Friday, December 19, 2014

Where Experience Matters: Asset Allocation and Asset Pricing with Opaque and Illiquid Assets

BUSS Adrian, UPPAL Raman, VILKOV Grigory
Read the working paper
INSEAD Working Paper 2014/68/FIN

Alternative assets, such as private equity, hedge funds, and real assets, are illiquid and opaque, thus posing a challenge to traditional models of asset allocation. In this paper, we study asset allocation and asset pricing in a general equilibrium model with liquid assets and an alternative risky asset, which is opaque and incurs transaction costs, and investors who differ in their experience in assessing the alternative asset. We find that the optimal asset-allocation strategy of the relatively inexperienced investors is to initially tilt their portfolio away from the alternative asset and to hold more of it with experience. Counterintuitively, a decrease in the transaction cost for the alternative asset increases the portfolio tilt, and hence, the liquidity discount. Transaction costs also induce portfolio inertia; thus, the inexperienced investor could be holding a majority of the alternative asset even if she is currently pessimistic about its expected payoff. During periods when the alternative asset is illiquid, investors trade the liquid equity index instead, leading to strong spillover effects.