Andrea Eisfeldt, University of California at Los Angeles and NBER; Hanno Lustig, Stanford University and NBER; and Lei Zhang, University of California at Los Angeles

Risk and Return in Segmented Markets with Expertise

Complex assets appear to earn persistent high average returns, and to display high Sharpe ratios. Despite this, investor participation is very limited. Eisfeldt, Lustig, andZhang provide an explanation for these facts using a model of the pricing of complex securities by risk-averse investors who are subject to asset-specific risk in a dynamic model of industry equilibrium. Investor expertise varies, and the investment technology of investors with more expertise is subject to less asset-specific risk. Expert demand lowers equilibrium required returns, reducing participation, and leading to endogenously segmented markets. Amongst participants, portfolio decisions and realized returns determine the joint distribution of financial expertise and financial wealth. This distribution, along with participation, then determines market-level risk bearing capacity. The researchers show that more complex assets deliver higher equilibrium returns to expert participants. Moreover, the researchers explain why complex assets can have lower overall participation despite higher market-level alphas and Sharpe ratios. Finally, they show how complexity affects the size distribution of complex asset investors in a way that is consistent with the size distribution of hedge funds.