Abstract
Executive Summary. Researchers have extensively debatedthe relevance of idiosyncratic risk in determiningasset returns. Merton (1987) suggests that investorswould consider idiosyncratic risk relevant when there isincomplete information for fully diversifying their portfolios.REITs possess characteristics of information opacityand represent a unique case for testing Merton's hypothesis.Using firm-level data of equity real estateinvestment trusts (EREITs), we find a significant positiverelation between idiosyncratic volatility and expectedEREIT returns. The positive relation persists evenafter controlling for firm characteristics and variablesthat are typically related to idiosyncratic volatility. Theresult supports the hypothesis of Merton and implies thatsome segments of the REIT industry might be informationallyinefficient. When we exclude small, low-priced,and illiquid EREITs from the sample, the relation betweenidiosyncratic volatility and expected EREIT returnsbecomes insignificant. The findings may have significantimplications for investing in REITs.
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