Capital Share Risk and Shareholder Heterogeneity in U.S. Stock Pricing

Value and momentum portfolios exhibit strong opposite signed exposure to an aggregate risk factor based on low frequency fluctuations in the capital share. This strong opposite signed exposure helps explain why both strategies earn high average returns yet are negatively correlated. But the finding is puzzling from the perspective of canonical asset pricing theories. We show that opposite signed exposure to capital share risk coincides with opposite signed exposure of value and momentum to the income shares of households in the top 10 versus bottom 90 percent of the stock wealth distribution. We use a model of shareholder heterogeneity to explain why the capital share is likely to be an important cross-sectional risk factor, and show how the result can be explained if investors located in different percentiles of the wealth distribution exhibit a central tendency to pursue different investment strategies. Models with capital share risk explain up to 85% of the variation in average returns on size-book/market portfolios and up to 95% of momentum returns and the pricing errors on both sets of portfolios are lower than those of the Fama-French three- and four-factor models, the intermediary SDF model of Adrian, Etula, and Muir (2014), and models based on low frequency exposure to aggregate consumption risk. In a horse race where long-horizon capital share betas are included alongside betas for these other factors, the capital share beta remains strongly significant while the others are driven out.