Complex Asset Markets

Abstract

Complex assets appear to have high average returns and high Sharpe ratios. However, despite these attractive attributes, participation in complex assets markets is very limited. We argue that this is because investing in complex assets requires a model, and investors’ individual models expose them to investor-specific risk. Investors with higher expertise have better models, and thus face lower risk. We construct a dynamic economy in which the joint distribution of wealth and expertise determines aggregate risk bearing capacity in the long-run equilibrium. In this equilibrium, more complex asset markets, i.e. those which are more difficult to model, have lower participation rates, despite having higher market- level Sharpe ratios, provided that asset complexity and expertise are complementary. In this case, higher expert demand reduces equilibrium required returns, depressing overall participation. Thus, our theory explains why complex assets can have “permanent alpha”, despite free entry.

Keywords: segmented markets, limits of arbitrage, heterogeneous agent models, industry equilibrium, firm size distribution