Opacity in Financial Markets

In my paper, Opacity in Financial Markets, forthcoming in the Review of Financial Studies, I study the implications of opacity in financial markets for investor behavior, asset prices, and welfare. In the model, transparent funds (e.g., mutual funds) and opaque funds (e.g., hedge funds) trade transparent assets (e.g., plain-vanilla products) and opaque assets (e.g., structured products). Investors observe neither opaque funds’ portfolios nor opaque assets’ payoffs. Consistent with empirical observations, the model predicts an “opacity price premium”: opaque assets trade at a premium over transparent ones despite identical payoffs. This premium arises because fund managers bid up opaque assets’ prices, as opacity potentially allows them to collect higher fees by manipulating investor assessments of their funds’ future prospects. The premium accompanies endogenous market segmentation: transparent funds trade only transparent assets, and opaque funds trade only opaque assets. A novel insight is that opacity is self-feeding in financial markets: given the opacity price premium, financial engineers exploit it by supplying opaque assets (that is, they render transparent assets opaque deliberately), which in turn are a source of agency problems in portfolio delegation, resulting in the opacity price premium.

This paper is motivated by the rising opacity in modern finance. Opaque investment companies, such as hedge funds—typically with secretive investment strategies and undisclosed holdings—have rapidly grown in size and seem to have played a major role in the markets. Moreover, the importance of opaque and complex financial assets, such as sophisticated structured products—whose payoff information is incomprehensible and/or inaccessible to most retail investors—was highlighted during the 2007-2009 financial crisis. How does opacity affect investor behavior, asset prices, and welfare? In terms of asset prices, an intriguing empirical fact is that opaque and complex assets have been traded at a premium, rather than at a discount. This is puzzling: it appears to be inconsistent with standard asset-pricing models with rational agents. Such models might predict that investors unable to comprehend the nature of an asset would require a discount on the price, rather than pay a premium. Why do opaque assets trade at a premium? More fundamentally, why do opaque assets emerge in the first place?

To answer these questions, I develop a fully rational, dynamic asset-market equilibrium model with portfolio delegation. Its baseline version has one risky asset and one riskless asset. To invest in the risky asset, investors need to give capital to a fund manager, who forms a portfolio consisting of the risky and riskless assets. The manager earns a management fee proportional to the assets under management. The model features two types of opacity in financial markets. First, the funds are opaque in that investors cannot observe the funds’ portfolios and the fund managers cannot commit to their portfolio choices. An example is a hedge fund adopting a flexible trading strategy that is not communicated to investors. Second, the risky asset is opaque in that investors cannot observe its payoffs. An example is a sophisticated derivative whose payoff information is, for nonprofessional investors, unavailable or prohibitively costly. Another manifestation of opacity is the complex nature of an asset that makes it difficult to comprehend its payoffs. For instance, understanding the payoff of a structured product may require wading through its prospectus and disclosure documents, which are hundreds of pages long and filled with technical jargon. The volume of information and extent of technical difficulty make the asset’s payoffs effectively unobservable to investors (the information overload problem).

An important consequence of these two layers of opacity is that, although investors can (obviously) observe the total return from a fund, they cannot see the composition of that return. This is the source of an agency problem. Investors try to infer (i.e., back out) the opaque asset’s unobservable payoff from the observed fund return, estimate the asset’s future returns, and allocate capital on that basis. Yet, because the fund manager controls the portfolio that determines the fund return, that manager can potentially manipulate investors’ estimations through his portfolio choice. More specifically, the manager can boost the expected fund return by (secretly) levering up and overinvesting in the opaque asset, in an attempt to inflate investors’ estimates of the asset’s future returns and hence their assessments of the fund’s future prospects. So, potentially, investors can be led to allocate excessive capital to the fund and thus pay excessive fees.

In equilibrium, such an agency problem results in overpricing of the opaque asset, excessively high fund leverage, and lower social welfare. A key mechanism for these results is “signal jamming.” Opaque funds’ managers are inclined to lever up secretly in an effort to inflate investor expectations about their funds’ future performance, thereby attracting more capital and thus more fees. Investors understand the managers’ desire to fool them and hence are not fooled in equilibrium; nevertheless, the managers still lever up because otherwise their funds’ future prospects would be underestimated by the investors who believe that the managers do lever up secretly. Overinvestment drives up the asset’s price, resulting in lower expected returns for both the asset and the funds. In terms of utility, investors are unaffected, but managers are worse off: they attract less capital and thus earn lower fees as they fail to commit to not fool investors using opacity. In contrast, if funds are transparent and portfolios are observable (e.g., mutual funds), then the equilibrium does not depend on whether or not the risky asset is opaque. Indeed, regardless of managers’ actions, investors always correctly back out the asset’s payoff from the funds’ observed portfolios and returns, and therefore there is no scope for the managers to manipulate investors’ estimations.

To study a more realistic setting, I extend the model to accommodate both transparent and opaque funds, as well as transparent and opaque assets with identical payoffs. Each fund can choose one of the two risky assets to which to invest. In equilibrium, the opaque asset trades at a premium over the transparent asset, consistent with empirical observations. The result holds even though it is common knowledge that these assets yield identical payoffs and all funds can purchase whichever asset they wish. This price gap—the opacity price premium—is accompanied by endogenous market segmentation: transparent (opaque) funds trade only transparent (opaque) assets. This result is consistent with the real-world observation that mutual funds tend to focus on traditional asset classes, whereas hedge funds often trade opaque, complex financial instruments. The reason behind this segmentation is as follows. Because opaque fund managers cannot commit to their portfolio choices, a moral hazard problem prevents them from buying the transparent asset credibly; however, they can purchase the opaque asset credibly, being motivated by their desire to inflate the investors’ expected fund assessment. In contrast, transparent fund managers simply buy the cheaper transparent asset because the asset’s opacity is irrelevant for them.

Last, I address the fundamental question of why opaque assets emerge in the first place. In this model, they arise naturally from the demand of opaque fund managers. To study the supply of opaque assets, I introduce “financial engineers”—that is, agents who can make a transparent asset opaque and vice versa. In effect, the engineers act as arbitrageurs who exploit the opacity price premium: as long as the premium is positive, they buy transparent assets, make them opaque, and sell them at a profit. In equilibrium then the engineers serve to eliminate the premium. In that sense, opacity is self-feeding: engineers exploit the opacity price premium by supplying opaque assets, which in turn are the source of agency problems (in portfolio delegation) that result in a premium for opacity.

The full paper is available for download here.