Investor heterogeneity and the cross-sectional stock returns in China

• Utilize a unique feature of no-short-selling in China to validate Miller's theory.
• A new measure of divergence of opinion for the entire investor population.
• A positive relationship between stock returns and divergence of opinion.
• The relationship is negative when divergence is measured by mutual fund holdings.
• Information disadvantage of individual investors seems to contribute to our findings.

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.