The notion that bearing firm specific risk (idiosyncratic risk) is not compensated with a risk premium is hard to grasp at first. I will try to explain why.
Asset pricing theory, i.e the CAPM, suggests that a stock's "expected" return (or risk premium) only depends on the stock's covariance with the market portfolio - the beta on the market portfolio in the CAPM. According to theory, investors do not receive compensation for bearing firm specific risk (changes in firm value that do not covary with the market) because investors that diversify do not demand compensation for this risk. Diversified investors eliminate exposure to idiosyncratic risk by a law of large numbers since an event at one firm may be offset by an event in the opposite direction at another firm. Diversified investors are willing to hold a security at a higher price than an undiversified investor because they require less compensation for the idiosyncratic risk. The diversified investor only requires a premium for exposure to the market since one cannot diversify or average out shocks to the overall market.
But, what if you are a stock picker and you focus on understanding the business and all of the idiosyncratic events on that firm's horizon? For example, what if you expect there is a chance that the firm will likely hire a new CEO or that the firm's efforts to improve profitability are likely to pay off? These events when realized or announced will lead to price increases.
Does is matter that the market does not compensate you for taking the risk that a better CEO will not be found or that profitability will not improve? After all, if the possible returns for these events are high, then I don't care about passing up on a risk premium. The flaw in this reasoning is that the market is continuously pricing idiosyncratic events. Investors are continuously pricing the market's belief of the probability that a firm will find a new CEO or improve profitability. Diversified investors are willing to price the stock so that conditional on realized changes in beliefs or information expected returns only depend on the firm's covariance with the market.
So why do mutual funds, hedge funds and stock pickers talk so much about firm specific events? Investment managers disclose in their letters to investors why they chose to invest in a particular firm or industry. Often the reasoning is something about opportunities to improve profitability, a new product launch, etc. However, asset pricing theory would say that investors already price these beliefs pointed out by investment manager's regularly in their letters. All that should remain is the risk premium for market exposure. The only way that managers can be compensated for firm specific beliefs is if their beliefs differ from the market's marginal investor (who prices the stock) and are more accurate than the marginal investor's. The more informed investor may not have an incentive to fully price the information because the investor is not a diversified investor and requires a risk premium. The more informed investor may also have limits to capital that prevent the investor from fully exploiting the information.
Clearly, the only advantage an investor can have is information that is better than the market's. The information needs to be better than everyone else's information - not just the information of the average investor. The reason is that the next best informed will already try to price in his or her information. Thus, to believe that an investment manager can earn out sized returns by picking stocks is a bet on the manager having the best information regarding a stock than every other investor.
Who may these best informed investors be? They must have deep access to the company. Large investors that sit on the boards of companies are candidates since they have great access to performance information that the market cannot have access to. CEOs and insiders are also candidates. While this better access may appear to allow for insider trading, insider trading is hard to show if the information is about long term performance not fully disclosed to the public.
I have interviewed with hedge funds and a common question is why does the market not already know this? The hurdle for a hedge fund to get better access to information is a high hurdle.
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