Institutional Skewness Preferences and the Idiosyncratic Skewness Premium∗

This study examines whether idiosyncratic skewness preferences of institutional investors influence stock returns. On aggregate, institutions exhibit an aversion for idiosyncratic skewness but prefer systematic skewness, and in the cross-section, larger (smaller) and more (less) diversified institutions exhibit stronger (weaker) aversion for idiosyncratic skewness. The aggregate institutional preferences generate an annual, risk-adjusted idiosyncratic skewness premium of 3.17%. However, in the cross-section, the premium is strongly negative (positive) when institutional ownership is lower (higher). These pricing effects are further amplified when arbitrage costs are higher. Idiosyncratic skewness preferences of institutions are partially reflected in the size factor (SMB). A factor which captures those preferences can explain about 14% of the variation in SMB. Collectively, the evidence indicates that institutional idiosyncratic skewness preferences get impounded into stock prices. IN AN ECONOMY WHERE INVESTORS HOLD CONCAVE PREFERENCES and like positive skewness (e.g., Arditti (1967), Kane (1982)), everything else equal, stocks that decrease the skewness of a portfolio earn higher expected returns (e.g., Kraus and Litzenberger (1976), Lim (1989)). In this economy, idiosyncratic skewness is irrelevant at the margin and is unlikely to influence expected stock returns. Consistent with these theoretical predictions, Harvey and Siddique (2000) find that stocks with lower systematic skewness (i.e., coskewness) outperform stocks with higher coskewness by about 3.60% per year. In other words, a positive and economically significant coskewness premium exists. This evidence suggests that marginal, price-setting investors prefer stocks with higher coskewness and their preferences get impounded into stock prices. Following Harvey and Siddique (2000), I decompose total skewness into systematic and idiosyncratic components. Idiosyncratic skewness of a stock is defined as the skewness of the residual from a regression where the excess (over the riskfree rate) stock returns are regressed on excess market returns and squared excess market returns. The systematic skewness (or coskewness) is the coefficient estimate of the squared excess market return variable. See Harvey and Siddique (2000) for other related coskewness measures.