !"# < 1 ! ! and 1 < !"# < !"# for !"# > 1. Similarly when !" = !" < 0, 1 < !"# < !"# for ! assets with !"# > 1 and 1 > !"# > !"# for !"# < 1. 2.3. A model for beta bias in the presence of both cross-sectional herding and sentiment The impact of sentiment on betas can be analyzed together with the impact of cross-sectional herding. Although the motivations behind the cross-sectional bias in betas are somewhat different, i.e., one from relative valuation with respect to the market regardless of systematic risk and the other from biased expectation on future returns due to sentiment, these two psychological biases have a common effect on betas; betas are biased by both market-wide sentiment (!" ) like bubbles as well as by cross-sectional herding. In order to model the effects of cross-sectional herding and sentiment on asset pricing, we decompose sentiment on an individual asset into three components: a common market-wide sentiment that evolves over time, !" , cross-sectional herding, !" (!"# 1), and an idiosyncratic sentiment, !" , such that; !" = !" !" (!"# 1) + !" . (5) Alternative structures might be proposed, but equation (5) is both simple and general enough to capture asymmetric biases in betas which cause cross-sectional distortion in asset price. The equation also satisfies the constraint that the cross-sectional expectation of sentiment on all individual assets must be equal to market-wide sentiment; 5

!! (!!" )

! = !"# = !"# !" (!"# 1),

(4)

! (!" ) = ! (!" !" (!"# 1) + !" ) = !" , since ! (!"# 1) = ! (!" ) = 0. By substituting !" into equation (2), we can express beta in the presence of the two psychological biases as follows: ! ! !"# = 1 + !!! (1 !" )(!"# 1) + !" . (6) Note that only in a few strict cases, e.g., all three sentiment components are zero or !" = 0 ! and !" = !" does (6) deliver the equilibrium beta, !"# = !"# . Otherwise, betas would be biased. 2.4.
!"

Beta herding When there is a common or homogenous outlook or sentiment, the investors follow or herd behind the performance of the market portfolio, buying or selling individual assets while disregarding the underlying equilibrium risk-return relationship of these stocks. Therefore, we measure mispricing through the cross-sectional variability of betas rather than the cross-sectional variability of returns proposed by Christie and Huang (1995), as the dynamics of the latter may just reflect the movement of other common factors. Let us consider how cross-sectional herding and sentiment affect individual asset prices. As we will measure the market-wide bias in asset pricing, the idiosyncratic sentiment, !" , is less important, and for simplicity, in the following argument we assume that !" , is zero. Table 1 summarizes four cases depending on the market-wide sentiment !" and the ! cross-sectional homogeneity !" . When !" = or !" = 1, !"# = 1 for all and the expected excess returns on the individual assets will be identical to that of the market portfolio regardless of their systematic risks. Thus, this case can be interpreted as perfect beta herding. In general, when !" > 0 or 0 < !" < 1, beta herding exists in the market, and the size of the bias will depend on the magnitude of !" or !" . Betas are ! asymmetrically biased: !"# > !"# > 1 for an asset with !"# > 1 whereas !"# < ! !"# < 1 for an asset with !"# < 1. Therefore, when there is beta herding, the individual betas are biased toward 1. In a market where rational investors are Bayes optimizers, the cross-sectional over- or under-valuation due to beta herding would be corrected by these rational investors. As a consequence, adverse beta herding is expected to follow beta herding. 4 When adverse beta herding appears, we would expect !" < 0 or !" < 0. In this case an asset with !"# < 1 ! will be less sensitive to movements in the market portfolio (i.e., !"# < !"# < 1), whereas an asset with !"# > 1 will be more sensitive to movements in the market portfolio (i.e., ! !"# > !"# > 1). 2.5 A Measure of Beta Herding Without loss of generality, we assume that the equilibrium !"# is not related to the idiosyncratic sentiment ( !" ). Then, we have the following relationship between the cross-sectional variance of betas and the two variables we are interested in (i.e., !" and !" );
! ! (!"# ) = ! ! ! !!!!"
!

(1 !" )(!"# 1) + !"

(7)

= (!!!

where ! (. ) represents cross-sectional variance.

4

!" )

(1 !" )! ! (!"# ) + ! (!" ) ,

Our term adverse herding is consistent with the use of disperse in Hirshleifer and Teoh (2003).

! The dynamics of the cross-sectional variance of the betas, ! (!"# ), reflect changes in sentiment (!" ) or cross-sectional herding (!" ) under the assumption that the cross-sectional variance of the true betas, ! (!"# ), does not change significantly over time, and the cross-sectional variance of the idiosyncratic sentiments remains constant over time. The first assumption may appear strong given the empirical evidence of time-varying betas (e.g., Ferson and Harvey (1991, 1995), Jagannathan and Wang (1996), Lewellen and Nagel (2006), and Ang and Chen (2006)). Note, however, that the assumption does not necessarily indicate that an individual assets or a portfolios equilibrium should remain constant over time, but simply needs an assumption that the dynamics of !"# are idiosyncratic, so that with a large number of assets, the variance, ! (!"# ), should not change significantly over the short-run. Likewise, there appears to be no strong reason not to believe that the cross-sectional variance of the idiosyncratic sentiment !" might be constant. ! Under the assumptions set out above, the dynamics of ! (!"# ) can be interpreted as irrational pricing due to sentiment. Beta herding can be measured as follows.

Definition The degree of beta herding is given by ! !! ! !" = ! !!! !"# 1 ! ,

!

(8)

where ! is the number of stocks at time . Beta herding decreases with !" . For given ! (!"# ) and ! (!" ), changes in the dynamics of our beta herd measure originate from just two sources, !" and !" . We observe a reduction in !" with a high level of cross-sectional herding or positive market-wide sentiment. When there is no cross-sectional herding but only market-wide sentiment, i.e., !" = 0 and !" 0, changes in !" are attributable to the movements of market-wide sentiment. In this case, the positive market-wide sentiment decreases !" , suggesting that a bubble might increase beta herding. Finally, as to the question of what contribution market-wide sentiment makes to the overall beta herding, we take the logs of equation (7) and analyze the following regression: ln!" = ln (1 !" )! ! (!"# ) + ! (!" ) 2ln(1 + !" ). (9) The equation suggests a negative relationship between ln!" and ln(1 + !" ), which provides an obvious hypothesis to test. In addition, the ! from the estimation of this equation would indicate the degree to which market-wide sentiment contributes to the beta herding. 2.6 Beta Herding with Portfolios The assumption of constant ! (!" ) is not, in fact, critical, since we can create portfolios such that the idiosyncratic element of sentiment for the portfolio is negligible. For a well diversified portfolio (with respect to !" ) the idiosyncratic sentiment of the portfolio becomes negligible. i.e., !" 0. Disregarding !" , we can then just decompose the effects of sentiment on the portfolio into the two components, market-wide sentiment and cross-sectional herding as above such that; !" = !" !" (!"# 1). (10) Then we have
! ! (!"# ) = ! ! !!!!" (!!!!" )! (!!!!" )!

(1 !" )(!"# 1)

(11)

! (!"# ).

Again under the assumption that ! (!"# ) is invariant over time, we can observe the 7

! dynamics of beta herding by measuring ! (!"# ). Moreover, using portfolio betas has an important empirical advantage in that the estimation error would be reduced. That is, as the ! ! number of equities within each portfolio increases, we have lim!"# = !"# . Disregarding the impacts of the idiosyncratic sentiment (i.e., ! (!" )) and the estimation error, we have the following relationship between the beta herding measured with individual stocks (7) and that measured with portfolios (11); ! !" = ! !" +
!

(!! !!) !!

! (!"# , !"# ),

(12)

! where !" and !" are the beta herd measures calculated with portfolios and individual assets, respectively, ! is the number of stocks in a portfolio 5 and ! (!"# , !"# ) denotes the covariance between !"# and !"# , , for assets and in the portfolio. Beta herding measured with individual stocks (7) is equivalent to that measured with portfolios (11) only when the !"# 's are not correlated with each other. In general, the betas are correlated and thus the results obtained with individual stocks and portfolios may not be identical.

2.7

Estimating and Testing Beta Herding ! The obvious obstacle in calculating !" is that !"# is unknown and needs to be estimated. We now demonstrate the problem that arises from using the least squares (LS) estimates of the betas and discuss why using their standardized values (i.e., the -statistics corresponding to the LS estimates) provide a better measure. The notation for beta and other parameters is simplified in what follows by omitting the subscript t. Given (window size) observations, the market model is represented as follows: ! !" = !! + !" !" + !" , = 1,2, . . . , , ! where !" is the idiosyncratic error for which we assume !" ~(0, !" ). The OLS estimator ! ! of !" for asset , !" , is then simply ! ! ! !" = !" /! , ! ! ! (!" ) = !" /! , ! ! where !" is the sample covariance between !" and !" , ! is the sample variance of ! !" , and !" is the sample variance of the OLS residuals. Using the OLS betas, we could then estimate the beta herding as ! ! ! ! = ! ! !" 1 ! . !!! ! ! However, ! will be significantly affected by the estimation error in !" . In order ! to evaluate the impact of the estimation error on ! , we first note that ! ! ! [!" ] = ! [!" + !" ] = 1, ! ! where !" is the estimation error, !" ~ 0, !" /! . Using the estimated betas in the herd ! measure, ! , is given by ! ! ! ! = ! ! (!" 1)! !!!
! ! ! ! ! ! !!! (!" 1) + ! !!! !" , ! ! ! ! ! ! ! since ! ! (!" 1)!" = 0. Note that ! ! !" = ! ! !" /! . When !" !!! !!! !!! ! ! ! and !" move with the same scale, ! ! !! /! (the cross-sectional average of estimation !!! ! errors, CAEE) is fixed and the dynamics of ! can be captured by ! . However, if either

(14)

(15) (16)

(17)

(18)

=!
!

! ! !!! (!"

+ !" 1)!

=!

We assume an equal number of stocks in each portfolio.

! the cross-sectional average of idiosyncratic variances (i.e., ! ! !" ) or the market !!! ! ! variance (i.e., ! ) is heteroskedastic, then changes in ! may not necessarily arise from sentiment or herd behavior, but originate from the changes in the ratio of firm level variance to market variance. ! ! One approach in order to avoid this unpleasant property of ! is to standardize !" ! with its standard error (Bring, 1994); in other words we use the statistic of !" instread of ! !" . The interpretation of the t statistic is that it shows the magnitude of beta estimate (numerator) as well as its precision (the reciprocal of estimation error in denominator) in asset pricing. The standardization would also make it possible to compare the dynamics of beta herding over different periods, as the t statistic will have a homoskedastic distribution and thus will not be affected by any heteroskedastic behavior in the CAEE. The standardized measure of beta herding is defined as ! = ! ! ! ! !! ! !" !!! !!" !

(19)

! where !" is the standard error of !" . We refer to expression (17) as the beta-based herd measure, whereas ! in (19) is referred to as the standardized herd measure. The following distributional result applies to (17).

Theorem 1

Let = !! !

!!

!" ! , where !" =

! !!" !!

! !!

! standard error of !" . Then with the classical OLS assumptions, !! ! !" , !"

!"

! and !!" is the

~ , , ! ! ! =
!! !! ! !!" !! ! !!
!"

where Then

!!

!!

, and is covariance matrix of . ! !

! ! = ! ! ~! ! (; ! ) + , (20) ! ! ! ! ! ! ! ! ! ! where is the rank of ! , ! = !!! (! ) /! , = !!!!! (! ) , ! is the th element of the vector ! , and and are the () matrices of the eigenvectors ! ! ! ! and eigenvalues of , respectively, i.e., = ! . ! is the jth eigenvalue of the ! ! ! ! ! diagonal matrix . The eigenvalues are sorted in descending order. ! Proof. See the Appendix.

This measure can be easily calculated using any standard estimation program, as it is based on the cross-sectional variance of the statistics of the estimated coefficients on the market portfolio. Theorem 1 shows that this new measure of beta herding is distributed as 1/ times the sum of non-central ! distributions with degrees of freedom and with ! non-centrality parameter ! and a constant. Therefore, the variance of ! is given by; ! ! [! ] = !! + 2! . (21) In practice, the non-centrality parameter would be replaced with its sample estimate. It is worth noting that this distributional result depends on the assumption that the number of ! observations used to estimate !" is sufficiently large and is multivariate normal. With ! too few observations, the confidence level implied in the theorem above would be smaller than it would be asymptotically and we would thus reject the null hypothesis too frequently.

3
! .

Empirical Properties of Beta Herding

In this section we empirically investigate properties of the behavioral bias captured in Our major concerns include whether or not ! is robust to estimation error, and how it behaves over time, in particular, in the presence of a crisis. Before we answer these questions, we describe how the measure is calculated. 3.1 Estimation of Beta and Data We use multi-factor unconditional models with rolling windows to capture the time variation in betas. We do this for several reasons; first, because the betas in our study are factor sensitivities to the market in the presence of other factors. Conventionally betas are estimated in the market model, but they are known to be not independent from other empirical factors such as size (for example, Fama and French (1992)), thereby indicating that our beta heard measure could be influenced by changes in these factors if not properly controlled. Alternatively, we could use conditional models similar to those of Jagannathan and Wang (1996), Ferson and Harvey (1999), or Ang and Chen (2007), but these models may be over-parameterized (Fama and French, 2006), or as demonstrated by Ghysels (1998), Jostova and Philipov (2005), and Lewellen and Nagel (2006), they do not necessarily specify beta better than simple linear models unless the true process is known. Therefore, following Fama and French (1992, 1993), we estimate betas in the presence of the well-known empirical factors; size, value/growth, and momentum. Second, we use rolling windows of 60 monthly observations and update the beta herd measure in (19) and its confidence interval as shown in Theorem 1. In this way, we can investigate whether the degree of herding has changed significantly over time. We could also, of course, select particular sample periods of interest and then compare the measures using their confidence levels in order to test significance between these periods, but prefer to observe the dynamic evolution of this behavioral bias as the correspondence with market events is more easily observed. Finally, with the least squares estimates of the betas, we can investigate how estimation error affects the herd measure. The state space model, used by Ang and Chen (2007), which is estimated with the Markov Chain Monte Carlo Gibbs sampling method, is not easily applied for evaluating how estimation error affects the herd measure, and the cost of calculating tens of thousands of stocks using the method would be prohibitively high. Moreover, the dynamics of the conditional beta are similar to those of the unconditional beta calculated with 60 monthly observations: see Ang and Chen (2007) for example. The beta estimates suffer various problems. Estimated betas of illiquid assets are likely to be biased due to nonsynchronous trading (Fisher, 1966; and Scholes and Williams, 1977). When prices do not reflect investors expectations due to illiquidity, our measure, which is calculated using observed returns, may not fully reflect what it was designed to show, in particular, during market crises when liquidity dries up quickly. In order to avoid these unwanted effects and extreme returns associated with microstructure biases and thin trading, we apply several filters as follows. Popular filters, which are widely used in the literature, are to include stocks whose prices are higher than $1 (non-penny stocks) at the estimation point and whose past 60 monthly observations are available. We also impose a few direct restrictions to remove a small number of stocks that are extremely illiquid or volatile: we omit stocks whose turnovers (trading volume divided by shares outstanding) belong to the bottom 1% or whose volatilities (standard deviations of returns) are excessively volatile or little volatility at all (top and bottom 1%) during the past 60 months. For portfolios, we use Fama-French 25 and 100 value weighted portfolios formed on 10

size and book-to-market and 46 industry portfolios (3 finance industry portfolios are excluded) from Kenneth Frenchs data library. An application of our herd measure to portfolios provides a several insights, both in terms of methodology and implications. First, we can minimize the estimation error in beta (i.e., the CAEE), and thus the beta-based and standardized herd measures should become similar for portfolios. Second, herding may show different patterns depending on how portfolios are formed. We expect herding to be more volatile in industry portfolios than the portfolios formed on size and book-to-market, as the performance of industry portfolios varies significantly due to the events that are directly related to certain industries (e.g., oil shocks or financial crises). Third, herding in portfolios may not be necessarily the same as herding in individual stocks because the idiosyncratic element of individual stocks is not expected to be significant in a portfolio. In addition, herding in portfolios might be influenced by changes in the cross-correlation of !"# s as shown in (12). The procedure by which we calculate the herd measure is as follows. We use the ! ! initial 60 observations to obtain OLS estimates of betas and the statistics of !" ! using Newey-West heterskedasticity consistent standard errors for each stock (or portfolio) ! ! ! and then calculate ! and its test statistic, where ! = ! ! !" .6 We then add one !!! observation at the end of the sample and drop the first and use the next 60 observations to re-calculate the beta herd measure and its test statistics and so on through the sample. We omit a small number of extreme beta estimates as these few outliers would numerically affect the beta herd measure with disproportionate weight and lead to inaccurate inference. We effectively employ a statistical trimming process where the top and bottom 1% of beta ! ! ! estimates and standardized beta estimates (i. e. , (!" ! )/(!" )) are omitted in our calculation of the beta herd measure. For industry portfolios, we omit industries in which there are less than 5 firms at the time of estimation. We use the monthly data file from the merged Center for Research in Security Prices (CRSP) - Compustat database for common stocks listed on the New York Stock Exchange (NYSE), American Stock Exchange (AMEX), and NASDAQ. Financial stocks (Standard Industrial Classification code from 6000 to 6999) are excluded from our sample. Our sample period consists of 594 monthly observations from January 1962 to June 2011. Using rolling ! windows of 60 months we obtain 534 monthly beta-based beta herd measure (!" ) and standardized beta herd measure (!" ) from January 1967 to June 2011. The number of stocks starts with 216 at January 1967 and increases to 2,486 at June 2011. The maximum number of stocks included is 2,373 at August 2005. For excess market returns the CRSP value weighted market portfolio returns and 1 month treasury bills are used, and Fama-Frenchs size (Small minus Big, SMB), book-to-market (High Minus Low, HML), and momentum (MM) are used. The portfolio returns and factor returns are obtained from Kenneth Frenchs data library. 3.2 Empirical Properties of Beta Herd Measures Table 2 reports some of the basic statistical properties of the beta-based and standardized beta herd measures with and without the control factors (i.e., SMB, HML, and
6

Note that the beta-based and standardized herd measures in equations (17) and (19) are calculated by replacing

1 with as the cross-sectional probability measure (equal weights) is not proportional to the market capitalization and thus [ ] = [ ] 1. Moreover, the CRSP value-weighted market portfolio, which we use as the market portfolio is constructed using all stocks available in the three exchanges, whereas the individual stocks in our study are a subset of the universe.

11

MM). All the beta herd measures are highly non-Gaussian being positively skewed and leptokurtic. Due to this non-normality, Spearman rank correlations are calculated to investigate the relationship between the four measures in Table 2. The beta-based measures from the market model and the four factor model (the first two columns in Table 2) are fairly close to each other; the rank correlation coefficient between the two is 0.95. The beta-based measure is not affected in a meaningful way by the inclusion of these three control variables. However, the final two columns of Table 2 show much more difference between the standardized measures using the market model and the four factor model; the rank correlation coefficient between the two is only 0.42. The high correlation for the beta-based measures and the lower correlation for the standardized measures indicate that the standard errors of the estimated betas are affected significantly by the presence of the additional factors such as HML, SMB, and MM. The last row in Table 2 reports a significant difference between the beta-based and ! standardized beta herd measures; the rank correlations between !" and !" are considerably low. As explained previously, the CAEE in equation (18) could affect the two herd measures differently. We regress the beta-based herd measure on the standardized herd measure with and without the CAEE: ! !" = 0.269 0.006!" + !
! !" = 0.148 + 1.505 + 0.057!" + ! , (!.!"#) (!.!"#) (!.!!") (!.!"#) (!.!"#)

where the numbers in the brackets are the Newey-West heteroskedastic adjusted standard errors, and the CAEE is calculate by taking the cross-sectional average value of the squared ! standard errors of !" s. The adjusted ! value of the regression is -0.001 and 0.95 for the first and second regression equations respectively. The results indicate that the dynamics of ! !" is driven by CAEE and once the CAEE is taken out, a strong positive relationship between the two herd measures emerges. In order to further examine the effects of CAEE on the two herd measures, we regress the measures on the CAEE separately. Table 3 shows that the coefficients on the CAEE are positive and significant for the beta-based measure, and moreover 89% of the beta-based measure is explained by the CAEE. The thin solid and dotted lines at the bottom of Figure 1 clearly indicate that the dynamic of the beta-based beta herd measure is dominated by that of the estimation error. On the other hand, the coefficients for the standardized measures are negative but the adjusted ! value is only 7%. The analysis clearly shows that the beta-based measures are driven by estimation error, and thus we can rely on the standardized measure for the behavioral bias we seek to measure. 3.3 Robustness to Fundamentals Another crucial issue, as discussed at the outset, is whether the dynamics of the measure is in fact explained by the time variation in betas driven by fundamentals. In the previous section, we hypothesized that the cross-sectional variance of the true betas, ! (!"# ), does not change significantly in response to different economic conditions. We test this hypothesis by taking four lagged macroeconomic variables as in Ferson and Harvey (1999) and Petkova and Zhang (2005): 1) one-month Treasury bill rate (! ) (Fama and Schwert, 1977; and Ferson, 1989), 2) the term spread (! , the difference between the US ten year and one year Treasury bond rate) (Campbell, 1987; and Fama and French, 1989), 3) the credit spread (! , the difference between Moody's Aaa and Baa rated corporate bonds) (Keim and Stambaugh, 1986), and 4) the dividend yield (! , the dividend yield of S&P500 index) (Fama and French, 1988, 1989). We also add contemporaneous market returns and market volatility to investigate whether or not our beta herd measure is determined by market 12

conditions. Lagged beta herd measure is inserted as an explanatory variable to control the persistence of the measure. The dividend-price ratio of the S&P500 index is obtained from Robert Shiller's homepage, and the other data are obtained from the Federal Reserve Bank of St. Louis. Market volatility is calculated by summing squared daily returns as in Schwert (1989). The results of the regression for the standardized herd measures are reported in Table 3. First, it is clear that market return does not explain the standardized beta herd measure. Therefore, the impact of sentiment and cross-sectional herding can occur in different market conditions: bull or bear markets. Term spread appears to explain the standardized herd measure depending on models and thus it is not conclusive that the variables matter. Market volatility has positive relationship with the standardized herd measure, suggesting that herding decreases when market volatility increases. We return to this relation later. Overall the explanatory power of the macroeconomic variables is limited, since these variables do not increase the adjusted R-square value. Together with market return and volatility, the four macroeconomic variables contribute less than 1% of the adjusted R-square value to the standardized beta herd measure. The standardized beta herd measure is potentially driven by behavioral biases such as those we have emphasized above. The beta-based beta herd measure also is not well explained by the fundamentals. It decreases with market volatility, but the explanatory power of the volatility is marginal: the adjusted R-square value hardly changes after controlling CAEE and persistence. In order to analyze the effects of the beta herd measure free from the CAEE, market return and volatility, as well as the four lagged macroeconomic variables, we regress the standardized measure on these seven variables and a constant, and then the residuals of the regression are added to the estimate of the constant to obtain an orthogonalized herd measure ! (!" ). Figure 1 demonstrates that the dynamics of the standardized herd measure and the orthogonalized measure move together in most cases confirming usually what we have found numerically above. The dynamics of the standardized beta herd measure is not driven by a small number of stocks whose extremely high or low betas change dramatically. We form decile portfolios based on the standardized betas and plot the dynamics of the betas of these portfolios in Figure 2. Both positive and negative standardized betas move in mirror image, indicating that our results are not driven by subsets of stocks but by the entire beta distribution. To summarize, the dynamics of the cross-sectional dispersion of the betas is not well explained by the variables that have been used in the literature to measure fundamentals and the two market variables, although individual asset returns may be better specified by allowing for these conditional variables. This result could be interpreted as showing that changes in economic conditions increase some betas while decreasing others, leaving the level of cross-sectional dispersion little changed. In the following analysis we report our ! results with !" , as we find that the results with !" are little different from those with !" 3.4 Beta Herding and Economic Events Figure 1 shows the evolution of the beta herd measure over time for the US market, ! noting that a lower value of !" (!" ) indicates higher beta herding. While our results above suggest there is little consistent statistical impact of fundamentals and market conditions on the bias, it seems clear from this graph that the evolution of beta herding does show clear movements at various times which appear to be stimulated by what might be called market events. Given that most of these movements are only weakly statistically related to the specific fundamentals or states of the particular market we have considered, the 13

behavioral forces we measure would respond to more general forces that drive confidence in the market with a separate dynamic to the market itself. With thousands of stocks, the confidence level calculated by equation (21) is small that we observe many significant but small changes in herding activity. Rather than focusing on all of these minor changes in herding, we identify major turning points in herding and connect them to economic events anecdotally, which provides insight into what we might expect from the herd measure. ! There were several periods when !" (!" ) was significantly lower (i.e., the level of herding increased) than other periods: 1) late 1968-1969, 2) 1974-1975 (two years following the first Oil Shock in 1973), 3) 1981-1982 (a few years following the second Oil Shock in 1979), 4) 1985-1987 (a few years before the 1987 Crash), 5) 1996-1998 (bull period before the Russian Crisis in 1998), 6) 1999-2002 (the boom and bust period around 2000), and 6) 2007-2008 (just before the 2008 credit crisis). Among these periods of high herding activity, the market was bullish only in periods 2), 4), 5) and 7), but was bearish in the other high herding periods. For example, the first herding period might be characterized by a bear market after the bubble in 1967 and 1968, and the second period by a bull market recovering from the first Oil Shock. This result is consistent with the weak statistical evidence linking market conditions and herding found in Table 3. In order to investigate whether or not changes in business cycle are linked to the dynamics of herding, we identify seven change points (months) from expansion to recession and from recession to recession respectively since 1962 from the national of Economic Research (NBER). Herd measures are then aligned for the change events and the average values of herd measure are calculated. Figure 3A show that for both cases there is no significant change in herding due to business cycle. We also perform the same procedure for the entire sample period from 1932 (herd measure is calculated with CRSP data as in Figure 4), but the results are the same. Business cycle does not affect the dynamics of herding. However, some economic events appear to change the direction of herding. Six such events are identified and herd measure before and after these events are plotted in Figure 3B. Following the two oil shocks in the 1970s herding began to increase. After the 1979 Oil Shock, the sharp interest rate rise in 1980 increased herding further. Strong herding existed during the early 1980s bear market, which ended in 1982 when interest rates began to fall and the market became bullish. On the other hand, after the two events, i.e., the 1987 Crash and the 1998 Russian Crisis, both of which occurred during high herding periods, herding decreased. Note that both events did not change the direction of the business cycle. For example, the 1987 Crash occurred within the financial market, mainly due to program trading, illiquidity, and market psychology. Likewise the 1998 Russian financial crisis and the following collapse of Long-Term Capital Management was not associated with major changes in the direction of the US economy. Interestingly, beta herding in the US market does not appear to be significantly affected by the Asian Crisis in 1997, despite the sudden jump in market volatility. September the Eleventh in 2001 also had little impact on beta herding. Strong beta herding during the bear period did not seem to be affected by that tragic event. From the end of 2002 the market turned from bear to bull, and the strong herding that existed during the bear market since 2000 began to disappear. There was a dramatic change at the end of the 2000s. Herding began to increase from the end of 2005 and was accelerated by the Quant Meltdown in 2007, which refers to the event that quantitative long/short equity hedge funds experienced unprecedented losses during August 2007. Khandani and Lo (2008) suggest that a coordinated deleveraging of similarly constructed portfolios is to be blamed for the event. The coordination of arbitrageurs would increase market-wide herding as arbitraging trading is seriously limited 14

during these periods. The increased herding suddenly disappeared in the summer of 2008 at the credit crunch crisis. The impact of the credit crisis is unprecedented as the sudden jump of the herd measure has not been observed since the 1960s. How can we interpret these results? The herd measure clearly shows that herding occurs when investors appear to be confident about the outlook of the future stock market. If the direction towards which the market is heading is assured, herding begins to increase, regardless of whether it is a bull or bear market. As claimed earlier in the previous section, it is investors over-confidence or consensus that induces herding. This would also explain how sentiment contributes to beta herding in bull markets. During crises in 1987, 1998, and 2008, however, investors lose confidence in their existing views and begin to focus more on fundamentals, thereby resulting in the disappearance of herding. In this sense, crises are beneficial to the market rather than harmful, although they may create stress for market participants. Our results are not necessarily inconsistent with those of previous studies, but they do explain why many empirical studies on herding in advanced markets have found little concrete evidence of herd behavior.7 However, our evidence does not support the view that herding occurs when financial markets are in stress (or in crisis). Figure 1 clearly shows that it is the estimation error that leads to sharp decreases in the beta-based herd measure. For example, see the sharp drop in the CAEE the crises in 1987, 1998, and 2008. When the estimation error is controlled, herding decreased during these crises. These results can be interpreted as follows. When a market is in crisis, we observe large negative returns in both the market index and the most of individual assets. However, we cannot conclude that there is herding during the crisis, because most betas are positive rather than negative (See Fama and MacBeth, 1973; and Fama and French, 1992). In so far as individual asset returns move following their systematic risks, the market-wide negative returns are rational. Only when individual aset returns move in one direction excessively, thus violating the equilibrium relationship with the market returns, we can call it irrational. In general, in popular linear factor models, we could claim herding arises when the factor loadings of individual assets are systematically biased and thus the equilibrium relationship between individual asset returns and factor returns no longer holds. The fact that the majority of assets show negative returns during a market crisis does not constitute sufficient evidence of herding itself. 3.5 Beta Herding in Portfolios and before 1967 The herd measures with the three portfolios (Fama-French 25 and 100 value weighted portfolios formed on size and book-to-market and 46 industry portfolios) are plotted in Figure 4 for the period from January 1932 to December 2011. The herd measure for non-penny and nonfinancial common stocks is calculated with CRSP monthly data using the same procedure above. All measures move in similar ways. When the individual stocks show high levels of herding, these portfolios also show high levels of herding. The statistical relationship between
7

However, in the South Korean case, Kim and Wei (1999) and Choe, Kho, and Stulz (1999) study herd behavior around the Asian Crisis in 1997 and find some evidence during the Crisis. These studies use the measure developed by Lakonishok, Shleifer, and Vishny (1992), which focuses on a subset of market participants. Therefore, we cannot conclude that their results are inconsistent with ours as our measure considers beta herding in the whole market, rather than a subset of participants. Chang, Cheng and Khorana (2000), using a variant of the method developed by Christie and Huang (1995), suggest the presence of herding in emerging markets such as South Korea and Taiwan, but failed to find such evidence in the US, Hong Kong and Japanese markets. See Bikhchandani and Sharma (2000) for further surveys on herding.

15

these herd measures is always positive and significant. However, the relationship between individual stocks and the 46 industry portfolios is particularly strong: the correlation coefficient is 0.81. However, these two herd measures do not show strong relationship with those of the other two portfolios formed on size and book-to-market: for example, the correlation coefficient between the herd measure of individual stocks and the two portfolios are close to 0.3. The main reason is that forming portfolios based on size or book-to-market induces a loss of information regarding betas of of individual stocks (Roll, 1977; Litzenberger and Ramaswamy, 1979; Ang, Liu, and Schwarz, 2010). Therefore, beta herding calculated with the Fama-French 25 or 100 portfolios may not fully reflect psychological biases. On the other hand, the dynamics of beta herding are far more volatile for the 49 industry portfolios. The herd measure from the industry portfolios is highly volatile. The extreme volatility is driven by a few sectors. For instance, for the time periods 1972-1974, 1982-1985, and 2003-2006, the industry portfolios show adverse herding, mainly due to the fact that Food became far more or less sensitive to the market than other sectors. In general, herding in industry portfolios is weaker and more volatile than in the size and book-to-market sorted portfolios. The patterns prior to 1967 support our previous argument that herding is created by a clear homogeneity of view in the direction in which the market is likely to move. Herding increased in the early 1930s and at the beginning of World War II. In the early 1930s the US economy was obviously in deep trouble and we empirically observe an increase in herding with our measure in 1932. During the relatively bullish market that existed from 1933 to 1936, the market showed high levels of herding recovering from the sharp decline in share prices from 1929 to 1932. The outbreak of the Second World War and the resultant uncertainty, however, brought about adverse herding. However, herding started to increase as the war continued. After the Second World War, herding weakened. At the end of the long bull period from 1947 to 1956, herding increased sharply, in particular in 1954 and 1955 when the annual CRSP value weighted returns rose by 51% and 30% respectively. The strong herding period peaked at 1955 and disappeared quickly as the long bull period ended. The results with portfolios also support the standardized herd measure. Since forming a small number of portfolios for a given number of stocks (or a larger number of stocks in each portfolio) reduces the CAEE, the beta-based herd measure calculated with portfolios is less likely to be affected by estimation error. Therefore, the correlation between the beta-based and standardized herd measures is expected to increase when they are calculated with portfolios. For example, the beta-based and standardized herd measures of the 25 portfolios in Figure 5 move in the same direction, and the rank correlation between them is 0.47 which is much higher than 0.09 in Table 2 we obtain with individual stocks. Our beta herd measure provides an insight into why CAPM does not work, in particular, after 1963, as has been shown in many previous studies such as Fama and MacBeth (1973) and Fama and French (1992, 1993). For CAPM to work, a necessary condition needs to be satisfied; the betas of portfolios should differ sufficiently and significantly from each other. Otherwise, for a given equity premium, the cross-sectional return difference calculated with betas would not show significant difference. Recall that we interpret the level of dispersion in the standardized betas as a measure of herding. Prior to 1963, there was a relatively large dispersion in the standardized betas, but after 1963 the level of dispersion was significantly low: i.e., the average value of the herd measure (from individual stocks) until the end of 1962 is 4.1, whereas the value from January 1963 to the end of our sample period is 2.5.

16

3.6

The Relationship between Market Sentiment and Beta Herding Our model suggests that beta herding increases with sentiment, ceteris paribus, and thus the cross-sectional variance of betas is negatively related to sentiment; see equation (9). We are also concerned with how much market-wide sentiment contributes to beta herding. If beta herding is affected significantly by sentiment, asset prices are seriously biased when sentiment is strong or during bubble periods. In order to answer these questions, based on equation (9), we run the following regression !" = + !" + ! , where !" is a sentiment index. We use our standardized herd measure calculated with individual stocks. 8 For the selection of sentiment index, more than a dozen sentiment measures have been proposed by a number of authors. Although Brown and Cliff (2004) show that direct sentiment measures (based on surveys) are closely related to indirect measures, we use several direct and indirect measures for comparison. The first two sentiment proxies are direct sentiment indices constructed by Investors Intelligence (II) for the period of July 1968 to December 2008, and the American Association of Individual Investors sentiment (AAII) for the period from July 1987 to June 2011. 9 Each week, opinions on future market movements are grouped as bullish, bearish, or neutral, and we use the bull-bear ratio as a proxy of sentiment, as in Brown and Cliff (2004). The third index is a component of the Index of Consumer Sentiment, Michigan University (Michigan). Among the many components we select an index on business conditions for the next 12 months, which reflects investor sentiment in financial markets. For the final index we use the monthly sentiment index by Baker and Wurgler (2006) (BW). BW is an indirect sentiment measure that is extracted from various activities in financial markets and orthogonalized to economic fundamentals, whereas the first three indices, i.e., II, AAII, and Michigan, reflect the sentiment of investors in the stock market and of the general public in the economy, respectively. All these four measures are standardized to examine the impact of these sentiment measures on beta herding. These four sentiment indices are not expected to be identical. The Spearman rank correlation matrix in panel A of Table 4 shows that the three direct sentiment indices are significantly related with each other whereas BW are weakly correlated with the other three and in particular are negatively correlated with II. This difference suggests the importance of selecting proper sentiment measures in empirical studies. Note that BW is constructed from six proxies of sentiment orthogonal to economic fundamentals (macroeconomic indicators), whereas the three direct indices are not orthogonalized to economic fundamentals. As the sentiment in our study (!" or !" in equation (2) represents the proportion of returns that is not explained by fundamentals, BW might better reflect the relationship between sentiment and beta herding in this study, but we report the results for all three sentiment indices for comparison purposes. Panel B of Table 4 shows that the sentiment index is negatively related with the herd measure for AAII, Michigan, and BW: the coefficients on these sentiment indices are negative and significant. Therefore, when these two sentiment measures are high, a high level of herding in the market (or low level of herd measure) is formed to exist. On the other hand, we do not detect a statistical relationship between herding and II. The relationship between
8

We have similar results from the orthogonalized herd measure ( ) and herd measures calculated with the portfolios. These results can be obtained from the authors upon request. 9 By counting the last week's sentiment index in each month, we constructed the monthly sentiment index. Thus, the monthly sentiment index could suffer measurement errors. However because of the nature of the sentiment index, in particular smoothness, the impact should not seriously devalue our results.

17

herding and sentiment in Figure 6 graphically shows that herding increases when sentiment is high except in the case of II. There are some periods in which sentiment and herding move in the same direction. For example, during the period from 1983 to 1984 we expect herd measure to be low as the consequence of increasing sentiment, but the results show that both were high. We could interpret this as meaning that, during this period, !" was much lower (e.g., negative value ! of !" ) than the sentiment level (!" ), and thus ! (!"# ) increased. Finally, the adjusted ! values provide insight into the question of the degree to which sentiment can explain beta herding. The answer depends on the sentiment measures, but on average only approximately 10% of beta herding appears to be explained by market-wide sentiment. Among the four sentiment measures we tested, Michigan has the strongest relationship with beta herding.

Beta Herding and Cross-sectional Asset Returns

It has been well documented that beta does not explain cross-sectional asset returns, e.g., Fama and French (1992, 1993, 1996). If so, is there anything that beta herding tells us about cross-sectional asset returns? Our model so far suggests that the performance of beta could be conditional: beta could matter during adverse herding periods when there is significant difference between large and small betas though it does not unconditionally. Moreover, the performance of firm characteristics that are closely related to betas may also vary depending on beta herding. In this section we investigate the effects of beta herding on cross-sectional asset returns by addressing these questions. 4.1 Cross-sectional Asset Returns Conditional on Beta Herding Our model indicates that the performance of high beta stocks relative to low beta stocks depend on beta herding. When beta herding is strong, cross-sectional asset returns would not differ significantly, since the difference between betas becomes smaller. On the other hand, when beta herding does not exist or adverse beta herding exists, and thus the difference between high and low betas increases, the cross-sectional difference in asset returns would increase. Considering the persistence of beta herding (see Table 3) and our interests in future asset returns, we examine whether or not beta matters in cross-sectional asset returns conditioning on the level of beta herding. Each month we form decile portfolios sorted on standardized betas (i.e., -statistics of ! ! ! estimated betas for individual stocks, (!" ! )/(!" )) with NYSE breakpoints, and then calculate the following months equally weighted return for each of these portfolios, depending on the previous months herding states. Three herding states are calculated from the herd measure, i.e., herding (bottom 30% of herd measure), no herding (middle 40% of herd measure), and adverse herding (top 30% of herd measure). The first row of Panel A of Table 5 confirms that, as in Fama and French (1992, 1993, 1996), beta does not forecast the following months cross-sectional returns unconditionally: high betas are not compensated for by subsequent higher returns. The following three rows also show that beta is not cross-sectionally priced regardless of the herding level. However, the last row of Panel A shows that the returns of high beta portfolios are higher following an adverse herding state than those following a herding state, whereas the returns of low beta portfolios are lower following adverse herding than those following herding states. The average return difference in the high beta portfolio following high and low herding is 1.07% a month but the average return difference in the low beta portfolio following high and low herding is merely 0.09%. 18

We consider three other cases, i.e., OLS beta estimates with the Fama-French three factors with momentum, standardized betas with the market factor, and OLS beta estimates with the market factor. Herd measures are calculated for each of these three cases. The results are summarized in Figure 7. In all four cases we test there is no cross-sectional return difference unconditionally for high and low (standardized) beta portfolios. However, the portfolios formed on standardized betas calculated with the Fama-French three factors and momentum show cross-sectional return difference conditioning on herding level. High beta stocks tend to show higher returns after adverse herding. Portfolios formed on OLS beta estimates neither show significant cross-sectional return difference nor depends on lagged beta-based herd measures. As expected, standardized betas (t-statistic of beta estimate) that provide precision of beta estimate as well as estimate itself is more informative. Standardized betas calculated with Fama-French three factors also perform in a similar way to the four factor model (not reported). In order to test if the cross-sectional return difference between high and low beta portfolios change significantly depending on beta herding, we conduct the following regressions ! ! !"#!,!!! !"#,!!! = ! + ! !" + !"!! , and ! ! !"#!,!!! !"#,!!! = ! + ! !" + ! !" + ! !"#$!! + ! !"#$!! + ! !!"!! + !"!! . Note that we omit excess market return from the right-hand side since the regressand is the ! ! beta-sorted portfolio returns. The high and low beta portfolio returns, !"#!,!!! and !"#,!!! , are obtained by equally weighting the top and bottom 30% of stocks formed on the standardized betas calculated at time with NYSE breakpoints. We set =1, 3, 6, 9, and 12 in order to investigate the explanatory power of beta herding on the beta sorted portfolios over time. For > 1, we follow Jegadeesh and Titman (2001) and construct overlapping ! portfolios in order to increase the power of the tests. For instance, !"#!,!!! is calculated by equally weighting high beta portfolios formed at , + 1, ..., + 1. As in the previous section, we use Baker and Wurgler (2006) orthogonalized sentiment index for !" . Panel B of Table 5 shows that when =3, 6 and 9, the coefficient on the lagged beta herding is significant with or without the sentiment and the control variables. Apparently the forecasting power of beta herding decreases with the forecasting horizon, and beta herding becomes insignificant over 9 months. The disappearance over longer horizons is not surprising since the distinction between standardized beta sorted portfolios becomes less clear as time elapses, owing to changes of betas of individual stocks. Summarizing, beta forecasts cross-sectional returns conditioning on the level of herding, although it does not unconditionally forecast cross-sectional asset returns. The positive coefficients on the herd measure confirm that betas are not priced when investors have confidence in the direction toward which the market is heading. Sentiment does not explain the performance of beta sorted portfolios although it partly contributes to beta herding. In the following we investigate if beta herding explains firm characteristics sorted portfolios. 4.2 Beta Herding and Firm Characteristics Baker and Wurgler (2006) show that market-wide sentiment affects individual assets differently. For firms that are difficult to price, i.e., newer, smaller, volatile, unprofitable, non-dividend paying, and distressed firms, asset returns are affected more profoundly by sentiment. The results of the asymmetry indicate low returns for these firms following high 19

sentiment. Our study proposes another testable explanation: if the firms identified by Baker and Wurgler (2006) have high betas, we could expect to see low returns for these firms during high beta herding. For example, if volatile firms have higher betas, their returns may be lower (higher) than they should be during high (adverse) beta herding periods. The two forces, sentiment and beta herding, predict cross-sectional asset returns in similar ways but the rationales underlying these two differ. The effects of sentiment on subsequent returns can be interpreted as a reversion toward the equilibrium price. Assets that are difficult to price are affected more significantly by sentiment, which reverts back after sentiment disappears. On the other hand, the beta herding-based explanation depends on persistence of betas and beta herding, rather than reversion, as well as the link between beta and firm characteristics. During periods of high herding, high beta stocks have downward-biased betas and so do their returns. The poor performance of high beta stocks would continue for some period after the high herding period depending on the persistence of betas and beta herding, whereas the effects of sentiment on the returns of the firms identified by Baker and Wurgler (2006) depend on the reversion speed. We first investigate which firm characteristics are related to betas. Every month we form the decile portfolios sorted on standardized betas with NYSE breakpoints and then calculate the firm characteristics of these portfolios. Using the CRSP-Compustat merged database for non-penny and nonfinancial stocks listed on the NYSE, AMEX, and NASDAQ markets, we calculate the firm characteristics as in Baker and Wurgler (2006): Size (ME, price times shares outstanding), Book-to-Market (BE/ME, shareholders equity plus balance sheet deferred taxes, divided by ME), Sales Growth (the change in net sales divided by prior-year net sales), External Finance (the change in total assets minus the change in retained earnings, divided by total assets), Dividend (dividends per share at the ex-date times shares outstanding divided by BE),10 Profitability (income before extraordinary items plus income statement deferred taxes minus preferred dividends, divided by BE), and Total Risk (the standard deviation of at least nine monthly returns over 12 months). These firm characteristics are calculated at the end of June using accounting data for fiscal year-ends in the previous year as in Fama and French (1992), and then assumed to remain the same from July to June of the following year.11 We report the median values of firm characteristics for each decile portfolio to minimize undesirable effects from a small number of extreme firm characteristics within the portfolio.12 Table 6 shows that the majority of firm characteristics are strongly related to the standardized betas. Statistical evidence of the cross-sectional relationship is reported in the last two columns of the table. Each month we run a cross-sectional regression of the firm characteristics of the decile portfolios on their standardized betas, and report the average coefficient and its standard error over the period from January 1967 to June 2011. All firm characteristics show significant relationships with the standardized betas. Note that the standardized betas increase with betas in the second row, suggesting that the information contained in betas is not likely to be undermined by the standardization when the portfolios are formed. High (standardized) beta stocks are volatile and less likely to pay dividends. They are
10 11

We omit a small number of stocks whose dividends exceed 200% of their BE values. Some of the firm characteristics in Baker and Wurgler (2006) are omitted. For example, age, is not used since we use stocks that have at least 5 years of history in order to calculate the betas. 12 We also calculated the average firm characteristics, which do not differ significantly from those reported in Table 6. For robustness, we repeat similar tests by first forming decile portfolios on each of the firm characteristics and then calculating the standardized betas of these decile portfolios. The results do not differ from those in Table 6.

20

also more likely to rely on external finance, have less tangible assets, and show high sales growth. However, they are neither small nor distressed (i.e., high book-to-market). Contrary to the results of Fama and French (1992) who demonstrate that high beta stocks tend to be smaller than low beta stocks, the results in Table 6 show that high beta stocks are larger than low beta stocks. This discrepancy can be explained by two distinct differences in the calculation of betas. First, in this study we calculate betas in the presence of SML, HML, and MM. Therefore our betas are less likely to be related to size or distress. Second, by comparing the sizes of the decile portfolios formed on estimated betas (not reported) and standardized betas, we find that when the estimated betas are high, their standard errors are also high such that the standardized betas tend to be smaller. In order to investigate whether or not the cross-sectional asset returns formed on the firm characteristics depend on the level of beta herding, we run the following time series regression of high minus low portfolio returns (!"#!,!!! !"#,!!! ) formed on the firm characteristics on the lagged beta herd measure and sentiment: !"#!,!!! !"#,!!! = ! + ! !" + ! !" + ! !"!! +! !"#$!! + ! !"#$!! + ! !!"!! + !"!! , where is set to 1, 6, and 12. The high and low portfolio returns are obtained by equally weighting the top and bottom 30% of stocks formed on firm characteristics with NYSE breakpoints except for Dividends and Profitability where we use dividends paying/nonpaying firms and positive/negative earnings firms, respectively. We also use excess market return, SMB, HML, and MM as control variables. The hedge portfolio return, !"#!,!!! !"#,!!! , is the return at time + for the hedge portfolio formed with available accounting data at the end of June using accounting data for fiscal year-ends in the previous year.13 Following Baker and Wurgler (2006), we also test !"#!,!!! !"##$%,!!! and !"##$%,!!! !"#,!!! for firm characteristics, where !"##$%,!!! represents the equally weighted return of a portfolio with the middle 40% of stocks at + . In the first two columns of Table 7, the average returns of the hedge portfolios and their standard errors are reported. The next two columns report coefficients on sentiment and herd measure in the presence of the four control variables. Small, highly volatile, value firms show higher future returns whereas profitable, dividend paying, growing, and external financing firms tend to underperform in the future. The majority of coefficients on the BW sentiment measure are similar to those reported by Baker and Wurgler (2006). In many cases the coefficients on sentiment are still significant when = 12. The reversion process does indeed take a long time, i.e., 1 year or possibly longer. Considering the difference in the sample period and in the frequency of the sentiment index we use in this study (monthly rather than annual), we conclude that our results are not different from those of Baker and Wurgler (2006). Our principal question in this exercise is whether or not beta herding can predict the performance of portfolios sorted on the firm characteristics. The effects of herding on these hedge portfolios are rather weak compared with sentiment. Although the relationship between beta and the firm characteristics are strong (Table 6), beta herding hardly predicts the performance of these firm characteristics-sorted portfolios only for a few cases; i.e., Tangibility. For Tangibility where beta herding matters, firms with a higher proportion of tangible assets tend to perform better than firms with a lower proportion during adverse beta herding periods. Summarizing, there is little evidence that beta herding affects the performance of
13

We use the CRSP-Compustat merged database for nonfinancial stocks listed on the NYSE, AMEX, and NASDAQ markets. The stocks whose prices at the end of the previous year are less than $1 are omitted.

21

portfolios formed on firm characteristics. Beta herding has limits in cross-sectional returns as it could affect these portfolios only via link between beta and firm characteristics. As many studies including Fama and French (1992, 1993) show evidence that firm characteristics matter rather beta in cross-sectional asset returns, the performance association between beta and firm characteristics would be weak. The empirical results in Tables 5 and 7 suggest that beta herding matters for beta sorted portfolios and sentiment matters for other characteristics sorted portfolio.

Conclusions

Herding is widely believed to be a critical element of behavior in financial markets, particularly when the market is in stress. However, the majority of herd measures proposed in the literature do not differentiate irrational herding behavior from a rational reaction to changes in fundamentals. In this study, we have proposed a new measure of irrational herding by focusing on changes in systematic risk which are not explained by fundamentals, and have interpreted significant changes in the dynamics of the measure as the results of investors irrational herding behavior. Beta herding, we propose, measures market-wide cross-sectional dispersion in betas. When high betas are downward-biased and low betas are upward-biased, asset returns are likely to follow market movements, rather than those suggested by the equilibrium betas. The existence of beta herding indicates that individual assets are mispriced, when equilibrium beliefs are suppressed. Our measure captures the impact of herding on asset prices rather than herding by individuals or a small group of investors, and thus is different from herd measures proposed by Lakonishok, Shleifer, and Vishny (1992) or Wermers (1999). We have applied our measure to the US stock market and found that beta herding disappeared during crises such as the 1987 Crash, the 1998 Russian Crisis, and the 2008 Credit Crunch Crisis. Contrary to a common belief that beta herding is significant when the market is under pressure, we find that beta herding becomes more apparent when investors feel confident regarding the future direction of the market. Once a crisis appears, beta herding weakens substantially as a concern for fundamentals takes over. This is consistent with our underlying assumption regarding herding. That is, herding occurs when investors expectations on the market are more homogeneous. When the direction toward which the market is heading is clear regardless of whether it is a bull or a bear market, investors become too optimistic/pessimistic by the prospects, rather than follow the equilibrium relationship between individual asset returns and market returns. Beta herding calculated with Fama-French size and book-to-market portfolios and industry portfolios confirms the main findings we obtained with individual stocks. We have also explained how sentiment affects beta herding. In our model beta herding activity increases with market-wide sentiment. When market-wide positive sentiment exists, such as the late 1990s dot-com bubble, individual asset returns tend to increase regardless of their fundamentals, thus increasing beta herding. Our empirical results confirm the positive relationship between sentiment and beta herding, but sentiment explains only 10% of beta herding. One important question would be whether or not beta herding predicts cross-sectional asset returns. Fama and French (1992, 1993, 1996) show that beta is not priced, and hence beta herding may not matter in cross-sectional asset pricing. However, we have found beta matters conditionally: high beta stocks are priced higher than low beta stocks after adverse beta herding. We have also tested whether or not beta herding predicts the performance of the portfolios formed on the firm characteristics that are closely related to the betas. We found 22

limited evidence that beta herding predicts the performance of a few firm characteristics-sorted. Therefore, beta herding and sentiment play different roles in explaining cross-sectional asset returns: sentiment does not explain beta sorted portfolio returns despite its negative association with beta herding. Clearly our empirical work has just scratched the surface of the potential applications of the approach we have developed here, and more detailed analyses of herding attractors in different phases of market development now seem possible. Our study has applied the new herding measures to the market as a whole. However, this approach can also be applied to the sector (industry) or regional levels and different herding behavior may well be found in different sectors such as IT or old economy stocks or on a geographical basis.

23

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25

Appendix
Proof of Theorem 1
! ! ! With the assumption of !"# ~(!"# , !!"# ) and observations, we obtain the following non-central distribution with the degrees of freedom 1;
! !!"# !!

! !!

~ 1; !"# ,

(8)

! ! where !"# is a non-centrality parameter, i.e., !"# = (!"# 1)/!!"# . Let !"# ! ! (!"# 1)/!!"# , and thus !"# ~ !"# , 1 . Let !" = !!" !!" . !"# ! . Then with the classical OLS assumption, for a large 1, !" ~ , !" , !" where = !!" !!" . !"# ! , and !" is covariance matrix of !" . !" In general, we may not assume that the matrix !" is fully ranked, since a large number of equities could mean 1 < , suggesting the () variance-covariance matrix !" being singular. Let = ! !" , where is the ( ) matrix of the eigenvectors of the symmetric matrix of !" , i.e., !" = ! and is the () diagonal matrix of the eigenvalues. Note that the eigenvalues are sorted in descending order and the eigenvectors are also sorted in accordance to the sorted eigenvalues. Then using ! = and () = ! (!" ) = ! !" ! ! ! () = ! !" ! !" !" !" = ! !" = , ! we have ~(!" , ), where ! = ! . When the rank () of the matrix is less than !" !" , i.e., , the first variables in the vector are normally distributed, ! ! ! ~(!"# , ! ), where ! is the th variable of , !"# is the th element of vector ! , !" and ! is the th eigenvalue of the diagonal matrix . On the other hand, the remaining variables of ! , = + 1, . . . , , are just constants since ! = 0 for = + 1, . . . , . Thus we have ! !" !" = ()! = ! ! = ! ! = ! !! + ! !!! !!!!! ! . ! Since ! ~(!"# , ! ) is independent (orthogonal) of ! for all for , , the first component is ! ! ! ! !!! ! ~ (; ! ), ! ! ! where ! is the non-centrality parameter, i.e., ! = ! (!"# )! /! . The second !!! ! ! ! ! ! component is a constant, i.e., !!!!! ! = !!!!! (!"# ) . Thus ! ! !" !" ~ ! (; ! ) + . Therefore, our herd measure follows ! ! !" = ! !" !" ! ~ ! ! (; ! ) + . .
!

!"#

!!

!! !!

26