Which Investors Matter for Equity Valuations and Expected Returns?

Abstract

We develop a new framework to quantitatively trace the connection between valuations, expected returns, and characteristics back to the demands of institutional investors and households. The portfolio tilts of investors along environmental, social, and governance (ESG) measures, as well as traditional risk and expected return char- acteristics, have a large impact on asset prices because of inelastic demand. We first show that a small set of characteristics explains more than half of the cross-sectional variation in valuation ratios. Using investor-level portfolio holdings data, we estimate asset demand as a function of these characteristics and quantify how the heterogeneity in portfolio tilts across investors is reflected in the cross section of valuation ratios. We find that hedge funds and small-active investment advisors are the most influential per dollar of assets under management because of their active strategies. Long-term investors, such as pension funds and insurance companies, and passive investment ad- visors are the least influential because of their more passive strategies. Compared with US investors, foreign investors tilt toward greener firms and are important for the pricing of environmental scores. Small-active investment advisors tilt toward less entrenched firms and are important for the pricing of governance scores.