Investor heterogeneity and the cross-sectional stock returns in China

We examine the relationship between divergence of opinion and the cross-sectional stock returns in Chinese A share market where short-selling of stocks is prohibited by law. Using a proxy for divergence of opinion among the entire investor base, we document a positive relationship between divergent beliefs and future stock returns. This is in sharp contrast to Miller's (1977) prediction of a negative relationship between the two. The result is likely to be driven by the dominance of individual investors and their speculative trading behaviors in China. Miller's prediction is confirmed when divergence of opinion is measured using data on mutual fund holdings. Our results are robust to a number of common return predictors. We also find a significantly negative relationship between the fraction of tradable shares in listed Chinese companies and future stock returns. Increase in the fraction of tradable shares tends to reduce the predictability of stock returns using divergence of opinion.