Investor Sophistication and Capital Income Inequality

Here is the first of the three paper you wanted to look at that support the idea that the rich get higher returns. Their SCF data they use in support their argument is bellow. Note when documenting the decline of retail investors they use 2000 as a baseline, that was of course the tech bubble, which likely skewed stock ownership more broadly

“…In the quantitative tests of the model in Figure 2, we show that sophisticated investors allocate their wealth first into assets with highest level of volatility and subsequently into assets with lower levels of volatility. Now, we provide additional evidence which suggests similar investors’ preferences. Our first piece of evidence is based on SCF data regarding households’ holdings in liquid wealth. The idea of this test is that unsophisticated investors should be more likely to invest in safe (liquid) assets. SCF provides detailed classification of wealth invested in such assets that include checking accounts, call accounts, money market accounts, coverdell accounts, and 529 educational state-sponsored plans. As before, in each period, we divide households into two groups: top 10% and bottom 50% of the wealth distribution. For each of the groups, we calculate the average ratio of liquid wealth to total financial wealth. Higher ratios would imply greater exposure to low-profit assets. We present the two time series in Figure 5. We find evidence that strongly supports predictions of our model. First, the average ratio of liquid wealth for sophisticated investors, equal to 15.3%, is significantly lower than that for unsophisticated investors, which in our sample equals 25%. In addition, while the exposure to liquid assets by sophisticated investors is generally non-monotonic (u-shaped), similar investment for unsophisticated investors exhibits a strong positive time trend, especially in the last 20 years: The average investment goes up from 16.7% in 1998 to 39% in 2010.This evidence strongly supports our economic mechanism in that differences in information capacity lead to retrenchment by unsophisticated investors from risky assets and relocation to safer assets. We further confirm this claim using evidence on institutional holdings from Thomson Reuters. To this end, we calculate average (equal-weighted) equity ownership of sophisticated investors (mutual funds and hedge funds) and unsophisticated (retail) investors. We report the respective time series quarterly averages of the ownership over the period 1989-2012 in Figure 6. The results paint a picture that is generally consistent with our model’s predictions. Although the average ownership level of unsophisticated investors is higher in an unconditional sample and equals 61%, the time-series evidence clearly indicates a very strong pattern: The average equity ownership for unsophisticated investors goes down while that for sophisticated investors significantly goes up…”

Marcin Kacperezyk, Jaromier Nosal and Luminita Stevens, "Investor Sophistication and Capital Income Inequality,"Journal Of Monetary Economics, September 2014, https://www.cmu.edu/tepper/faculty-and-research/assets/docs/Nosal_KNS_paper_sep2014.pdf

“…An important component of total income, capital income is by far the most polarized part of household income in the United States, and it exhibits a strong upward trend in polarization…we provide a micro-founded mechanism for the return differential and show that, when embedded in a general equilibrium framework, it can go a long way in explaining the growth in capital income inequality, qualitatively and quantitatively. The main friction in the model is heterogeneity in investor sophistication. Intuitively, when information about financial assets and its processing are costly, individuals with different access to financial resources differ in terms of their capacity to acquire and process information. Sophisticated investors have access to better information, which allows them to earn higher income on the assets they hold. As a result, their wealth diverges from that of the unsophisticated investors with relatively less information. In addition, unsophisticated investors perceive their information disadvantage through asset prices and allocate their investments away from the allocations of informed investors, resulting in further divergence….This basic intuition resonates well with robust empirical evidence that documents the growing presence of sophisticated, institutional investors in risky asset classes, over the last 20-30 years….. Specifically, the average institutional equity ownership has more than doubled over the last few decades, and it accounts now for more than 60% of the total stock ownership. Our hypothesis also fits well with a puzzling phenomenon of the last two decades of a growing retrenchment of retail investors from trading and stock market ownership in general…. even though direct transaction costs, if anything, have fallen significantly. We document such avoidance of risky assets both for direct stock ownership and ownership of intermediated products, such as actively managed equity mutual funds. Specifically, we find that direct stock ownership has been falling steadily over the last 30 years, while flows into equity mutual funds coming from less sophisticated, retail investors began to decline and turn negative starting from the early 2000s, implying a drop in cumulative flows by 2012 by an astounding 70% of their 2000 levels….First, we show that sophisticated ownership increases with aggregate sophistication, which can be interpreted as general progress in information processing technologies. This result holds even if we keep the relative sophistication of the two investor types constant. Intuitively, the more an investor knows, the easier it is for her to learn on the margin. This effect reinforces the general equilibrium effect that the same growth in sophisticated investors’ capacity raises prices more than that of unsophisticated investors’ and leads to unsophisticated investors being priced out of the risky asset market. Second, we show that sophisticated investors are more likely to invest in and learn about more volatile assets within a set of risky assets. Thus, the mechanism implies a robust, unique way in which investors expand their risky portfolio holdings as the total capacity in the economy expands - they keep moving down in the asset volatility dimension. At the same time, unsophisticated investors abandon risky assets and hold safer assets. Third, similar effects occur in terms of trading intensity. Sophisticated investors frequently trade their assets while unsophisticated investors turn over their risky assets much less. Finally, we show that the symmetric expansion in capacity leads to lower expected market returns. These results play an important role in that they cut against plausible alternative explanations, such as the model with heterogeneous risk aversion or differences in trading costs…..What contributes to the growing income inequality across households? This question has been of great economic and policy relevance for at least several decades starting with a seminal work by Kuznets. We approach this question from the perspective of capital income that is known to be highly unequally distributed across individuals. We propose a theoretical information-based framework that links capital income derived from financial assets to a level of investor sophistication. Our model implies the presence of income inequality between sophisticated and unsophisticated investors that is growing in the extent of total sophistication in the market and in relative sophistication across investors. Additional predictions on asset ownership, market returns, and turnover help us pin down the economic mechanism and rule out alternative explanations. The quantitative predictions of the model match qualitatively and quantitatively the observed data.Although our empirical findings are strictly based on the U.S. market, our model should have similar implications for other financial markets. For example, qualitatively, we know that income inequality in emerging markets tends to be even larger than the one documented for the U.S. To the extent that financial sophistication in such markets is much more skewed one could rationalize within our framework the differences in capital incomes. Similarly, the U.S. market is considered to be the most advanced in terms of its total sophistication, which is possibly why we find a greater dispersion in capital income compared to other developed markets, such as those in Europe or Asia. More generally, one could argue that although the overall growth of investment resources and competition across investors with different skill levels are generally considered as a positive aspect of a well-functioning financial market, our work suggests that one should assess any policy targeting overall information environment in financial markets as potentially exerting an offsetting and negative effect on socially relevant issues, such as distribution of income. We leave detailed evaluation of such policies for future research….”