Investor Betas *

Abstract

We provide novel evidence that asset prices reflect covariance risk when betas are measured against institutional investor portfolios. Leveraging the insights of Markowitz (1952), we propose a simple model of holding constrained investors that generates the following prediction: an asset's expected return is linear in its beta with respect to each investor's portfolio return, averaged across institutions that hold the asset. Empirically, a unit increase in this "investor beta" measure commands 5-8% greater annual expected returns in equity markets with a cross-sectional R 2 of approximately 80-90% in test portfolios. We observe a similar investor beta-returns relationship in the bond market where the return increase per unit of investor beta risk is over 100bps. Betas measured from the perspective of otherwise similar institutions that choose not to hold a particular asset are uncorrelated with returns. Based on our results, we calculate that lack of diversification can explain 20-30% of the equity risk premium.

Keywords: CAPM, risk, return, idiosyncratic, portfolio, active, investor

JEL Classification: G11, G12