Asset Complexity and the Return Gap
Pengjie Gao, Allen Hu, Peter Kelly, Cameron Peng, Ning Zhu
Review of Finance, Volume 28, Issue 2, March 2024, Pages 511–550, https://doi.org/10.1093/rof/rfad027
There is significant evidence that portfolio returns increase with wealth/sophistication. In recent work, Bach et al. (2020) and Fagereng et al. (2020) document that – even within asset class – investment returns increase with investor wealth. These differing rates of return are a key source of wealth inequality – therefore, it is critical for policymakers and academics to understand the source of this return gap. We suggest that wealthier investors outperform since they are able to navigate complexity better. Analyzing detailed account-level data of millions of Chinese investors, we provide evidence for this mechanism.
We compare the trading of complex, structured products in the Chinese market – B funds – with the trading of simple, non-structured funds. We show that the return gap between the naïve and sophisticated is an order of magnitude greater when trading B funds. The figure below presents aggregate profits (losses) scaled by average daily balance by investor type for B funds and simple, non-structured funds. While there is a large return gap for B funds, there is little evidence of a return gap for simple non-structured funds. This is consistent with our hypothesis that asset complexity widens the return gap.
In our paper, we provide evidence that this widening return gap can be directly attributed to product complexity. These B funds had difficult-to-understand downward restructuring events, which implied a clear reduction in market value. We show that wealthy and sophisticated investors navigated complex restructuring events much better than their unsophisticated counterparts.
Why did unsophisticated investors buy these products? We provide evidence that their entry was driven by the embedded leverage of the products and high past returns. This should motivate regulators to consider higher barriers to entry such that it is more likely for investors to be aware of the dangers. This recommendation is particularly relevant for products with high embedded downside risk, but little realized downside risk. Such products often appear quite attractive—they usually have salient high realized returns without any significant negative returns—but they also have a hidden risk that is difficult to understand. This may lead naive investors to purchase when the embedded risk is heightened because they don’t understand the true underlying risk. These types of products are also more likely to generate a return gap since the sophisticated can better navigate these embedded risks than their unsophisticated counterparts.
While our empirical analysis centers on Chinese markets, we think our findings offer insights to products in other markets. For example, leveraged ETNs and TerraUSD were complex products with high embedded downside risk, but little realized downside risk. During the COVID-19 pandemic, leveraged ETNs in the US market anecdotally contributed to personal bankruptcies (“Individual Investors Get Burned by Collapse of Complex Securities,” The Wall Street Journal, June 1, 2020). Recently, investing in an exchange-traded complex algorithmic stablecoin – TerraUSD – led to significant losses for unsophisticated investors (“TerraUSD Crash Led to Vanished Savings, Shattered Dreams”, The Wall Street Journal, May 27, 2022).