DP10437 Where Experience Matters: Asset Allocation and Asset Pricing with Opaque and Illiquid Assets

Author(s): Adrian Buss, Raman Uppal, Grigory Vilkov
Publication Date: February 2015
Keyword(s): alternative assets, heterogeneous beliefs, incomplete markets, portfolio choice, private equity, transaction costs
JEL(s): G11, G12
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10437

Alternative assets, such as private equity, hedge funds, and real assets, are illiquid and opaque, and thus pose 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 at the initial date, and hence, the liquidity discount. Transaction costs may induce inexperienced investors to hold a majority of the illiquid asset at later dates, even if they are pessimistic about future payoffs, and produce a sizable liquidity discount. During periods when the alternative asset is illiquid, investors trade the liquid equity index instead, leading to strong spillover effects.