Back to the Beginning: Does Investor Diversification Affect the Firm's Cost of Equity?

Abstract

We test whether the diversification of marginal investor affects the underlying firm’s cost of equity. We use institutional investor holdings data to identify the marginal investor. Compared with individual investors, institutional investors are more likely to be the marginal investor, given their trading size and sophistication. We measure institutional investor diversification as the goodness of fit of a benchmark asset pricing model with respect to the investor portfolio returns. We find that firms with less diversified investors have a higher cost of equity and lower real investment. A zero-cost equity portfolio sorted by institutional diversification generates a Carhart alpha of 0.52% (equally-weighted) or 0.73% (value-weighted) per month during the period 1981-2013. These findings are not driven by firm size, idiosyncratic volatility, institutional ownership, liquidity, investor stock selectivity, or behavioral biases. Collective evidence leans toward the market incompleteness explanation (Merton, 1987).