Idiosyncratic Risk and Expected Returns of Equity Real Estate Investment Trusts
Sun, Qian, Yung, Kenneth, Journal of Real Estate Portfolio Management
Executive Summary. Researchers have extensively debated the relevance of idiosyncratic risk in determining asset returns. Merton (1987) suggests that investors would consider idiosyncratic risk relevant when there is incomplete information for fully diversifying their portfolios. REITs possess characteristics of information opacity and represent a unique case for testing Merton's hypothesis. Using firm-level data of equity real estate investment trusts (EREITs), we find a significant positive relation between idiosyncratic volatility and expected EREIT returns. The positive relation persists even after controlling for firm characteristics and variables that are typically related to idiosyncratic volatility. The result supports the hypothesis of Merton and implies that some segments of the REIT industry might be informationally inefficient. When we exclude small, low-priced, and illiquid EREITs from the sample, the relation between idiosyncratic volatility and expected EREIT returns becomes insignificant. The findings may have significant implications for investing in REITs.
Conventional asset pricing models posit that only the systematic risk of an asset is compensated in its expected return whereas the idiosyncratic risk is irrelevant because it can be diversified away. However, the studies by Basu (1977), Banz (1981), Jegadeesh (1990), and Fama and French (1992) suggest that cross-sectional differences in average returns are determined not only by the market risk, but also by idiosyncratic firm factors such as market capitalization, book-to-market, and prior return. Despite the fact that Fama-French (1993, 1996) show that the impact of security characteristics on expected returns can be explained within a risk-based multifactor model, the risk-return controversy lingers among researchers.
The assumption of a diversified portfolio in conventional asset pricing models has been challenged by a number of researchers. Levy (1978) shows that idiosyncratic risk affects equilibrium asset prices if investors hold a limited number of assets in their portfolio. Merton (1987) hypothesizes that investors will be concerned about total risk if they cannot invest in the market portfolio. There is empirical evidence that investors, despite their keen concern to diversify, tend to hold insufficiently diversified portfolios in order to limit transaction costs (Barber and Odean, 2000; Benartzi and Thaler, 2001; and Barberis and Thaler, 2003). While systematic risk is important to holders of diversified portfolios, idiosyncratic risk is also relevant for incompletely diversified investors.
The importance of idiosyncratic risk in explaining cross-sectional stock returns and the time-series predictability of returns is examined in a number of recent studies. Campell, Lettau, Malkiel, and Xu (2001) document that idiosyncratic risk has increased in U.S. stock returns in recent decades. Dennis and Strickland (2004) also show that idiosyncratic volatility has increased over the past 20 years and that firm-specific idiosyncratic volatility is positively related to institutional ownership and leverage. Both studies suggest that idiosyncratic risk is likely to be increasingly important to investors in recent periods.
Opposite views have been expressed regarding the impact of idiosyncratic risk on stock returns. Malkiel and Xu (1997) find empirical evidence that portfolios with higher idiosyncratic risk have higher average returns. More recently, Malkiel and Xu (2002) find a significantly positive relation between idiosyncratic risk and the cross-section of expected returns at the firm level. Spiegel and Wang (2005) find that expected stock returns are increasing with the level of idiosyncratic risk and decreasing in a stock's liquidity. In contrast, Ang, Hodrick, Xing, and Zhang (2006) examine the impact of idiosyncratic risk on cross-sectional U.S. stock returns and find a strong negative relation between idiosyncratic risk and average returns. …