Which Investors Matter for Equity Valuations and Expected Returns

Much work in finance is devoted to identifying characteristics of firms, such as measures of fundamentals and beliefs, that explain differences in asset prices and expected returns. We develop a framework to quantitatively trace the connection between valuations, expected returns, and characteristics back to institutional investors and households. We use it to analyze (i) what information is important to investors in forming their demand beyond prices and (ii) what is the relative importance of different investors—differentiated by type, size, and active share—in the price formation process. We first show that a small set of characteristics explains the majority of variation in a panel of firm-level valuation ratios across countries. We then estimate an asset demand system using investor-level holdings data, allowing for flexible substitution patterns within and across countries. We find that hedge funds and small, active investment advisors are most influential per dollar of assets under management, while long-term investors, such as pension funds and insurance companies are least influential. In terms of pricing characteristics, small, active investment advisors are most important for the pricing of payout policy, cash flows, and the fraction of sales sold abroad. Large, passive investment advisors are most influential in pricing the Lerner index, a measure of markups, and hedge funds for the CAPM beta.