29 Pages Posted: 28 Jan 2021
Date Written: November 1, 2020
Investors’ return on their portfolios, as proxied by the market, is a theoretically appealing but empirically unsuccessful asset pricing factor. In practice, many institutional investors choose to deviate substantially from the market portfolio. We propose a simple model in the spirit of Merton (1987) which implies that an asset’s expected return is linear in its average idiosyncratic beta with respect to each active investor’s portfolio return. We estimate this relation using 13F holdings data for active investors and find that a unit increase in investor betas commands 5-10% greater annual expected return. The results are robust to alternative ways of estimating betas and using daily or monthly returns. In sum, investors appear to be compensated for holding stocks that have a high covariance with the idiosyncratic component of their portfolio.
Keywords: CAPM, risk, return, idiosyncratic, portfolio, active investor
JEL Classification: G11, G12
Suggested Citation: Suggested Citation