Investor Heterogeneity and Factor Pricing

Abstract

This paper shows that institutional ownership plays an important role in the pricing of a broad set of factors. Characteristic (macro-related) factors earn a significantly smaller (larger) risk premium by 64 (54) basis points per month within stocks held by institutions compared to those held by retail investors. This empirical evidence suggests that the "flat" risk premium puzzle documented in the existing literature can be partly attributed to the tug-of-war between institutional and retail investors. Among institutional investors, investment companies and advisors, especially those excluding mutual funds and predominantly comprising hedge funds, contribute the most to these findings. Institutional investors, being relatively more rational, demand a premium for bearing systematic risks. Thus, the findings indicate that macro-related factors are proxies for fundamental risks, whereas characteristic factors are proxies for mispricing.

Keywords: Factor Pricing, Institutions, Investor Heterogeneity