Abstract
Merton (1987) shows that stocks that not all investors are informed about should yield a return premium. This premium depends on the shadow cost of incomplete information which in turn is composed of the shareholder base, relative market size and idiosyncratic risk. Utilizing a comprehensive database of investor shareholdings, we demonstrate that stock returns are positively related to the shadow cost. Also in line with Merton, we find that the shareholder base is negatively related to returns when controlling for size and idiosyncratic risk. Zero-cost portfolios based on the shadow cost / shareholder base yield substantial trading profits which are either uncorrelated or have negative correlation with the market and are only modestly explained by the four factor model.
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