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THE JOURNAL OF FINANCE VOL. LXVIII, NO.

1 FEBRUARY 2013

Industry-Specic Human Capital, Idiosyncratic Risk, and the Cross-Section of Expected Stock Returns
ESTHER EILING ABSTRACT
Human capital is one of the largest assets in the economy and in theory may play an important role for asset pricing. Human capital is heterogeneous across investors. One source of heterogeneity is industry afliation. I show that the cross-section of expected stock returns is primarily affected by industry-level rather than aggregate labor income risk. Furthermore, when human capital is excluded from the asset pricing model, the resulting idiosyncratic risk may appear to be priced. I nd that the premium for idiosyncratic risk documented by several empirical studies depends on the covariance between stock and human capital returns.

ACCORDING TO TRADITIONAL ASSET pricing theory, investors choose their optimal portfolios by maximizing the expected utility of their lifetime consumption. In addition to investments in tradable assets such as stocks and bonds, part of their wealth is typically tied up in nontradable assets. A nontradable asset that forms a signicant fraction of wealth for virtually all investors is human capital. Heaton and Lucas (2000) report that about 48% of household wealth is due to human capital, while only 6.8% is invested in nancial assets. Lustig, van Nieuwerburgh, and Verdelhan (2010) even estimate human capital to be 90% of total wealth, while the share of equities is only 2%. This suggests that, in theory, human capital should matter for portfolio choice and asset pricing.

Eiling is with the Rotman School of Management, University of Toronto. I would like to thank the Editor (Campbell Harvey), the Associate Editor, and an anonymous referee for insightful comments and suggestions. I am also grateful to Bruno Gerard, Frans de Roon, and Raymond Kan for many comments and discussions. Furthermore, I thank Lieven Baele, Olesya Grishchenko, Ravi Jagannathan, Frank de Jong, Ralph Koijen, Francis Longstaff, Hanno Lustig, Stijn van Nieuwerburgh, Theo Nijman, Tim Simin, Walter Torous, Kevin Wang, and participants at the 2009 American Finance Association meetings, the 2008 European Finance Association meetings, the 2008 Northern Finance Association meetings, the UCLA Anderson School, Tilburg University, Amsterdam University, the Stockholm School of Economics, HEC Paris, HEC Lausanne, Erasmus University, the University of Rochester, the University of WisconsinMadison, Rice University, Georgetown University, Rutgers University, the University of Toronto, the Free University of Amsterdam, and York University for helpful suggestions. I gratefully acknowledge the Award for Best Business Valuation Research Paper at the 2008 NFA meetings. Support for this research has been provided by a grant from the Netherlands Organization for Scientic Research (NWO). An earlier version of this paper was titled Can Nontradable Assets Explain the Apparent Premium for Idiosyncratic Risk? The Case of IndustrySpecic Human Capital.

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Various empirical studies document a relationship between human capital or labor income and equity returns (e.g., Shiller (1995), Campbell (1996), Palacios-Huerta (2003), Lustig and van Nieuwerburgh (2008)).1 Consequently, due to their nontradable human capital, investors are already endowed with certain exposures to stock returns. To achieve their desired exposures, investors may need to adjust their portfolio decisions. The nature of human capital is investor-specic and depends on, for example, age, education, occupation, or the industry or rm in which the investor works. Heterogeneity in human capital may induce different hedging demands for stocks across investors, due for instance to different levels of labor income risk or differences in correlations between human capital and equity returns. The effect of human capital heterogeneity on portfolio decisions is studied by Davis and Willen (2000b), who analyze optimal portfolios for workers with different occupations. Empirical asset pricing papers, however, focus on proxies for aggregate human capital to explain the cross-section of expected stock returns (e.g., Jagannathan and Wang (1996), Campbell (1996)). This paper shows that human capital heterogeneity affects the cross-section of expected stock returns. I focus on industry-specic human capital.2 In the labor economics literature, several papers document the existence of signicant inter-industry wage differentials (e.g., Katz and Summers (1989), Neal (1995), and Weinberg (2001)), suggesting that labor income and human capital are determined in part by industry afliation. I estimate industry-specic human capital returns as the contemporaneous growth rate in industry-level labor income. Based on a mean-variance framework, I rst show that the portfolio adjustments for human capital are often signicantly different for investors working in different industries. To assess the impact of industry-specic human capital on the cross-section of stock returns, I estimate a linear asset pricing model that includes equity market returns and multiple human capital factors, corresponding to human capital returns from different industries. This specication can be motivated in the context of the Mayers (1972) model. In a single-period mean-variance framework, investors are endowed with positions in nontradable assets. In the resulting nontradable assets model, expected stock returns are affected by their exposures to aggregate nontradable asset returns in addition to returns on the equity market portfolio. Aggregate human capital returns are not observable and a commonly used proxy is the growth rate in aggregate labor income (e.g., Jagannathan and Wang (1996)). However, this measure largely ignores heterogeneity in human capital and assumes that labor income dynamics are the same across industries, with identical growth and discount rates. I relax
1 Lettau and Ludvigson (2001), Julliard (2004), and Santos and Veronesi (2006) show that future equity returns can be predicted using variables that are related to human capital. 2 In addition to industry-level heterogeneity in human capital, there may exist important intraindustry variation due to, for example, the rm or occupation. As explained in the following section, the nontradable assets model that I estimate includes a separate factor for each type of human capital. A natural starting point is to include industry-specic human capital.

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this assumption and include industry-specic labor income growth rates as separate factors in the model. An asset pricing model with industry-specic labor income risk can also be motivated based on the literature on heterogeneous agent models with incomplete risk sharing.3 If industry-level labor income risk can be completely diversied away, only aggregate labor income risk should be priced. However, if investors working in different industries cannot perfectly share their industryspecic labor income risks, industry-level idiosyncratic labor income risk may be priced as well. I estimate the model including labor income growth rates from ve broad industries spanning aggregate labor income: goods producing, manufacturing, distribution, services, and the government. I use the value-weighted index of all stocks traded on the NYSE, Amex, and NASDAQ as a proxy for the tradable market portfolio. The main benchmark model includes only one human capital factor: aggregate labor income growth. This model is also referred to as the human capital Capital Asset Pricing Model (CAPM). I show that industry-specic human capital signicantly impacts the crosssection of returns. When estimating the model for monthly returns on 25 size and book-to-market sorted portfolios, three out of ve human capital industries have signicant coefcients. The model captures 61% of the cross-sectional variation in returns and the null hypothesis that all pricing errors are zero cannot be rejected. In sharp contrast, aggregate labor income growth is not signicantly priced and the human capital CAPM has an ordinary least squares (OLS) adjusted- R2 of only 9%. The pricing errors are signicantly different from zero. Next, I separate industry-idiosyncratic human capital returns from the common component. To this end, I estimate a model that includes aggregate labor income growth and industry-specic labor income growth rates that are orthogonal to the aggregate growth rate. Using this alternative model specication, I nd that the coefcient on aggregate human capital returns is not signicant, while again three out of ve industries are signicantly priced. The above results suggest that what matters for asset pricing are primarily the industry-specic labor income risks that are not shared across investors. This nding is robust to using returns on 100 size-beta sorted portfolios as in Jagannathan and Wang (1996) and to using quarterly returns. Further, I nd that, even when including orthogonalized returns of a single human capital industry, the coefcient on the industry is typically highly signicant and the R2 is often substantially higher than for the model with only aggregate human capital returns. The poor performance of the human capital CAPM seems to contrast with Jagannathan and Wang (1996). An important difference is that they use
3 Several theoretical models show that uninsurable idiosyncratic labor income risk affects asset pricing and helps to (partially) explain the equity premium puzzle when investors face high transaction costs (e.g., Heaton and Lucas (1996)) or when labor income shocks are persistent and their volatility increases in economic downturns (e.g., Mankiw (1986), Constantinides and Dufe (1996)).

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1-month lagged aggregate labor income growth to account for the reporting lag in aggregate labor income data. I focus on contemporaneous growth rates, as investors can observe their own wages in real time. Similar to Heaton and Lucas (2000) and Jagannathan, Kubota, and Takehara (1998), I nd that the pricing of aggregate labor income growth is very sensitive to the 1-month lag. In sharp contrast, industry-specic labor income growth is robust to timing issues. As a result, while the model with industry-specic labor income growth rates outperforms in both cases, the difference between the models is more pronounced when using contemporaneous labor income growth rates. From an economic perspective, this is the most relevant measure. I compare the performance of the model with industry-specic human capital to a number of well-known asset pricing models. I nd that my model has higher OLS and generalized least squares (GLS) R2 s, and lower pricing errors, than the static CAPM (Sharpe (1964), Lintner (1965), and Black (1972)) and the conditional CAPM of Jagannathan and Wang (1996). The Fama and French (1993) three-factor model, including extensions with a momentum fac tor (Carhart (1997)) and a liquidity factor (Pastor and Stambaugh (2003)), explains a larger share of the cross-sectional variation in average returns on the 25 size and book-to-market portfolios. However, for 100 size-beta sorted portfolios, these benchmark models have similar R2 s and pricing errors to the model with industry-specic human capital. In the nal part of the paper, I relate human capital to the apparent premium for idiosyncratic risk (IR henceforth). Various papers provide empirical evidence of a cross-sectional relation between stocks idiosyncratic volatilities and expected returns (e.g., King, Sentana, and Wadhwani (1994), Malkiel and Xu (1997, 2004), Spiegel and Wang (2005), Fu (2009), Ang et al. (2006, 2009)). This creates a puzzle, as true IR should not be priced. Whereas several other explanations for this puzzle have been investigated, the link to human capital has thus far received little attention.4 Papers documenting a premium for IR typically measure IR as the residual variance of the CAPM or the Fama and French (1993) three-factor model. I conrm a positive premium for IR: I nd that portfolios consisting of high IR stocks have higher CAPM and three-factor alphas than those with low IR stocks.5 However, precisely these high IR stocks also have higher exposures
4 Spiegel and Wang (2005) relate IR to liquidity. Baker, Coval, and Stein (2007) use IR as a proxy for differences in opinion. Panousi and Papanikolaou (2012) document a negative relationship between IR and investment. Goyal and Santa Clara (2003), Bali et al. (2005), and Guo and Savickas (2006) examine whether IR can predict market returns. Campbell et al. (2001) and Brandt et al. (2010) examine the time-series properties of IR. 5 Ang et al. (2006, 2009) nd a negative relationship between realized IR (estimated using daily returns over the past month) and future returns. This result is puzzling, as theories such as Merton (1987) predict a positive relation when investors underdiversify. Fu (2009) shows that lagged realized IR is an imprecise measure of expected IR due to its time-varying properties. Using an EGARCH model, he documents a positive relation between expected IR and expected returns, similar to, for example, King, Sentana, and Wadhwani (1994), Malkiel and Xu (1997, 2004), and Spiegel and Wang (2005). This paper also uses an EGARCH model to estimate IR and conrms the positive relationship.

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to (industry-specic) human capital returns. This can be explained as follows. The benchmark models used to estimate systematic risk (i.e., the CAPM or the Fama and French (1993) model) do not include human capital. Hence, systematic risk due to (industry-specic) human capital that is not captured ends up in the error term, which thus appears to be systematically priced. Using the nontradable assets model, I show that the resulting premium for IR depends on the hedging demand induced by nontradable human capital. My empirical results conrm this: the covariance between CAPM idiosyncratic returns and industry-specic human capital returns signicantly affects the cross-section of expected stock returns. Furthermore, the model with aggregate and orthogonalized industry-specic human capital captures 68% of the crosssectional variation in returns on 100 size and IR sorted portfolios. Finally, based on pricing errors of 10 IR sorted portfolios (averaged over all size deciles), I nd that industry-specic human capital explains 10% to 36% of the premium for IR. The remainder of this paper is structured as follows. Section I presents the nontradable assets model. Section II analyzes industry-specic human capital returns and the corresponding hedging portfolios. Section III presents the empirical analysis of the impact of industry-specic human capital on the crosssection of stock returns. In Section IV, I investigate the link with the premium for IR. Section V concludes. An Internet Appendix contains details of the model derivation, labor income data, and auxiliary results.6 I. Asset Pricing with Nontradable Human Capital: A Simple Model This section discusses the theoretical framework that serves as a basis for examining the relation between industry-specic human capital and the crosssection of expected stock returns. In Section IV, I extend this framework to investigate the relation with IR. I treat human capital as a nontraded asset, following, amongst others, Mayers (1972), Bottazzi, Pesenti, and van Wincoop (1996), Baxter and Jermann (1997), and Viceira (2001). While investors may borrow against their future labor income, most would not trade claims against future labor income due to adverse selection and moral hazard problems. This makes human capital essentially nontradable.7 Consider a one-period mean-variance framework with N tradable assets and K nontradable assets, similar to Mayers (1972). It is straightforward to show that an investors demand for tradable assets includes hedging demand induced by her xed positions in the nontradable assets, in addition to the usual speculative demand. Consequently, expected returns on tradable assets (tr )
6 The Internet Appendix for this article is available online in the Supplements and Datasets section at http://www.afajof.org/supplements.asp. 7 Housing and private businesses are two other important nontradable assets that could be included in the model. I focus on human capital only, which forms a nonnegligible fraction of wealth for virtually all investors. Palia, Qi, and Wu (2007) empirically show that, while all three types of nontradable assets impact households stock market participation and stock holdings, human capital dominates.

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are linear in their covariances with the tradable market portfolio tr ,mkt and in their covariances with the returns on nontradable assets tr ,nt .8 The Internet Appendix derives the following pricing equation: tr =
tr ,mkt

tr ,nt qnt ,

(1)

where is the market aggregate risk aversion coefcient and qnt is the K 1 vector of aggregate wealth due to the nontradable assets divided by the total value of tradable assets. I refer to this model as the nontradable assets model. Note that I dene the tradable market portfolio as the value-weighted portfolio of all N tradable assets, and I include the returns on nontradable assets separately in the model. An alternative model specication is based on the return on the total market portfolio including all tradable and nontradable assets. However, this specication is not directly empirically testable, as the returns on the total market portfolio are not observable.9 Since qnt contains the relative values of the nontradable assets, the pricing equation in (1) can be expressed as a two-factor model with returns on the tradable market portfolio and aggregate returns on all nontradable assets as factors. In this paper, I use the model to empirically estimate the impact of nontradable human capital returns from K different industries on expected stock returns. The relative values of industry-specic human capital are not observable and are difcult to estimate. Consequently, aggregating industry-specic human capital returns is challenging. The existing literature sidesteps this problem by directly estimating aggregate human capital returns as the growth rate in aggregate labor income. However, in the next section I argue that this approach is problematic if human capital has different growth and discount rates across industries of employment. To allow for heterogeneity in human capital while avoiding the need to estimate its value, I include human capital returns from different industries in the model separately. The pricing equation can be expressed as a multifactor model including a market beta and K nontradable asset betas:10
K

E[rtr ,i ] = mkt,i
K

E[rmkt ]
k=1

Cov[rmkt , Rnt,k]qnt,k

+
k=1

Var [ Rnt,k]qnt,k , nt,k,i

(2)

8 The tradable market portfolio has weights . The N 1 vector of covariances between tradable asset returns and the market portfolio returns is tr tr ,mkt . The N K matrix with covariances between tradable and nontradable asset returns is denoted by tr ,nt and does not contain any variances. 9 Roll (1977) argues more generally that, unless all assets are included in the market portfolio, its mean-variance efciency is not testable. 10 The nontradable assets model is similar to certain models from the international nance literature; for instance, Errunza and Losq (1985) and De Jong and de Roon (2005). In these partial segmentation models, domestic investors are restricted from investing in foreign assets.

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rtr ,i ,rmkt ] rtr ,i , Rnt,k ] where mkt,i Cov[ and nt,k,i Cov[ . This expression shows Var[rmkt ] Var[ Rnt,k ] that expected excess returns on tradable assets depend on a quasi market risk premium (i.e., the expected excess return on the tradable market portfolio, adjusted for its exposure to nontradable asset returns) and a value-weighted sum of quasi risk premia on nontradable assets. In this single-period framework, the motivation to include industry-specic human capital in the asset pricing model is empirical, as heterogeneity in human capital affects the measurement of human capital returns. An alternative motivation follows from the literature on heterogeneous agent models and the equity risk premium. Various theoretical models show that uninsurable idiosyncratic labor income risk may help to (partially) explain the equity premium puzzle in the presence of trading frictions (e.g., Heaton and Lucas (1996)) or persistent labor income shocks that become more volatile during economic downturns (e.g., Mankiw (1986), Constantinides and Dufe (1996), Storesletten, Telmer, and Yaron (2007)).11 This suggests that, when investors cannot perfectly share labor income risk that is specic to their industry of employment, industry-level idiosyncratic labor income risk may affect asset pricing. To test the pricing of industry idiosyncratic labor income risk more directly, Section III also estimates an alternative model specication that separates the common component in labor income risk from the industry-specic components. The specication includes aggregate labor income growth and industry-level income growth rates that are orthogonalized to the aggregate growth rate.

II. Industry-Specic Human Capital Returns Various papers in the labor economics literature show that industry afliation is a major determinant of human capital (e.g., Krueger and Summers (1988), Katz and Summers (1989), Neal (1995), Parent (2000), Weinberg (2001)). Investors working in various industries may face different amounts of labor income risk, different correlations between their labor income and equity returns, and variation in the relative values of their human capital. Examples of factors that inuence human capital risk include, for instance, transferability of human capital (e.g., possibilities to move to a different sector), the risk that the investors human capital becomes obsolete due to technological developments, or the strength of labor unions. These factors are likely to be industry-dependent. For instance, consider an investor who works in an industry in which human capital is very specialized and not easily
11 The literature on heterogeneous agent models and the equity risk premium is too large to review here. In general, in heterogeneous agent models, agents trade nancial securities to selfinsure against idiosyncratic income shocks. To generate a sizeable equity premium, the models need to incorporate sufcient barriers against self-insurance, that is, high transaction costs or persistent income shocks. Constantinides and Dufe (1996) and Krueger and Lustig (2010) show conditions under which uninsurable idiosyncratic labor income risk does not affect the equity premium.

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transferable to another industry (e.g., an investor working in the investment banking industry). She likely faces higher labor income risk, which results in more adjustments to her stock portfolio to account for her human capital. In Section II.C, I analyze some of the portfolio implications of industry-specic human capital. However, my main focus is on the asset pricing implications. A. Measuring Human Capital Returns Returns on human capital are difcult to estimate since the cash ow component is observed (labor income) but not the discount rate component, which is used to calculate the present value of all future labor income, that is, the value of human capital. To estimate returns on human capital, I follow a similar approach to Jagannathan and Wang (1996).12 The setup is as follows. Assume that the expected rate of return on human capital r is constant and per-worker labor income Lt follows the rst-order autoregressive process Lt = (1 + g) Lt1 + t , (3)

where g is the expected growth rate in labor income and t has a mean of zero and is independently distributed over time. Human capital wealth is Wthc = Lt . rg (4)

Under these assumptions, the return on human capital wealth equals the growth rate in labor income. If human capital has the same discount and growth rates in all industries, the return on aggregate human capital can be calculated as the growth rate in aggregate labor income. However, if discount rates and growth rates vary across industries, total human capital wealth is affected by these differences, which are unobservable. Consequently, aggregate human capital returns can no longer be calculated as aggregate labor income growth. This paper allows for different labor income processes across industries by calculating returns on human capital for each industry as the growth rate in industry-level labor income. The main benchmark is aggregate labor income growth. Jagannathan and Wang (1996) use aggregate labor income with a 1-month lag to take into account the publication delay for aggregate labor income data. However, as Heaton and Lucas (2000) note, investors observe their own labor income at the same time they observe stock returns. Hence, from an economic perspective, the contemporaneous labor income growth rate is a more appropriate measure of human capital returns. Also, the effect of lagged labor income
12 The literature provides several models for estimating returns on aggregate human capital. These models are based on fairly restrictive assumptions, such as a constant human capital discount rate (Shiller (1995), Jagannathan and Wang (1996)) or a perfect correlation between the discount rates on human capital and stock returns (Campbell (1996)). Lustig and van Nieuwerburgh (2008) investigate the extent to which these models can match consumption data and nd that, while all three models fail, the Jagannathan and Wang (1996) measure comes closest.

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growth on stock returns may be confounded by announcement effects of labor income or employment data (see also Cochrane (2008)). Therefore, I measure human capital returns as the contemporaneous growth rate in labor income. In Section III, I also compare this measure to the 1-month lagged labor income growth rate and show that aggregate human capital returns are particularly sensitive to the timing issue, while industry-specic human capital returns are not. To diminish the inuence of measurement errors, I follow Jagannathan and Wang (1996) and Heaton and Lucas (2000) and use a 2-month moving average of Lt . I estimate the returns on human capital for industry k in month t as
hc Rk ,t =

Lk,t + Lk,t1 1. Lk,t1 + Lk,t2

(5)

B. Labor Income Data and Summary Statistics I retrieve monthly labor income data from the National Income and Product Accounts (NIPA) Table 2.7. This table provides monthly wages and salaries for ve industries: goods producing, manufacturing, distribution, service, and government. As these industries span aggregate labor income, I am able to allow for heterogeneity and at the same time include the full universe of human capital assets in the asset pricing model. I scale wages and salaries by the number of workers in the industry, using monthly employment data from the Current Employment Statistics survey. The sample period runs from April 1959 to December 2009. Further details about the data can be found in the Internet Appendix. Table I, Panel A reports various descriptive statistics for the monthly data. The average growth rate in aggregate labor income for the United States as a whole is 0.38% per month and its standard deviation is 0.39%. Industryspecic labor income growth is substantially more volatile for the goods producing industry (0.49%), the manufacturing industry (0.56%), and the service industry (0.63%). The average growth rate in labor income is the highest for the service industry (0.45%), and the lowest for the distribution industry and the government (0.36% and 0.37%, respectively). Except for the government, the median and mean returns on industry-specic human capital are nearly identical. Furthermore, Wald tests show that the differences in the mean and variance of labor income growth across industries are statistically signicant at the 1% level, and the null hypothesis that average growth rates for all ve industries are jointly equal to zero is rejected at the 1% level. Panel B reports the correlation matrix of the monthly returns. All correlations between industry-specic human capital returns are positive and range from 0.038 (services and government) to 0.713 (distribution and services). The panel also reports correlations between human capital returns and other asset pricing factors, which are discussed in Section III.D.13 For aggregate labor
13 This includes the equity market index, the lagged yield spread, the Fama and French (1993) size and value factors, the Carhart (1997) momentum factor, and the Pastor and Stambaugh (2003) liquidity factor.

Table I

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Summary Statistics and Correlations

Panel A reports summary statistics for the monthly returns on the CRSP value-weighted index ( Rmkt ); the lagged yield spread ( Rprem), which is measured as the yield difference between Moodys Baa- and Aaa-rated corporate bonds; the Fama and French (1993) size and value factors (SMB and H ML); the Carhart (1997) momentum factor (Mom); the Pastor and Stambaugh (2003) liquidity factor (Liq); the 30-day T-bill rate ( R f ); and returns on human capital. Human capital returns are calculated as the growth rate in monthly per worker labor income, where labor income is measured as total wages and salaries. I use a 2-month moving average of labor income. Labor income growth is calculated for the United States as a whole hc ( RU S ) and for ve different industries: goods producing (excluding manufacturing), manufacturing, distributive industries, service industries, and government. Labor income data are retrieved from the National Income and Product Accounts, Table 2.7, and monthly employment data are from the Current Employment Statistics survey released by the Bureau of Labor Statistics. The sample period runs from April 1959 to December 2009, a total of 609 months. Panel A reports the mean, standard deviation, minimum, maximum, and rst-order autocorrelation (denoted by (1)). The panel reports p-values (in parentheses) of the null hypotheses that the mean growth rates in labor income are zero or equal across all ve industries (based on a Newey and West (1987) covariance matrix). The last row reports the p -value of the null hypothesis that the variance of human capital returns is equal across all industries. The asymptotic covariance matrix of the estimated variances is based on Eiling et al. (2012). Panel B reports the unconditional correlation matrix. , , and denote signicance at the 1%, 5%, and 10% levels, respectively. Panel A: Descriptive Statistics Stdev (%) 4.46 0.47 3.10 2.87 4.25 5.69 0.39 0.49 0.56 0.40 0.63 0.40 0.23 22.54 0.32 16.85 12.37 34.69 38.21 3.99 1.48 5.32 3.42 6.63 1.21 0.00 16.56 3.38 21.99 13.87 18.35 28.62 3.10 4.01 3.97 2.67 5.49 2.85 1.35 Min (%) Max (%) (1) 0.10 0.97 0.06 0.16 0.06 0.01 0.34 0.43 0.35 0.28 0.26 0.39 0.96 (<0.001) (<0.001) (<0.001) (Continued) p-value

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Mean (%)

Median (%)

Rmkt 0.86 1.26 Rprem 1.01 0.87 SMB 0.21 0.05 HML 0.41 0.41 Mom 0.75 0.88 Liq 0.00 0.66 hc RU 0.38 0.38 S hc Rgds 0.38 0.38 hc Rman 0.40 0.41 hc Rdist 0.36 0.36 hc Rser 0.45 0.45 v hc Rgo 0.37 0.29 v Rf 0.43 0.41 H0 : mean Rhc is zero for all 5 industries H0 : mean Rhc is equal for all 5 industries H0 : Var( Rhc ) is equal for all 5 industries

Table IContinued

Panel B: Unconditional Correlation Matrix of Monthly Returns on the Factors SMB HML Mom Liq
hc RU S hc Rgds hc Rman hc Rdist hc Rser v

rmkt

Rprem

Industry-Specic Human Capital

Rprem SMB HML Mom Liq hc RU S hc Rgds hc Rman hc Rdist hc Rser v hc Rgo v 0.237 0.017 0.169 0.066 0.040 0.101 0.006 0.024 0.058 0.170 0.116 0.017 0.059 0.080 0.047 0.031 0.012 0.032 0.039 0.003 0.092 0.071 0.015 0.034 0.059 0.119 0.005 0.018 0.025 0.112 0.394 0.826 0.842 0.885 0.266 0.305 0.346 0.251 0.074

0.055 0.302 0.319 0.139 0.344 0.032 0.025 0.053 0.009 0.041 0.027

0.085 0.049 0.127 0.033 0.020 0.017 0.034 0.025 0.034 0.152

0.702 0.676 0.057

0.713 0.082

0.038

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income growth, all correlations are insignicant. For industry-specic labor income growth rates, several correlations are signicant. For example, the correlation between human capital returns from the manufacturing industry and the size factor ( SMB) is positive and signicant. This is in line with the nding that small-size portfolios generally have higher human capital betas than large-size portfolios (Jagannathan, Kubota, and Takehara (1998)). C. Hedging Demand Due to Human Capital To further highlight the importance of heterogeneity in human capital returns, I analyze how industry-specic human capital affects optimal stock portfolios. As ve human capital industries are rather coarse for estimating portfolio choice implications, in this section I focus on nine industries for which quarterly labor income data are available from the State Quarterly personal income tables (provided by the Bureau of Economic Analysis (BEA)). The summary statistics for quarterly labor income growth rates for nine industries are reported in the Internet Appendix and show similar patterns as monthly human capital returns for ve industries. A natural way to hedge industry-specic human capital risk is to adjust the industry weights of ones stock portfolio. Therefore, I create eight equity industry portfolios that match the industries of the human capital returns based on SIC codes, excluding the government. The portfolio returns are based on all common stocks traded on the NYSE, Amex, and NASDAQ from the return les of the Center for Research in Security Prices (CRSP). 1 The hedging portfolio weights of investor i are given by tr tr ,nt qi , where qi contains the value of investor i s human capital over her nancial wealth.14 I estimate these weights by regressing human capital returns for one particular industry on a constant and the excess returns on the eight industry equity portfolios. I multiply the regression coefcients by 1, which implies that I estimate the hedging portfolio weights up to qi . Table II, Panel A reports the results. Consider a young investor who typically has little nancial wealth and the main part of his wealth is due to human capital. Suppose that 90% of his total wealth is due to his human capital and 10% is due to his equity investments (i.e., qi = 9). If he was working in the manufacturing industry, his optimal stock portfolio should be adjusted as follows. The coefcient estimates in the fourth column show that the investor should underweight stocks from this own industry by about 27% (3.0% 9). Due to his human capital, he is already exposed to stock returns from the manufacturing industry and to diversify he optimally invests less in manufacturing stocks. On the other hand, stocks from the retail industry form a good hedge against his labor income risk; he should overweight stocks from this industry by 34.5%. In fact, the column with hedging portfolio weights can be interpreted as the
14 As discussed in the Internet Appendix, q is a K 1 vector with investor i s positions in each i of the K nontradable assets. When the investor works in industry 1, elements 2 to K are zero.

Industry-Specic Human Capital


Table II

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Matched Human Capital and Equity IndustriesHedging Portfolio Weights


This table reports the estimated weights of equity industry portfolios in the hedging portfolios induced by nontradable human capital from nine different industries of employment. I create eight equity industry portfolios that are matched by SIC codes with the human capital industries: mining, construction, manufacturing, transportation, wholesale trade, retail trade, nance, and services. In addition, I include human capital from the government. Each month I construct value-weighted industry equity returns, using all common stocks traded on the NYSE, Amex, and NASDAQ from the return les of CRSP. I then calculate quarterly compounded returns in excess of the 3-month Treasury bill rate from 1959Q3 to 2009Q4. Quarterly human capital returns are calculated as the contemporaneous growth rate in quarterly per-worker labor income. Panel A reports the hedging portfolio weights in percentages. The rst column gives the weights of the eight equity industries in the hedging portfolio for an investor who works in the mining industry. The subsequent columns present hedging portfolio weights for investors working in other industries. These weights are estimated up to q, which is the value of the investors human capital over her nancial (equity) wealth. The weights are estimated based on an OLS regression of human capital returns on a constant and excess returns on the eight industry equity portfolios. and denote signicance at the 5% and 10% levels, based on Newey and West (1987) standard errors with six lags. The last row of Panel A reports the p-values (in parentheses) for the Wald test that all hedging portfolio weights in that column are jointly equal to zero. Panel B reports p-values (in parentheses) for the Wald tests of the null hypothesis that the hedging portfolio weights for a pair of human capital industries are equal. The Wald tests are based on a White covariance matrix. Panel A: Hedging Portfolio Weights (in %) mining mining constr manuf transp wholes retail nance serv p-value constr 2.25 manuf transp wholes retail 0.02 0.04 0.57 0.11 0.56 0.21 0.00 0.75 (0.998) nance serv gov 0.67 0.32 2.03 3.75 1.61 0.71 1.80 1.35 (0.170)

2.75 0.47 0.60 0.64 4.32 2.88 0.77 0.25 0.02 5.04 0.58 5.74 1.03 0.20 1.67 (0.412) (0.360)

0.65 0.39 0.79 0.27 0.52 0.58 3.00 0.39 1.73 0.57 3.23 1.04 0.41 0.64 0.23 3.83 0.03 2.76 0.37 1.42 1.78 1.74 2.07 1.61 (0.417) (0.664) (0.349)

3.88 0.90 1.86 0.42 6.39 0.21 0.05 0.49 2.41 0.53 4.82 1.97 3.70 0.81 2.51 2.55 (0.289) (0.366)

Panel B: p-values of Wald test H0 : HC Industries i and j Have the Same Hedging Portfolios mining mining constr manuf transp wholes retail nance serv constr (0.301) manuf (0.198) (0.056) transp (0.198) (0.035) (0.118) wholes (0.117) (0.009) (0.557) (0.712) retail (0.465) (0.035) (0.042) (0.306) (0.275) nance (0.318) (0.015) (0.139) (0.066) (0.042) (0.247) serv (0.103) (0.006) (0.443) (0.641) (0.770) (0.316) (0.028) gov (0.103) (0.195) (0.097) (0.458) (0.126) (0.206) (0.113) (0.057)

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adjustments that an industry pension fund should incorporate for its members human capital. Note that, for about half of the industries, investors should underweight stocks in their own industry. The table shows that, next to their economic signicance, several individual portfolio weights are also statistically signicant. However, the null hypothesis that all hedging portfolio weights are jointly equal to zero cannot be rejected, suggesting that the portfolio weights are estimated with considerable noise. In addition, the analysis assumes that correlations between human capital and equity returns are constant over the full sample period. The Internet Appendix reports a robustness test in which the hedging portfolio weights are estimated separately for the rst and second half of the sample period. I nd that the null hypothesis that all weights are zero can be rejected for three and four human capital industries, respectively. Next, I perform Wald tests of the null hypothesis that workers from two different industries have the same hedging portfolios, that is, I test whether the different columns in Panel A are equal. Panel B of Table II shows that, for the resulting 36 pairwise tests, the null can be rejected 12 times, suggesting there is considerable heterogeneity in human capital hedging portfolios across industries of employment. A related paper, Davis and Willen (2000b) analyzes portfolio implications of heterogeneity in human capital at the occupational level.15 The authors show that the covariances between occupation-level income shocks and equity returns for the closest matched industry are positive for 9 of the 10 occupations under consideration. They then calibrate optimal portfolio weights based on a life cycle portfolio choice model. The menu of tradable assets includes either own-industry equity returns or equity market returns, and returns on sizebased and value-based portfolios. The analysis presented in this section is based on a simpler single-period model. In addition to own-industry equity returns, I also consider other industries in the menu of tradable assets. This allows me to examine how industry-specic human capital affects the industry composition of ones equity portfolio. III. Industry-Specic Human Capital and the Cross-Section of Stock Returns I examine the impact of industry-specic human capital on expected stock returns, based on the multi-beta specication in expression (2). The model is compared to various benchmark models, including one with aggregate labor income growth.

15 Based on a life-cycle model, Davis and Willen (2000a) examine labor income risk hedging for synthetic persons based on birth cohort, education, and gender. They show that introducing new nancial assets, such as an equity portfolio that matches the industry composition of the persons in the cohort, leads to substantial welfare gains. Fugazza, Giofr e, and Nicodano (2011) argue that the optimal portfolios of pension funds vary depending on the industry in which the members work.

Industry-Specic Human Capital A. Econometric Approach

57

I test all models using the two-stage cross-sectional regression method (e.g., Black, Jensen, and Scholes (1972), and Fama and MacBeth (1973)). While a common approach is to use multiple regression betas in the rst stage, this has an important drawback. Unless the factors are uncorrelated, rst-stage betas depend on the other factors included in the multiple regression. This complicates model selection based on estimated factor risk premia (e.g., Jagannathan and Wang (1998), Cochrane (2005, p. 261), Kan and Robotti (2011)). Also, the nontradable assets model in (2) is expressed in terms of simple regression betas. Therefore, I follow Chen, Roll, and Ross (1986) and Jagannathan and Wang (1996) and use simple regression betas to determine whether a factor is priced in the presence of other factors. As the matrix of simple betas is a linear transformation of the matrix of multiple betas, the errors and R2 s of the cross-sectional regression are the same as when using multiple regression betas. Throughout the paper, I estimate betas by performing OLS regressions over the full sample period.16 I then run a cross-sectional regression of the average excess returns on all N assets on a constant and the betas. The standard errors are adjusted for sampling error in the betas following Jagannathan and Wang (1998), who show that, in the presence of conditional heteroskedasticity, Fama and MacBeth (1973) standard errors do not necessarily overreject in nite samples. Therefore, following Jagannathan, Kubota, and Takehara (1998) and Lettau and Ludvigson (2001), I report the classical FamaMacBeth t-statistics (t-value F M ) in addition to the adjusted t-statistics (t-value JW ). A useful diagnostic statistic to evaluate and compare the different models is the OLS adjusted- R2 of the cross-sectional regression, which I calculate as in Jagannathan and Wang (1996). In addition, I report the GLS R2 as an alternative measure of model t, as suggested by Kandel and Stambaugh (1995) and Lewellen, Nagel, and Shanken (2010). The GLS R2 is related to a factors proximity to the minimum-variance boundary. Finally, I report the square root of the average squared pricing error (rmspe) and the F -statistic of the test of whether the average pricing error equals zero.17 In a robustness check, I

16 The original Fama and MacBeth (1973) approach uses beta estimates based on the previous 60 months. However, the estimated cross-sectional regression coefcients are generally not consistent when using rolling betas (Kan and Robotti (2012)). I follow, among others, Black, Jensen, and Scholes (1972) and Jagannathan and Wang (1996), and use full sample betas. The Internet Appendix shows that the relative performance of the models based on 60-month rolling window betas is similar. 17 In general, the test statistic for the test that the pricing errors are zero is given by 2 ( ( T e V N is the vector of OLS pricing errors for all N test assets, V e) e )+ e M1 , where e ( is its estimated covariance matrix, and V e)+ denotes its pseudo inverse. The number of factors ( in the model is denoted by M. I estimate V e) as in Kan and Robotti (2012), which is robust in

the presence of conditional heteroskedasticity. I use an approximate F -test for better nite-sample properties. The test statistic is approximately FN M1,T N+1 distributed.

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include portfolio characteristics in the cross-sectional regressions as another test of model misspecication.

B. Portfolio Returns I estimate the asset pricing models for three sets of equity portfolio returns. First, I consider the well-known 25 size and book-to-market sorted (size-BM) equity portfolios, constructed as in Fama and French (1992, 1993). As these portfolios are known to have a strong factor structure (Lewellen, Nagel, and Shanken (2010)), I also consider 100 size-beta sorted portfolios, constructed as in Fama and French (1992) and Jagannathan and Wang (1996). Third, in Section IV, I consider returns on 100 size and IR sorted equity portfolios. Before performing cross-sectional regressions, I rst test the signicance of the human capital betas as suggested by Kan and Zhang (1999). Human capital betas are difcult to estimate accurately (Jagannathan, Kubota, and Takehara (1998)). The two main reasons are that labor income is relatively stable over time and labor income data may suffer from measurement error.18 Nevertheless, Wald tests reveal that the betas are often jointly signicant. I test whether the exposures to a certain type of human capital (i.e., aggregate or industry-specic) are jointly equal to zero or whether they are all equal for the equity portfolios under consideration. The results are reported in the Internet Appendix. For the 25 size-BM portfolios, both null hypotheses can be rejected for aggregate human capital as well as human capital from the service industry and the government. For the 100 size-beta portfolios, both null hypotheses can be rejected for all types of human capital returns. These results imply that the labor income growth series are unlikely to be useless factors. Moreover, there are strong economic motivations for including human capital in an asset pricing model. Finally, given the relatively high correlation between human capital returns from different industries, as reported in Table I, a possible concern is that the human capital betas are highly correlated. One of the assumptions of the cross-sectional regressions is that the matrix [ N B ] has full column rank, where N is an N -dimensional vector of ones and B is an N M matrix with the test assets betas with respect to all M factors in the model. I test the null hypothesis that [ N B ] has less than full column rank, using the test proposed by Cragg and Donald (1997) and modied by Gospodinov, Kan, and Robotti (2010).19 The Internet Appendix shows that the null can be rejected for the 100 size-beta sorted portfolios, but not for the 25 size-BM sorted portfolios. While this does not necessarily imply that the null is true, the results for the 25 size-BM portfolios should be interpreted with some caution.

18 In Section IV, I report individual human capital betas for 10 IR sorted portfolios, and in the Internet Appendix I report human capital betas for 100 size-IR portfolios. 19 I thank Raymond Kan for showing me how to perform the rank test.

Industry-Specic Human Capital C. Cross-Sectional Regressions C.1. Aggregate versus Industry-Specic Labor Income Growth Rates

59

I estimate the nontradable assets model, which includes a beta with respect to the equity market portfolio and betas with respect to industry-specic labor income growth rates:
5

E[ritr ] = c0 + cmkt mkt,i +


k=1

hc hc ck k,i ,

(6)

where mkt,i is estimated as the slope coefcient of an OLS regression of the excess returns on portfolio i on a constant and the returns on the value-weighted hc CRSP index in excess of the 30-day T-bill rate, and k ,i is estimated as the slope coefcient in a regression of the excess portfolio returns on a constant and the labor income growth rate in industry k. The main benchmark model includes aggregate instead of industry-specic labor income growth rates
hc hc E[ritr ] = c0 + cmkt mkt,i + cU S U S,i .

(7)

Expression (7) is also known as the human capital CAPM (e.g., Jagannathan and Wang (1996), Lettau and Ludvigson (2001)). While the cross-sectional regression model is the same as that of the nontradable assets model when K = 1, the human capital CAPM has a slightly different motivation. This model assumes that human capital is tradable. As its weight in the market portfolio is unknown, aggregate human capital returns are added as an additional factor. In contrast, in the nontradable assets model, additional factors arise due to hedging demand induced by investors nontradable human capital. Table III, Panel A reports the cross-sectional regression results for the 25 size-BM portfolios. The model with industry-specic human capital has an OLS adjusted- R2 of 61% and a GLS R2 of 25%. The square root of the mean squared pricing error (average pricing error in short) equals 0.12% and the null hypothesis that all pricing errors jointly equal zero cannot be rejected. Based on FamaMacBeth standard errors, the cross-sectional regression coefcients of human capital from the goods producing, manufacturing, and distribution industries are signicant. For the rst two industries, the coefcients are no longer signicant when considering adjusted t-statistics. In sharp contrast, the model with aggregate labor income growth captures only 9% of the cross-sectional variation in average returns. The GLS R2 is 13%. The model has an average pricing error of 0.20% and the null hypothesis that all pricing errors are equal to zero is rejected. Furthermore, the cross-sectional regression coefcient of aggregate labor income growth is not statistically signicant, with t-values close to one. These results highlight the importance of allowing for heterogeneity in human capital. On the basis of aggregate labor income growth rates, one may erroneously conclude that human capital does not affect expected stock returns, while industry-specic human capital appears to play a signicant role.

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Table III

Cross-Sectional Regressions for 25 Size-BM Portfolios: Aggregate versus Industry-Specic Human Capital
This table compares three asset pricing models with aggregate and industry-specic labor income growth rates for ve industries: goods producing, manufacturing, distribution, services, and govhc hc ernment. The rst model is based on E[r tr ,i ] = c0 + cmkt mkt,i + cU S U S,i ,where rtr ,i is the excess return on portfolio i , i = 1, . . . , N , rmkt is the excess return on the value-weighted CRSP index, hc hc RU S is the growth rate in aggregate per-worker labor income, and mkt,i (U S,i ) is estimated as hc the slope of the OLS regression of rtr ,i on a constant and rmkt ( RU S ). The second model is based K hc hc hc on E[r tr ,i ] = c0 +cmkt mkt,i + k =1 ck k,i , where Rk is the labor income growth rate for industry k. Panel A uses contemporaneous labor income growth, which is the main measure used in this paper. Panel B uses a 1-month lag, similar to Jagannathan and Wang (1996). The third model in Panel A K hc hc hc hc hc is based on E[r tr ,i ] = c0 +cmkt mkt,i +cU is the contemporaneous k=1 ck k,i , where Rk S U S,i + hc labor income growth rate for industry k , which is orthogonalized to RU S . All betas are calculated as hc slope coefcients in simple regressions including a constant and the relevant Rk . The table reports results based on excess returns on 25 size-BM sorted portfolios, constructed as in Fama and French (1992, 1993), from April 1959 to December 2009. The models are estimated using the Fama and MacBeth (1973) procedure. First, simple betas are estimated using time-series regressions over the full sample period. Next, average returns are regressed on a constant and the cross-section of betas. The table reports cross-sectional regression coefcients estimates, FamaMacBeth t-values (t-value F M , in parentheses), t-values that have been adjusted for estimation error in the betas using the Jagannathan and Wang (1998) adjustment (t-value JW , in parentheses), the cross-sectional regressions OLS adjusted- R2 calculated as in Jagannathan and Wang (1996), and below that the GLS R2 . The last column reports the square root of the mean squared pricing error (rmspe) and below that (in square brackets) the F -statistic of the test of H0 : all pricing errors equal zero. This test is robust to estimation error in the rst-stage betas and conditional heteroskedasticity. Panel A: Cross-Sectional Regressions for 25 Size-BM Portfolios, Contemporaneous Rhc c0 c ( 102 ) t-value F M t-value JW c ( 102 ) t-value F M t-value JW c ( 102 ) t-value F M t-value JW 1.53 (4.34) (3.38) 1.20 (4.33) (2.31) 1.29 (4.67) (2.18) cmkt
hc cU S hc cgds hc cman hc cdist hc cser v hc cgo v 2 Rols (gls)

rmspe 0.20% [2.37] 0.12% [0.96] 0.12% [0.79]

0.92 0.17 (2.36) (1.37) (1.99) (1.18) 0.94 (2.50) (1.40) 1.02 0.18 (2.70) (1.53) (1.32) (0.76)

9.35% 12.53% 0.44 (2.66) (1.55) 0.64 (3.57) (1.62) 0.61 (2.79) (1.46) 0.28 (3.35) (1.68) 0.68 0.23 0.04 60.92% (3.77) (0.83) (0.42) 24.88% (1.86) (0.49) (0.24) 0.13 0.06 0.19 60.10% (2.25) (0.68) (1.37) 29.43% (1.07) (0.32) (0.68)

Panel B: Cross-Sectional Regressions for 25 Size-BM Portfolios, Lagged Rhc c0 c ( 102 ) t-value F M t-value JW c ( 102 ) t-value F M t-value JW 1.29 (3.53) (2.42) 1.46 (4.51) (2.08) cmkt
hc cU S hc cgds hc cman hc cdist hc cser v hc cgo v 2 Rols (gls)

rmspe 0.19% [2.10] 0.14% [0.65]

0.71 0.33 (1.81) (2.27) (1.37) (1.69) 0.84 0.73 1.04 0.42 0.64 (2.31) (4.57) (3.17) (1.92) (2.27) (1.05) (2.07) (1.35) (0.73) (0.84)

19.18% 10.63% 0.16 48.46% (1.36) 22.33% (0.60)

Industry-Specic Human Capital

61

The weak performance of the model with aggregate labor income growth seems to contrast with ndings in Jagannathan and Wang (1996) and Lettau and Ludvigson (2001). However, they are in line with Fama and Schwert (1977), who nd little empirical support for the Mayers (1972) model with aggregate labor income growth as a proxy for human capital returns. Jagannathan and Wang (1996) use 1-month lagged labor income growth to account for the reporting lag in aggregate labor income data. As discussed in Section II, I use contemporaneous growth rates. This is the economically more relevant measure, because investors can observe their own labor income in real time. For comparison, Panel B of Table III reports the results when using 1-month lagged labor income growth rates. In this case, the coefcient on lagged aggregate labor income growth is signicant and the model captures 19% of the cross-sectional variation in returns. The nontradable assets model with lagged industry-specic labor income growth rates continues to have a higher OLS adjusted- R2 of 48%. Additionally, all industries except for the government have signicant coefcients. The GLS R2 of this model is also higher and the average pricing errors are lower. The sensitivity of aggregate labor income growth to the timing of returns suggests that the pricing of lagged aggregate labor income growth may be due to announcement effects of aggregate labor market data. This is also noted by Jagannathan, Kubota, and Takehara (1998), Heaton and Lucas (2000), and Cochrane (2008). In contrast, the ability of the model with industry-specic human capital to capture the cross-section of average returns even improves when using contemporaneous rather than lagged labor income growth rates. The Internet Appendix discusses the impact of the timing of human capital returns in greater detail and shows that the results are similar when using quarterly returns. As mentioned earlier, for the 25 size and book-to-market portfolios, commonality in betas may complicate the interpretation of the estimated cross-sectional regression coefcients. For example, note that in Table III not all coefcients for industry-specic human capital have the expected positive sign. Table IV, Panel A reports the cross-sectional regression results for an alternative set of portfolios, namely, 100 size-beta sorted portfolios, for which the null hypothesis of the Cragg and Donald (1997) test can be rejected. The performance of the model with aggregate labor income growth is better for this set of test assets. The coefcient on aggregate labor income growth is positive and signicant, and the OLS R2 is 31%. However, the GLS R2 is close to zero (1.10%). When including industry-specic human capital returns, both R2 s increase to 61% and 12%, respectively. Based on unadjusted t-statistics, human capital from the goods producing, service, and government industries is signicant at the 1%, 5%, and 1% levels, respectively. After adjusting the t-statistics for estimation error in the betas, the goods producing and government industries remain signicant at the 1% and 5% levels. The coefcient estimates are 0.0032 and 0.0019.20
The models in Tables III and IV have positive and signicant estimates of the intercept, while it should be zero when using excess returns. Also, the market risk premium estimates are negative
20

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Table IV

Cross-Sectional Regressions for 100 Size-Beta Portfolios: Aggregate versus Industry-Specic Human Capital
This table reports results for monthly excess returns on 100 size-beta portfolios from April 1959 to December 2009, constructed as in Fama and French (1992) and Jagannathan and Wang (1996). Panel A reports the results for the human capital CAPM (equation (7)), the nontradable assets model with industry-specic human capital (equation (6)), and a model with aggregate and orthogonalized industry-specic human capital (equation (8)). Human capital returns are calculated as contemporaneous labor income growth rates. Simple betas are estimated using time-series regressions over the full sample period. Average returns are then regressed on a constant and the cross-section of betas. The table gives cross-sectional regression coefcient estimates, Fama and MacBeth (1973) t-values (t-value F M , in parentheses), Jagannathan and Wang (1998) adjusted t-values (t-value JW , in parentheses), the cross-sectional regressions OLS adjusted- R2 , the GLS R2 , the square root of the mean squared pricing error (rmspe), and below that the F -statistic of the test of H0 : all pricing errors equal zero. Panel B rst repeats the industry-specic human capital risk premia estimates from Panel A, where and indicate signicance at the 1% and 5% levels based on adjusted t-values. In the nontradable assets model, these coefcients are estimates hc of Var( Rk )qk, where is the coefcient of risk aversion and qk is the value of human capital in industry k over the market value of all tradable assets. The implied qk is based on = 5 and assuming that the three insignicant risk premia estimates equal zero. Next, the panel sets = 10 and calculates qk for these three industries (assuming they have equal qk s) such that the sum of all qk equals that of the base case. Below, the panel reports the implied risk premia. Finally, the three insignicant risk premia estimates are set at two standard errors above their point estimates from the base case. Below, the panel reports the implied qk , for = 10. Panel A: Cross-Sectional Regressions for 100 Size-Beta Portfolios c0 c ( 102 ) t-value F M t-value JW c ( 102 ) t-value F M t-value JW c ( 102 ) t-value F M t-value JW 1.01 (5.86) (3.75) 0.73 (4.81) (3.51) 0.71 (4.78) (3.59) cmkt 0.45 (1.87) (1.36) 0.10 (0.44) (0.33) 0.11 (0.48) (0.37)
hc cU S hc cgds hc cman hc cdist hc cser v hc cgo v 2 Rols (gls)

rmspe 0.18% [1.16] 0.14% [0.94] 0.13% [1.00]

0.37 (2.95) (2.27)

30.65% 1.10% 0.09 (0.87) (0.60) 0.00 (0.08) (0.06) 0.35 (2.55) (1.49) 0.14 (2.47) (1.94) 0.19 (2.63) (2.09) 0.06 (0.90) (0.65) 60.99% 11.82% 61.89% 12.04%

0.32 0.03 (4.16) (0.19) (2.99) (0.14) 0.03 0.21 0.04 (0.45) (3.63) (0.80) (0.37) (2.74) (0.58)

Panel B: Economic Interpretation of CSR Coefcients gds Base case: c ( 102 ) stdev( Rhc ) implied q 0.32 0.49% 26.86 man dist serv 0.35 0.63% 0.00 gov 0.19 0.40% 23.05 11.53 0.19 0.19 11.53
K k=1 qk

0.03 0.56% 0.00

0.09 0.40% 0.00

49.91 49.91

5 10

Experiment 1: adjusting the relative values of human capital adjusted q 13.43 8.32 8.32 8.32 implied c ( 102 ) 0.32 0.26 0.13 0.33 Experiment 2: adjusting the estimated risk premia adjusted c ( 102 ) 0.32 0.39 0.38 implied q 13.43 12.38 23.79 0.12 2.99

64.12

10

Industry-Specic Human Capital

63

To interpret the magnitudes of these estimated human capital risk premia, it is useful to consider the nontradable assets model in expression (2). Accordhc are estimates of ing to the model, the cross-sectional regression coefcients ck Var[ Rnt,k]qnt,k, that is, the risk aversion coefcient multiplied by the variance of human capital returns and the value of human capital over the value of all stocks. Panel B of Table IV reports the implied relative values of industryspecic human capital (i.e., qnt,k), given the estimated risk premia from Panel A, the variance of human capital returns, and a risk aversion coefcient of ve. First, I assume that the risk premia estimates that are not statistically signicant are equal to zero. The implied relative values of human capital in the goods producing and government industries are qgds = 26.9 and qgov = 23.1. While the value of human capital cannot be observed, Lustig, van Nieuwerburgh, and Verdelhan (2010) estimate that about 90% of total wealth is due to human capital (in line with Jorgenson and Fraumeni (1989) and Palacios (2010)), while only 2% is due to equities.21 This would lead to an aggregate measure of q of 45, which is relatively close to the sum of the implied values of qgds and qgov . These ndings show that the two human capital risk premia estimates are reasonably in line with the model for a risk aversion coefcient of ve. The above calculations should be interpreted with some caution, as they effectively assume that the value of human capital in the remaining three industries equals zero. To examine the impact of nonzero risk premia for human capital from the manufacturing, distribution, and service industries, I perform two simple experiments. First, I calculate the maximum human capital value in the three industries that would still lead to a plausible total relative value of human capital. Since for a risk aversion coefcient of ve the sum of qgds and qgov is already above 45, I use a risk aversion coefcient of 10, which lowers the sum of qgds and qgov to 25. I make the simplifying assumption that the three remaining industries have equal values of q. Keeping the total value of K human capital the same as in the base case ( k =1 qk = 49.9) leads to qman = qdist = qser v = 8.3. Panel B of Table IV shows that the implied risk premia given these values of q are 0.26%, 0.13%, and 0.33%, respectively, which are similar to the regression coefcient estimates of the goods producing and government industries. The second experiment adjusts the risk premia estimates of the three industries by setting them two standard errors above their point estimates (based on Jagannathan and Wang (1998) adjusted standard errors). Using = 10, I
(similar to, for example, Fama and French (1992), Jagannathan and Wang (1996), Lettau and Ludvigson (2001)). In the Internet Appendix I estimate these models imposing a zero intercept. The resulting estimates of cmkt are always positive and often signicant. This suggests that the nonzero estimates of the intercepts could be related to the similarity in market betas for many of the portfolios. 21 This implies that the value of equity is approximately 20% of all nonhuman wealth, which is roughly in line with several studies that use the Survey of Consumer Finances data to analyze the composition of households nancial wealth (e.g., Poterba and Samwick (2001) and Heaton and Lucas (2000)).

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nd that the implied values of q are higher, leading to a total relative value of human capital of 64.1. A risk aversion coefcient of 13 would bring the total value down to 49, as in the base case. This discussion suggests that the economic magnitudes of the two signicant human capital risk premia estimates are reasonable for a risk aversion coefcient of ve. When allowing for nonzero human capital risk premia in the remaining three industries as well, economic magnitudes are plausible for a risk aversion coefcient of at least 10. C.2. Aggregate and Orthogonalized Industry Human Capital Returns To separate the common component from the industry-specic components in labor income growth, I estimate the following alternative model specication:
K hc hc E[r tr ,i ] = c0 +cmkt mkt,i +cU S U S,i + k=1 hc Aggregate labor income growth RU S is used as a proxy for the common component. The orthogonalized industry-specic human capital returns for industry hc hc ) are estimated as the residual of a regression of Rk on a constant and k ( Rk hc RU S . The slope coefcient of a time-series regression of rtr ,i on a constant and hc hc Rk is denoted by k ,i . As discussed in Section I, several heterogeneous agent models show that idiosyncratic labor income risk may affect asset pricing. Intuitively, when investors cannot perfectly share their industry-level labor income risk, industryspecic idiosyncratic labor income risks may affect expected returns, in addition to aggregate labor income risk. The model specication above allows me to test more directly whether industry-level idiosyncratic labor income risks are priced. An additional advantage of removing the common component from the industry-specic human capital returns is that it results in substantially lower correlations between the orthogonalized industry-specic human capital returns, which range between 0.44 (service and government) and 0.028 (goods producing and distribution). The results are reported in Table III, Panel A (for 25 size-BM portfolios) and Table IV, Panel A (for 100 size-beta portfolios). In both panels, the coefcient on aggregate labor income growth is close to zero and insignicant. On the other hand, exposures to industry-specic orthogonalized human capital returns signicantly affect the cross-section of expected stock returns. For the 25 size-BM portfolios, the coefcients on the goods producing, manufacturing, and distributive industries are signicant, while for the 100 size-beta portfolios, the coefcients on the goods producing and service industries are signicant. As expected, the R2 s are almost identical to those of the models with industry-specic human capital returns only. These ndings emphasize that what matters for expected stock returns are mainly the industry-specic human capital risks that cannot be shared, rather than labor income risk that is common to all investors. hc hc ck k,i .

(8)

Industry-Specic Human Capital D. Comparison with Alternative Asset Pricing Models

65

Next, I compare the performance of the model with (orthogonalized) industryspecic human capital to ve well-known asset pricing models. I rst estimate all models for the 25 size-BM portfolios. The results are reported in Table V, Panel A. I start with the traditional static CAPM: E[ritr ] = c0 + cmkt mkt,i . (9)

Panel A documents the well-known result that this model fails to capture the returns on the 25 size-BM portfolios. The estimated market price of risk cmkt is negative and insignicant. The OLS and GLS R2 s are 8.6% and 11%, respectively. I also consider the conditional CAPM, as in Jagannathan and Wang (1996). They show that, when betas and expected returns vary over time, the conditional CAPM can be expressed as an unconditional multifactor model, which includes the market beta and a so-called premium beta that measures the beta-instability risk: E[ritr ] = c0 + cmkt mkt,i + c prem prem,i , (10)

where prem,i is measured with respect to the 1-month lagged yield spread between Moodys Baa- and Aaa-rated corporate bonds from the Federal Reserve Bulletin. The estimated c prem is positive and signicant. The OLS R2 is 31% and the GLS R2 is 11%. Next, I consider the Fama and French (1993) three-factor model (referred to as FF3), which is based on the following cross-sectional regression model: E[ritr ] = c0 + cmkt mkt,i + csmbsmb,i + chml hml,i , (11)

where smb,i is estimated as the slope coefcient of a simple regression of the portfolio returns on a constant and the Fama and French (1993) size factor SMB, and hml,i is estimated similarly using the value factor H ML. Both factors are downloaded from Frenchs website. Perhaps not surprisingly, the FF3 model better explains the cross-section of returns on the 25 size-BM sorted portfolios than the models discussed so far. The OLS and GLS R2 s are higher (71% and 34%), and both SMB and H ML have signicant and positive risk premia estimates. The following benchmark model also includes a momentum factor: E[ritr ] = c0 + cmkt mkt,i + csmbsmb,i + chml hml,i + cmommom,i , (12)

where mom,i is the slope coefcient with respect to Mom, the momentum factor proposed by Carhart (1997), which is also downloaded from Kenneth Frenchs website. Table V shows that the momentum factor is signicant and positive, and the R2 s improve slightly compared to the FF3 model (75% and 41%). Various papers show that aggregate liquidity is a priced risk factor (e.g., Pastor and Stambaugh (2003), Acharya and Pedersen (2005), Korajczyk and

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Table V

Cross-Sectional Regressions: Comparison with Alternative Asset Pricing Models


This table evaluates ve benchmark asset pricing models for monthly excess returns on 25 sizeBM equity portfolios (Panel A) and 100 size-beta sorted portfolios (Panel B), from April 1959 to December 2009. The rst model is the static CAPM. The second model is the conditional CAPM from Jagannathan and Wang (1996): E[r tr ,i ] = c0 + cmkt mkt,i + c prem prem,i , where Rprem,t1 is the lagged yield difference between Moodys Baa- and Aaa-rated corporate bonds and prem,i is calculated as the slope of the OLS regression of rtr ,i ,t on a constant and Rprem,t1 . The three remaining models are based on the following cross-sectional regression model: E[r tr ,i ] = c0 + cmkt mkt,i + csmb smb,i + chml hml,i + cmommom,i + cliq liq,i , where smb,i and hml,i are estimated as the slope coefcients with respect to the Fama and French (1993) size and value factors SMB and HML, mom,i is estimated as the slope coefcient of an OLS regression of rtr ,i ,t on a constant and the Carhart (1997) momentum factor, and liq,i is estimated as the slope coefcient on the Pastor and Stambaugh (2003) liquidity factor. I consider the Fama and French (1993) three-factor model that only includes the rst three factors, as well as the four-factor model including momentum and a model including all ve factors. The liquidity factor is available for a shorter sample period, from August 1962 to December 2008. The cross-sectional regression model is estimated using the Fama and MacBeth (1973) procedure. The table gives estimates of the cross-sectional regression coefcients, the corresponding FamaMacBeth t-values (t-value F M , in parentheses), Jagannathan and Wang (1998) adjusted tvalues (t-value JW , in parentheses), the cross-sectional regressions OLS adjusted- R2 calculated as in Jagannathan and Wang (1996), and below that the GLS R2 . In the last column, the table reports the square root of the mean squared pricing error (rmspe) and below (in square brackets) the F -statistic of the test of H0 : all pricing errors are equal to zero. This test is robust to estimation error in the rst-stage simple betas as well as conditional heteroskedasticity. Panel A: Cross-Sectional Regressions for 25 Size-BM Portfolios c0 c ( 102 ) t-value F M t-value JW c ( 102 ) t-value F M t-value JW c ( 102 ) t-value F M t-value JW c ( 102 ) t-value F M t-value JW c ( 102 ) t-value F M t-value JW 1.20 (3.23) (3.15) 1.73 (4.89) (2.60) 1.15 (4.23) (4.24) 0.49 (1.49) (1.15) 0.73 (2.17) (1.76) cmkt 0.51 (1.24) (1.22) 1.45 (3.76) (2.21) 0.69 (1.78) (1.74) 0.87 (1.49) (1.12) 0.39 (0.58) (0.49) c prem csmb chml cmom cliq
2 Rols (gls)

rmspe 0.21% [2.68] 0.18% [1.18] 0.11% [2.10] 0.10% [1.46] 0.10% [1.35]

8.57% 10.50% 0.61 (4.10) (2.58) 31.13% 10.89% 0.41 (2.76) (2.51) 0.32 (2.07) (1.36) 0.29 (1.72) (1.19) 0.38 (2.72) (2.73) 1.08 (4.53) (3.16) 0.76 (3.18) (2.53) 71.27% 33.51% 3.27 (3.66) (2.72) 1.99 (2.29) (1.92) 74.65% 41.41% 2.38 (1.90) (1.56) 78.06% 46.14%

Panel B: Cross-Sectional Regressions for 100 Size-Beta Portfolios c0 c ( 102 ) t-value F M t-value JW 0.67 (3.81) (3.81) cmkt 0.01 (0.02) (0.02) c prem csmb chml cmom cliq
2 Rols (gls)

rmspe 0.22% [1.44] (Continued)

1.02% 0.00%

Industry-Specic Human Capital


Table VContinued Panel B: Cross-Sectional Regressions for 100 Size-Beta Portfolios c0 c ( 102 ) t-value F M t-value JW c ( 102 ) t-value F M t-value JW c ( 102 ) t-value F M t-value JW c ( 102 ) t-value F M t-value JW 0.70 (4.01) (2.66) 0.65 (3.77) (3.87) 0.58 (3.12) (2.88) 0.58 (3.18) (2.82) cmkt 0.49 (1.97) (1.40) 0.24 (0.72) (0.71) 0.03 (0.07) (0.06) 0.07 (0.15) (0.12) c prem 0.50 (3.52) (2.58) csmb chml cmom cliq
2 Rols (gls)

67

rmspe 0.18% [0.87] 0.13% [1.44] 0.13% [1.31] 0.13% [1.33]

37.25% 0.19% 0.45 (2.81) (2.75) 0.47 (3.02) (2.83) 0.46 (2.80) (2.40) 0.37 (1.64) (1.73) 0.41 (1.74) (1.55) 0.37 (1.59) (1.30) 63.36% 5.23% 0.74 (1.94) (1.78) 0.98 (2.70) (2.28) 64.63% 12.16% 0.40 (0.60) (0.53) 64.76% 12.85%

Sadka (2008)). In the nal benchmark model, I include the Pastor and Stambaugh (2003) liquidity factor.22 I estimate the following ve-factor model: E[ritr ] = c0 + cmkt mkt,i + csmbsmb,i + chml hml,i + cmommom,i + cliq liq,i . (13) The results in Panel A show that the coefcient estimate cliq is marginally signicant based on the unadjusted t-statistic, and the OLS and GLS R2 s increase slightly compared to the four-factor model (78% and 46%). Panel B reports the results based on the 100 size-beta sorted portfolios. The poor performance of the static CAPM is even more dramatic, with R2 s close to zero. Furthermore, the coefcient on the liquidity factor loses signicance. The ranking of the models based on R2 s and pricing errors is similar to Panel A. Overall, the results in Table V show that a model with (orthogonalized) industry-specic human capital returns compares reasonably well to the ve benchmark models. The model easily outperforms the static and conditional CAPM, and has similar R2 s and pricing errors as the models with size, value, momentum, and liquidity factors when estimated for 100 size-beta sorted portfolios. For the 25 size-BM portfolios, the latter three models capture 11% to 18% more of the cross-sectional variation in stock returns. E. Robustness Check This section briey discusses a number of robustness checks. The results and a more detailed discussion can be found in the Internet Appendix. First, the results are robust to using quarterly instead of monthly returns.
22 The liquidity factor is downloaded from Pastors website. The factor is only available from August 1962 to December 2008. Therefore, model specications that include the liquidity factor are estimated for this shorter sample period.

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Second, I include one human capital industry at a time to address possible concerns that the outperformance of the model with industry-specic human capital is due to the larger number of factors. While the OLS R2 s are adjusted for the degrees of freedom, they may not completely control for the difference in the number of factors. The resulting model includes the market return, aggregate labor income growth, and orthogonalized human capital returns for one industry. Using the 25 size-BM portfolios as test assets, I nd that the coefcient on orthogonalized human capital is signicant for all industries. Also, for all industries except manufacturing, the OLS R2 is substantially higher than for the model with only aggregate labor income growth. For instance, adding orthogonalized human capital returns of the goods producing industry increases the R2 from 9% to 47%. The results for the 100 size-beta portfolios are similar. These ndings conrm that the higher OLS adjusted- R2 s of the model with industry-specic human capital are not merely due to the larger number of factors. Third, I add the factors of the benchmark models (i.e., the yield spread, size, value, momentum, and liquidity) to the models with human capital returns. The signicance of aggregate and industry-specic human capital is not affected much. I nd that the momentum factor loses signicance when added to industry-specic human capital returns. Momentum also becomes insignificant when added to aggregate human capital for the 100 size-beta portfolios. All other factors remain at least marginally signicant. Finally, as suggested by Jagannathan and Wang (1998), I include rm characteristics in the cross-sectional regressions. If the model is correctly specied, characteristics should not have any explanatory power. I nd that average log rm size and book-to-market ratios are signicant in the cross-sectional regressions with both aggregate and industry-specic human capital, suggesting that the models do not pass this model misspecication test. Nevertheless, two (respectively three) human capital industries remain signicant. IV. Human Capital and the Premium for Idiosyncratic Risk The results presented in Section III support an asset pricing model that includes industry-specic labor income growth rates. In this section, I examine the consequences of ignoring human capital in an asset pricing model. In particular, I link (industry-specic) human capital to the premium for IR that has been documented in the literature. According to modern portfolio theory, investors should not receive compensation for stocks IR, since this can be diversied away. However, various empirical papers report evidence of a cross-sectional relation between IR (measured as the CAPM or FF3 model residual volatility) and expected returns. Among others, King, Sentana, and Wadhwani (1994), Malkiel and Xu (1997, 2004), Spiegel and Wang (2005), and Fu (2009) nd a positive relationship. This is in line with the theoretical models of Levy (1978), Merton (1987), and Malkiel and Xu (2004) in which investors underdiversify due to market frictions. In contrast, Ang et al. (2006, 2009) document a negative relationship, based on realized residual volatility using daily data over the past month. Fu (2009)

Industry-Specic Human Capital

69

shows that this is an imprecise measure of expected idiosyncratic volatility because of its time-varying nature. Using an Exponential GARCH model to estimate expected idiosyncratic volatility, he nds a positive relationship.23 Testing whether IR, measured as the residual volatility of a particular asset pricing model, is priced can be interpreted as a test of model misspecication. If the model captures all systematic risk, residual volatility should not affect expected returns.24 However, if the model fails to capture all systematic risk, part of that risk ends up in the error term and the resulting IR may appear to be priced. The results presented in Section III show that industry-specic human capital affects expected returns. Therefore, a natural follow-up question is: what happens if human capital is ignored in the asset pricing model? Could this induce a relation between the models residual volatility and expected returns? Before analyzing these issues empirically, I rst demonstrate the intuition theoretically, using the nontradable assets model. A. Idiosyncratic Risk in the Nontradable Assets Model If systematic risk is measured using the CAPM, the resulting idiosyncratic (i.e., residual) variance equals

tr

2 mkt mkt mkt .

In the absence of nontradable assets (i.e., qnt = 0), the tradable market portfolio is an appropriate benchmark for measuring systematic risk and is the true IR, which does not affect expected returns. However, in the presence of nontradable assets, the CAPM does not capture all systematic risk and contains systematic risk due to nontradable assets. Consequently, affects expected returns. This can be seen by rewriting expression (1) as tr = mkt mkt +
H , where

H=

1 tr

tr ,nt qnt .

(14)

This alternative specication of the nontradable assets model shows that expected returns are affected by CAPM residual risk, depending on the aggregate hedging demand induced by nontradable assets ( H ). To empirically investigate the link between IR and nontradable human capital, it is convenient to express equation (2) as follows:
K

E[rtr ,i ] = mkt,i E[rmkt ] +


k=1

hc hc Cov[ei , Rk ]qk ,

(15)

where ei,t = rtr ,i,t mkt,i rmkt,t , that is, asset i s residual return with respect to the tradable market portfolio. This expression explicitly shows how the idiosyncratic return with respect to the CAPM can enter the pricing equation,
23 Also, Bali and Cakici (2008) report that the sign and magnitude of the results in Ang et al. (2006) depend on data frequency, portfolio weighting schemes, and portfolio breakpoints. 24 This argument can also be made when investors underdiversify, for instance, due to transaction costs. If the model incorporates these market frictions, idiosyncratic risk with respect to the adjusted measure of systematic risk should not affect expected returns.

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depending on its covariance with the returns on (industry-specic) human capital. The model can be tested using a cross-sectional regression including the market beta and the covariance between CAPM residuals and human capital returns. Section IV.C discusses the results. B. Returns on Idiosyncratic Risk Sorted Portfolios To empirically investigate the impact of IR on the cross-section of expected returns and the link with (industry-specic) human capital, I construct 10 IR sorted portfolios, controlling for size. To this end, I rst construct 100 size and IR sorted stock portfolios using all common shares traded on the NYSE, Amex, and NASDAQ (from CRSP).25 I estimate rm-level idiosyncratic volatility as the market model residual variance, which is in line with equation (14). As a robustness check, I estimate IR as the residual variance of the FF3 model. Following Spiegel and Wang (2005) and Fu (2009), I estimate monthly IR using an EGARCH model (Bollerslev (1986), Nelson (1991)). For each stock, using all available monthly returns with a minimum of 60 observations, I estimate nine EGARCH( p, q) models, for ( p, q) {1, 2, 3}. I select the model with the lowest Akaike Information Criterion. Each month I double-sort stocks into size and IR deciles. The breakpoints are based on NYSE stocks only. I calculate value-weighted returns on the resulting 100 portfolios and subtract the 1-month T-bill rate.26 The Internet Appendix reports summary statistics and CAPM alphas of the full set of 100 size-IR sorted portfolios. I construct 10 IR sorted portfolios by averaging over all size deciles within each IR decile. Sorting stocks based on idiosyncratic volatility leads to a substantial spread in the portfolio characteristics. Table VI, Panel A shows that the time-series average excess returns are increasing in IR and range from 0.30% per month for the low IR portfolio to 1.28% per month for the high IR portfolio. This is in line with Fu (2009) and Spiegel and Wang (2005), who report similar large returns for portfolios consisting of high IR stocks. Panel A shows that the standard deviation of the portfolio returns ranges from 3.32% (low IR) to 8.88% (high IR) per month. By construction, the size of the portfolios is similar, although the average size of the low IR portfolios slightly exceeds that of the high IR portfolios. Portfolios with higher IR stocks also have higher market betas, but this cannot fully account for the return difference between high and low IR portfolios. I
25 A potential concern when investigating IR for portfolio returns is that, in portfolios, stocks idiosyncratic risks are diversied away. However, the premium for IR that is predicted by the nontradable assets model does not concern true diversiable IR, but systematic risk not captured by the CAPM, which should be present in portfolio returns. 26 Since the parameters of the EGARCH model are estimated over the full sample period, the 100 size-IR portfolios do not form a true trading strategy. This could be solved by estimating the EGARCH model for each stock for each month, using all returns prior to that month. However, this would require estimation of a much larger number of EGARCH models. Also, the main purpose of the 100 size-IR portfolios is to examine the contemporaneous link with human capital returns and not to design a trading strategy based on idiosyncratic volatility. Fu (2009) nds similar results based on full sample or expanding window estimates.

Industry-Specic Human Capital


Table VI

71

Ten Idiosyncratic Risk Sorted Portfolios: Summary Statistics and Human Capital Betas
This table reports summary statistics and human capital betas of excess returns on 10 idiosyncratic risk (IR) sorted portfolios from April 1959 to December 2009. Every month, all stocks traded on the NYSE, Amex, and NASDAQ are sorted into size deciles based on their market capitalization at the beginning of the month. Within each size decile, the stocks are then sorted into IR deciles based on the estimated conditional idiosyncratic volatility for that month. This double sorting results in value-weighted returns on 100 size-IR sorted portfolios. Breakpoints are determined using NYSE stocks only. Idiosyncratic volatility is estimated as the residual volatility of the market model. For each asset, monthly idiosyncratic volatility is estimated using an EGARCH model for all available returns. Returns on the 10 IR sorted portfolios are calculated as the average return over all size deciles for a given IR decile. Panel A reports summary statistics (mean, median, standard deviation, average log size (in log $ thousands), and average conditional idiosyncratic volatility of the stocks in each portfolio), the CAPM market beta, and the alphas of time-series regressions with respect to the CAPM, the FamaFrench three-factor model, and the Carhart four-factor model. Panel B reports human capital betas, which are calculated based on a simple regression of excess stock returns on a constant and human capital returns. Human capital returns are estimated as contemporaneous labor income growth rates. Panel C reports the covariance between the CAPM residual return and human capital returns. All panels report the results for the 10 IR sorted portfolios, as well as for the difference between the highest and lowest IR portfolios (H-L). , , and denote signicance at the 1%, 5%, and 10% levels, respectively, based on a Newey and West (1987) adjustment with four lags. Tests for differences in human capital betas are based on a White covariance matrix. The last row of Panel B reports corresponding t-values in parentheses. Panel A: Summary Statistics of 10 Idiosyncratic Risk Sorted Portfolios Mean (%) Low IR 2 3 4 5 6 7 8 9 High IR H-L 0.30 0.44 0.47 0.53 0.57 0.60 0.61 0.69 0.71 1.28 0.98 Median (%) 0.51 0.76 0.89 0.87 0.94 0.83 0.97 0.81 1.11 1.11 0.61 Stdev (%) 3.32 3.95 4.33 4.65 4.95 5.24 5.58 6.09 6.74 8.88 5.55 avg IR (%) 4.21 5.65 6.50 7.24 7.97 8.75 9.65 10.79 12.52 18.41 14.20 mkt 0.68 0.82 0.90 0.97 1.04 1.09 1.17 1.27 1.38 1.66 0.98 C AP M (%) 0.00 0.09 0.08 0.11 0.12 0.12 0.10 0.14 0.12 0.56 0.56 F F3 (%) 0.16 0.11 0.13 0.11 0.09 0.10 0.11 0.06 0.07 0.50 0.66 4 F (%) 0.16 0.10 0.11 0.07 0.04 0.02 0.03 0.08 0.11 0.77 0.93

avg Size 12.73 12.73 12.71 12.70 12.69 12.68 12.67 12.66 12.64 12.60 0.12

Panel B: Human Capital Betas


hc U S hc gds hc man hc dist hc ser v hc go v

Low IR 2 3 4 5 6 7 8 9 High IR

0.10 0.06 0.20 0.21 0.29 0.44 0.54 0.62 0.81 1.74

0.18 0.25 0.35 0.30 0.42 0.42 0.48 0.46 0.60 0.81

0.04 0.11 0.19 0.16 0.30 0.38 0.46 0.49 0.62 1.39

0.30 0.18 0.12 0.19 0.12 0.04 0.02 0.08 0.07 0.28

0.04 0.09 0.17 0.15 0.19 0.23 0.31 0.34 0.43 0.88

0.50 0.42 0.40 0.28 0.32 0.17 0.05 0.03 0.12 0.45 (Continued)

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Table VIContinued Panel B: Human Capital Betas
hc U S hc gds hc man hc dist hc ser v hc go v

H-L t-value

1.84 (2.43)

0.63 (1.10)

1.36 (2.19)

0.58 (0.84)

0.85 (1.82)

0.95 (1.27)

Panel C: Cov[e, Rhc ] 105


hc RU S hc Rgds hc Rman hc Rdist hc Rser v hc Rgo v

Low IR 2 3 4 5 6 7 8 9 High IR H-L

0.545 0.366 0.194 0.230 0.134 0.050 0.165 0.239 0.459 1.725 2.270

0.051 0.152 0.342 0.183 0.444 0.399 0.515 0.393 0.674 1.022 0.971

0.799 0.750 0.591 0.783 0.445 0.261 0.109 0.149 0.105 2.150 2.949

0.588 0.413 0.324 0.445 0.344 0.227 0.206 0.325 0.322 0.189 0.776

0.646 0.592 0.385 0.538 0.430 0.345 0.136 0.114 0.113 1.575 2.221

0.479 0.278 0.213 0.024 0.016 0.260 0.481 0.569 0.873 1.544 2.023

nd that time-series alphas with respect to the CAPM are generally increasing in IR. While low IR portfolios do not have signicant alphas with respect to the CAPM, the highest IR portfolio has a signicant alpha of 0.56% per month. The difference between the top and bottom portfolios, that is, the premium for IR, is signicant at the 5% level. Furthermore, the table reports alphas with respect to the FF3 model and the four-factor model that includes momentum. The premium for IR cannot be explained by these models. In fact, the differences between alphas of the high and low IR portfolios are even larger. In the Internet Appendix, I estimate IR as the residual variance of the FF3 model. The resulting premium for IR is highly signicant at 0.91% per month. These ndings conrm the positive relation between IR and expected returns that is reported in various papers.

C. Empirical Results The results presented in this section display a link between human capital and the premium for IR. First, I nd that high IR stocks have higher exposures to human capital returns. Next, the model with orthogonalized industryspecic human capital returns explains 68% of the cross-sectional variation in returns on 100 size-IR sorted portfolios. Third, the covariance between CAPM residual returns and human capital returns is increasing in IR and is signicantly priced in the cross-section of returns.

Industry-Specic Human Capital C.1. Human Capital Betas

73

Table VI, Panel B reports human capital betas of 10 IR sorted portfolios, showing that the betas are increasing in IR. The differences between low and high IR portfolios are substantial. For example, the lowest IR portfolio has a beta with respect to human capital from the manufacturing industry of 0.04, while the beta of the highest IR portfolio is 1.39. The difference between these betas is signicant at the 5% level. The difference between betas of high and low IR portfolios is also statistically signicant for aggregate labor income growth and labor income growth from the service industry.27 Hence, stocks with higher IR have higher exposures to human capital returns. Precisely these stocks have higher alphas with respect to the CAPM, FF3, and four-factor models. In other words, the apparent premium for IR is larger for stocks with higher exposures to human capital.

C.2. Cross-Sectional Regressions I examine the extent to which the nontradable assets model with industryspecic human capital can explain the cross-section of returns on IR sorted portfolios, based on returns on 100 size-IR portfolios. First, I nd that the null hypothesis of the Cragg and Donald (1997) test can be rejected at the 1% level. Also, the null hypotheses that all betas are zero or equal across the 100 portfolios are both rejected for all types of human capital.28 I estimate the three models with aggregate and (orthogonalized) industryspecic labor income growth rates, that is, equations (6), (7), and (8). The results are presented in Table VII , Panel A. These ndings conrm that the model with industry-specic human capital outperforms the model with aggregate labor income growth. The OLS adjusted- R2 is 60% versus 36%, and the GLS R2 is more than twice as high. All human capital industries have at least marginally signicant coefcients, while the coefcient on aggregate labor income growth is not signicant. The model with aggregate and orthogonalized industry-specic labor income growth captures 68% of the cross-sectional variation in returns. Panel B reports the results of the ve benchmark models discussed in Section III. The model with industry-specic labor income growth has similar OLS R2 s as the conditional CAPM (65%), four-factor (64%), and ve-factor (59%) models. However, these benchmark models have lower GLS R2 s. The static CAPM and FF3 models have lower OLS R2 s (36% and 44%, respectively). The Internet Appendix reports robustness checks similar to those for the 25 size-BM and 100 size-beta portfolios.

27 The Internet Appendix shows similar results for human capital betas of all 100 size-IR sorted portfolios. 28 These results are reported in the Internet Appendix.

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Table VII

Cross-Sectional Regressions for 100 Size-IR Sorted Portfolios


This table reports cross-sectional regression results for monthly excess returns on 100 size-IR portfolios from April 1959 to December 2009. Panel A reports the results for three different models with human capital returns: the human capital CAPM with aggregate labor income growth (equation (7)), the nontradable assets model with industry-specic human capital (equation (6)), and a model with aggregate human capital and industry-specic human capital returns that have been orthogonalized to the aggregate human capital returns (equation (8)). Monthly human capital returns are calculated as the contemporaneous growth rate in per-worker labor income, using a 2-month average. Panel B reports results for ve benchmark models: the static CAPM (equation (9)), the conditional CAPM (equation (10)), the Fama and French (1993) three-factor model (equation (11)), the four-factor model including the Carhart (1997) momentum factor (equation (12)), and the four-factor model augmented with the Pastor and Stambaugh (2003) liquidity factor (equation (13)). The models are estimated using the Fama and MacBeth (1973) procedure. The slope coefcient mkt,i is estimated using an OLS regression of ri ,t (i =1, . . . ,100) on a constant and rmkt,t , using returns over the full sample period. The other betas are estimated similarly. The table gives estimates of the cross-sectional regression coefcients, the corresponding FamaMacBeth t-values (t-val F M , in parentheses), and the Jagannathan and Wang (1998) adjusted t-values (t-val JW , in parentheses). The table also reports the cross-sectional regressions OLS adjusted- R2 calculated as in Jagannathan and Wang (1996) and below that the GLS R2 . The last column reports the square root of the mean squared pricing error (rmspe) and below that (in square brackets) the F -statistic of the test of H 0 : all pricing errors are equal to zero. This test is robust to estimation error in the rst-stage simple betas as well as conditional heteroskedasticity. Panel A: Models Including (Industry-Specic) Human Capital c0 c ( 102 ) t-val F M t-val JW c ( 102 ) t-val F M t-val JW c ( 102 ) t-val F M t-val JW 0.19 (1.21) (1.01) 0.39 (2.59) (1.11) 0.65 (4.55) (2.56) cmkt
hc cU S hc cgds hc cman hc cdist hc cser v hc cgo v 2 Rols (gls)

rmspe 0.36% [3.48] 0.28% [1.20] 0.25% [1.84]

0.67 0.17 (2.72) (1.37) (2.56) (1.41) 0.72 0.40 0.29 (2.99) (3.44) (2.05) (1.52) (1.85) (0.94) 0.98 0.33 0.11 0.23 (4.13) (4.49) (1.27) (4.62) (2.33) (1.84) (0.65) (1.73)

36.43% 6.93% 0.74 (6.01) (2.86) 0.21 (5.92) (2.15) 0.41 0.15 (2.55) (1.66) (1.28) (0.88) 0.36 0.57 (5.81) (8.40) (1.80) (2.73) 59.91% 14.65% 68.01% 20.18%

Panel B: Alternative Asset Pricing Models c0 c ( 102 ) t-val F M t-val JW c ( 102 ) t-val F M t-val JW c ( 102 ) t-val F M t-val JW 0.45 (2.02) (2.07) 0.06 (0.31) (0.19) 0.23 (1.58) (1.56) cmkt 0.97 (3.29) (3.41) 0.16 (0.63) (0.41) 0.57 (1.83) (1.83) c prem csmb chml cmom cliq
2 Rols (gls)

rmspe 0.37% [4.02] 0.27% [1.95] 0.34% [4.42] (Continued)

35.94% 3.24% 0.50 (5.17) (3.42) 64.50% 11.25% 0.38 (2.22) (2.38) 0.28 (1.34) (1.43) 43.67% 4.56%

Industry-Specic Human Capital


Table VIIContinued Panel B: Alternative Asset Pricing Models c0 c ( 102 ) t-val F M t-val JW c ( 102 ) t-val F M t-val JW 0.17 (1.02) (0.57) 0.16 (1.02) (0.53) cmkt 0.36 (0.96) (0.50) 2.12 (5.33) (2.79) c prem csmb 0.27 (1.83) (1.17) 0.08 (0.50) (0.28) chml 0.54 (2.06) (0.87) 0.17 (0.63) (0.30) cmom 3.26 (6.48) (4.19) 2.21 (4.17) (2.41) cliq
2 Rols (gls)

75

rmspe 0.27% [3.05] 0.26% [1.81]

63.97% 6.50% 6.35 (8.40) (5.03) 58.74% 9.68%

C.3. The Covariance between CAPM Residual Returns and Human Capital Returns According to the nontradable assets model expressed as in equation (15), the covariance between CAPM idiosyncratic returns and human capital returns affects expected stock returns. Panel C of Table VI reports estimates of hc ] for the 10 IR sorted portfolios. I nd that for the lowest IR portfoCov[ei , Rk hc ] is always negative (except for the goods producing industry), lios, Cov[ei , Rk while for the highest IR portfolios it is always positive. In all cases, the covariance is increasing in IR. This conrms the patterns in human capital betas. hc ] should be priced in the cross-section According to expression (15), Cov[ei , Rk of returns. Therefore, I estimate the following cross-sectional regression:
K

E[rtr ,i ] = 0 + mkt mkt,i +


k=1

hc kCov[ei , Rk ],

(16)

where mkt,i is the estimated slope coefcient of a regression of rtr ,i on a constant and rmkt , and ei is the time-series regressions residual. The intercept 0 should be zero. If the apparent premium for IR is related to the presence of nontradable assets, k should be nonzero. Table VIII reports the results. I nd that the cross-sectional regression coefcients k are highly signicant for industry-specic human capital for four industries. For aggregate labor income growth, the coefcient is not signicant. Estimates of the intercept are negative, and for the model with industry-specic human capital it is statistically signicant. In Panel B, I rerun the cross-sectional regressions imposing the restriction that the intercept equals zero. The R2 is now measured as one minus the sum of squared errors divided by the sum of squared average rehc turns. The coefcient with respect to Cov[ei , RU S ] for aggregate human capital is positive and marginally signicant. For industry-specic human capital, the coefcients for all industries except for services are signicant. The OLS adjusted- R2 s remain high. These results conrm that the apparent premium for IR is related to nontradable human capital. According to expression (15), the cross-sectional regression coefcients k are hc . When restricting the intercept to zero, which is in line with estimates of qk

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Table VIII

Nontradable Human Capital and the Apparent Premium for Idiosyncratic Risk
This table reports tests of the cross-sectional regression model: E[r tr ,i ] = 0 + mkt mkt,i + K hc k=1 k Cov[ei , Rk ], where rtr ,i is the excess return on portfolio i , rmkt is the excess return on the value-weighted CRSP index, mkt,i is the slope of an OLS regression of rtr ,i on a constant and rmkt , ei is the residual excess return of portfolio i with respect to the market model, and Rhc is the return on human capital, estimated as the contemporaneous growth rate in per-worker labor income (aggregate or industry-specic). The model is estimated using monthly excess returns on 100 size and IR sorted equity portfolios using the Fama and MacBeth (1973) procedure. The terms hc mkt,i and Cov[ei , Rk ] are estimated using time-series regressions over the full sample period. In the second stage, average excess portfolio returns are regressed on the cross-section of betas and covariance estimates. t-values (in parentheses) are adjusted using NeweyWest with four lags. Panel A reports the results of the unrestricted cross-sectional regressions, while Panel B restricts the intercept to zero. The table reports OLS cross-sectional regressions adjusted- R2 s and GLS R2 s. In Panel A, the OLS adjusted- R2 is calculated as in Jagannathan and Wang (1996). In Panel B, the R2 s are based on the (weighted) sum of squared mean returns on the test assets instead of their variance. Panel A: Results Unrestricted Cross-Sectional Regressions 0 mkt
hc U S hc gds hc man hc dist hc ser v hc go v 2 Rols (gls)

0.00 0.01 108.92 t-value (1.07) (2.91) (1.34) 0.00 0.01 171.46 t-value (2.32) (2.90) (3.12)

92.05 464.03 103.81 (2.09) (5.08) (2.50)

90.32 (1.58)

36.43% 6.93% 59.91% 14.65%

0= 0 Panel B: Results Restricted Cross-Sectional Regressions: 0 t-value t-value 0 n.a. 0 n.a. mkt
hc U S hc gds hc man hc dist hc ser v hc go v 2 Rols (gls)

0.01 161.36 (2.65) (1.72) 0.00 171.47 126.09 482.65 (1.77) (3.12) (2.62) (5.24)

70.63 135.89 (1.56) (2.34)

76.99% 3.23% 85.05% 9.68%

the model, the coefcient on aggregate human capital is positive and signicant at 161. Assuming again that qhc = 45 for aggregate human capital results in an implied coefcient of risk aversion of 3.6, which is a reasonable value. The magnitudes for the industry-specic coefcients are more difcult to interpret. Four out of ve industries have signicant coefcients, but the coefcient for the distribution industry is negative. The positive coefcients range from 126 hc ) to 171, which would result in reasonable relative values of human capital (qk only for a risk aversion coefcient of 10.

D. Analysis of Cross-Sectional Regression Pricing Errors Arguably, human capital is not the only missing factor from the CAPM. Therefore, in this section I examine the fraction of the premium for IR that

Industry-Specic Human Capital


Static CAPM 1.6 Fitted expected excess return (%) 1.4 1.2 1 0.8 0.6 0.4 0.2 0.2 Fitted expected excess return (%) 1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0.2 HC CAPM with aggregate labor income growth

77

0.4 0.6 0.8 1 1.2 1.4 Realized average excess return (%)

1.6

0.4 0.6 0.8 1 1.2 1.4 Realized average excess return (%)

1.6

Nontradable assets model with industry-specific human capital 1.6 Fitted expected excess return (%) 1.4 1.2 1 0.8 0.6 0.4 0.2 0.2

Aggregate and orthogonalized industry-specific human capital 1.6 Fitted expected excess return (%) 1.4 1.2 1 0.8 0.6 0.4 0.2 0.2

0.4

0.6 0.8 1 1.2 1.4 Realized average excess return (%)

1.6

0.4

0.6 0.8 1 1.2 1.4 Realized average excess return (%)

1.6

Figure 1. Realized average returns versus tted expected returns. Each scatter plot reports the realized full sample average portfolio excess returns against the tted expected excess portfolio returns (in percentages) for 10 IR sorted equity portfolios, constructed as in Table VI. tr The tted value for the expected excess portfolio return E[r i ] is based on the estimates of eight different models: the static CAPM (equation (9)), the human capital CAPM with aggregate labor income growth (equation (7)), the nontradable assets model with industry human capital (equation (6)), a model with aggregate human capital and orthogonalized industry-specic labor income growth (equation (8)), the conditional CAPM (equation (10)), the Fama and French (1993) threefactor model (equation (11)), a four-factor model including the Carhart (1997) momentum factor (equation (12)), and a ve-factor model including the Pastor and Stambaugh (2003) liquidity factor (equation (13)). The cross-sectional regressions are estimated for the 10 IR sorted portfolios augmented with 25 size and book-to-market sorted portfolios. Human capital returns are estimated as the contemporaneous growth rate in per-worker labor income, based on a 2-month moving average. The straight line is the 45-degree line through the origin. The models are estimated using Fama and MacBeth (1973), where mkt,i is estimated as the slope of an OLS regression of ri ,t (i = 1, . . . . , 35) on a constant and rmkt,t . The other betas are estimated similarly.

can be explained by the nontradable assets model with industry-specic human capital. To this end, I analyze the pricing errors of IR sorted portfolios. The typical approach based on time-series regression alphas cannot be used because human capital is not a tradable factor. Therefore, I analyze patterns in the pricing errors based on cross-sectional regressions. The results in

78
1.6 Fitted expected excess return (%) 1.4 1.2 1 0.8 0.6 0.4 0.2 0.2

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Conditional CAPM Fitted expected excess return (%) 1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0.2 Fama and French three-factor model

0.4 0.6 0.8 1 1.2 1.4 Realized average excess return (%) Four-factor model

1.6

0.4 0.6 0.8 1 1.2 1.4 Realized average excess return (%) Five-factor model

1.6

1.6 Fitted expected excess return (%) 1.4 1.2 1 0.8 0.6 0.4 0.2 0.2

1.2 Fitted expected excess return (%) 1.1 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 Realized average excess return (%)

0.4 0.6 0.8 1 1.2 1.4 Realized average excess return (%)

1.6

Figure 1. Continued.

Table VII show that the model with (orthogonalized) industry-specic labor income growth rates has lower average pricing errors on 100 size-IR portfolios than the human capital CAPM, static CAPM, and FF3 model. To analyze patterns in individual pricing errors, I focus on 10 IR sorted portfolios, which are averaged over all size deciles. This allows me to examine the relation between the pricing errors and IR, while controlling for size effects. First, I add these 10 portfolio returns to the 25 size-BM sorted portfolios and estimate the cross-sectional regressions for the resulting set of 35 portfolio returns. Figure 1 shows scatter plots of the average realized excess returns versus the tted expected excess returns for the 10 IR sorted portfolios. This gure provides a visual impression of the model t. If all points are on the 45-degree line through the origin, the model prices all IR sorted portfolios correctly. There is one portfolio in particular that has substantial pricing errors: the highest IR portfolio. The failure of the CAPM to price this portfolio is an indication of the apparent premium for IR. The tted expected returns based on the CAPM are comparable for the 10 IR sorted portfolios; the 10 dots are only slightly upward sloping. Similar results obtain for the model with aggregate

Industry-Specic Human Capital


Table IX

79

Analysis of Cross-Sectional Regression Pricing Errors


This table reports pricing errors of 10 IR sorted portfolios, based on cross-sectional regressions. In Panel A, the 10 IR sorted portfolios are added to 25 size and book-to-market sorted portfolios and the cross-sectional regressions are estimated for the resulting set of 35 portfolios. In Panel B, the cross-sectional regressions are estimated for 110 portfolios: the 10 IR sorted portfolios and 100 size-beta portfolios. The 10 IR sorted portfolios are constructed as in Table VI and the other portfolio returns are constructed as in Tables III and IV. The panels report the individual pricing errors (in percentages) of the 10 IR sorted portfolios, as well as the difference between the highest IR and the lowest IR portfolio (H-L). The corresponding t-values (in parentheses) are based on the asymptotic covariance matrix of the cross-sectional regressions pricing errors (see, for example, Kan and Robotti (2012)). The cross-sectional regressions are estimated using the Fama and MacBeth (1973) methodology. Both panels report pricing errors for the following eight models: the static CAPM (equation (9)), the human capital CAPM with aggregate labor income growth (equation (7)), the nontradable assets model with industry-specic human capital (equation (6)), a model with aggregate human capital and industry-specic human capital returns that have been orthogonalized to the aggregate human capital returns (equation (8)), the conditional CAPM (equation (10)), the Fama and French (1993) three-factor model (equation (11)), the Carhart (1997) four-factor model (equation (12)), 4F, and the four-factor model augmented with the Pastor and Stambaugh (2003) liquidity factor (equation (13)), 5F. Human capital returns are estimated as the contemporaneous growth rate in per-worker labor income, based on a 2-month moving average. Panel A: Pricing Errors (%) of 10 IR Portfolios When Added to 25 Size-BM Portfolios Aggr HC 0.26 0.14 0.13 0.08 0.05 0.04 0.04 0.03 0.02 0.49 0.75 (7.47) Ind HC 0.19 0.04 0.07 0.03 0.06 0.01 0.05 0.03 0.15 0.31 0.50 (5.29) Aggr HC +Ind 0.19 0.05 0.08 0.05 0.06 0.00 0.03 0.04 0.14 0.28 0.47 (5.72) Cond CAPM 0.34 0.22 0.19 0.11 0.08 0.09 0.09 0.02 0.02 0.43 0.78 (6.26)

CAPM Low IR 2 3 4 5 6 7 8 9 High IR H-L t-value 0.25 0.14 0.13 0.09 0.07 0.05 0.06 0.00 0.01 0.49 0.74 (7.41)

FF3 0.06 0.04 0.08 0.07 0.06 0.09 0.11 0.08 0.11 0.44 0.50 (9.03)

4F 0.11 0.07 0.10 0.08 0.07 0.10 0.11 0.10 0.14 0.38 0.49 (8.41)

5F 0.06 0.05 0.08 0.07 0.04 0.06 0.11 0.03 0.07 0.46 0.51 (9.43)

Panel B: Pricing Errors (%) of 10 IR Portfolios When Added to 100 Size-Beta Portfolios Aggr HC 0.33 0.20 0.19 0.10 0.07 0.07 0.07 0.02 0.02 0.34 0.68 (5.96) Ind HC 0.26 0.15 0.13 0.07 0.05 0.05 0.05 0.06 0.03 0.55 0.81 (6.79) Aggr HC +Ind 0.26 0.15 0.13 0.07 0.04 0.04 0.03 0.06 0.05 0.56 0.82 (7.37) Cond CAPM 0.33 0.20 0.16 0.06 0.04 0.06 0.06 0.00 0.01 0.41 0.74 (4.73)

CAPM Low IR 2 3 4 5 6 7 8 9 High IR H-L t-value 0.34 0.21 0.19 0.13 0.10 0.07 0.07 0.01 0.02 0.57 0.90 (9.44)

FF3 0.30 0.18 0.16 0.09 0.06 0.05 0.03 0.04 0.04 0.54 0.84 (9.26)

4F 0.30 0.19 0.18 0.12 0.09 0.06 0.07 0.02 0.02 0.50 0.80 (7.01)

5F 0.30 0.19 0.16 0.12 0.08 0.05 0.09 0.03 0.01 0.36 0.66 (7.40)

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labor income and for the conditional CAPM. For the other models, the tted returns fall closer to the 45-degree line, although all models have difculties pricing the highest IR portfolio. The models with (orthogonalized) industryspecic human capital have the lowest pricing errors for the high IR portfolio. Table IX, Panel A reports the individual pricing errors for all models. The bottom two rows report the difference between the pricing errors of the highest and lowest IR portfolios (H-L), and the corresponding t-statistics. For the CAPM, the difference in pricing errors is 0.74% per month. This alternative approach to estimating the premium for IR results in a higher estimate than based on the time-series alphas presented in Table VI. The human capital CAPM with aggregate human capital returns leads to a slightly higher estimate of H-L compared to the CAPM, which is 0.75%. In sharp contrast, the premium for IR is reduced substantially to 0.50% when the model includes industry-specic human capital and even further to 0.47% for the model with aggregate and orthogonalized industry labor income growth. Based on these estimates, the nontradable assets model with (orthogonalized) industry-specic human capital can reduce the premium for IR by 36%. The benchmark models have H-L estimates that range from 0.49% (four-factor model) to 0.78% (conditional CAPM). The premium remains statistically signicant for all model specications. As a robustness check, I estimate the pricing errors of the 10 IR sorted portfolios when added to the 100 size-beta portfolios. The results are reported in Panel B. Similar to Panel A, H-L is positive and highly signicant for all models. For the CAPM, the estimated premium for IR is 0.90%. In this panel, the model with aggregate labor income growth leads to a lower H-L estimate than the model with industry-specic human capital returns (0.68% vs. 0.81%). According to these estimates, the premium for IR is reduced by 10% to 25% when including human capital in the model. In sum, while human capital is arguably not the only missing factor from the CAPM, an analysis of pricing errors on 10 IR sorted portfolios reveals that the model with industry-specic human capital can explain 10% to 36% of the premium for IR. V. Conclusion Human capital, one of the main components of wealth, is heterogeneous across investors. This paper shows that human capital heterogeneity at the industry level affects the cross-section of stock returns. Industry-specic labor income dynamics and human capital discount rates affect the measurement of human capital returns. This is largely ignored in the commonly used proxy for aggregate human capital returns, which is based on aggregate labor income growth. Furthermore, several heterogeneous agent models show that uninsurable idiosyncratic labor income risk may affect asset pricing. This suggests that, if investors cannot completely share their industry-specic labor income risks, these risks may be priced. I estimate a linear asset pricing model that includes growth rates in industrylevel rather than aggregate labor income, in addition to the returns on the

Industry-Specic Human Capital

81

equity market portfolio. In cross-sectional regressions, several human capital industries have signicant coefcients, while the coefcient on aggregate labor income growth is often close to zero. Also, allowing for industry-level human capital heterogeneity increases the cross-sectional R2 substantially: from 9% to 61% for 25 size and book-to-market sorted portfolios. These results show that what matters for the cross-section of expected stock returns are primarily the industry-specic human capital risks rather than aggregate labor income risk. Next, I relate human capital to the premium for IR that is documented in various empirical papers. I show, both theoretically and empirically, that, when (industry-specic) human capital is excluded from the benchmark used to measure systematic risk, the resulting residual risk affects the cross-section of expected returns. The magnitude of the IR premium depends on the exposure to human capital returns.
Initial submission: June 30, 2009; Final version received: June 20, 2012 Editor: Campbell Harvey

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