Working Paper: NBER ID: w24143
Authors: David Hirshleifer; Chong Huang; Siew Hong Teoh
Abstract: In a setting with information asymmetry and a tradable value-weighted market index, ambiguity averse investors hold undiversified portfolios, and assets have nonzero alphas. But when a passive fund offers the risk-adjusted market portfolio (RAMP), whose weights depend on information precisions as well as market values, all investors hold the same portfolios as in the economy without model uncertainty and thus engage in index investing. So RAMP improves participation and risk sharing. Asset alphas are zero with RAMP as pricing portfolio. RAMP can be implemented by a fund of funds even if no manager individually has sufficient knowledge to do so.
Keywords: Index Investing; Asset Pricing; Information Asymmetry; Ambiguity Aversion
JEL Codes: F3; G11; G12; G14; G15; G4; G41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| ambiguity aversion (D81) | lack of diversification (G19) |
| ambiguity aversion (D81) | lack of risk sharing (D81) |
| ambiguity aversion (D81) | VWMP perceived as extremely risky (G32) |
| VWMP perceived as extremely risky (G32) | discouragement of market participation (G18) |
| VWMP does not facilitate stock market participation (G19) | non-zero asset alphas (G19) |
| ramp introduction (Y20) | correct inefficiencies (D61) |
| holding ramp (L93) | same portfolio holdings as in model without uncertainty (G19) |
| ramp serves as correct pricing portfolio (G19) | all assets have zero alphas relative to ramp (G19) |