Index and Smart Beta when Investors are

Ambiguity Averse

David Hirshleifer Chong Huang Siew Hong Teoh∗

June 1, 2018

Abstract
We show that in a rational expectations equilibrium model, investors who are am-
biguity averse about the market volatility give up index investing strategy. We then
design a new index that takes stock idiosyncratic volatilities into the weight. If a
smart beta fund offering such a new index is publicly available, ambiguity averse
investors hold the fund and an information-based portfolio, and thus participate in
all asset markets, directly or indirectly. This result follows from a new separation
theorem, which states that an investor’s equilibrium portfolio can be decomposed
into components, each matching the optimal portfolio based on only one informa-
tion source (price versus private signal). Asset risk premia satisfy the CAPM with
the fund as the pricing portfolio.

∗ Paul Merage School of Business, University of California, Irvine.David Hirshleifer, [email protected];

Chong Huang, [email protected]; Siew Hong Teoh, [email protected]. We thank Hengjie Ai (discussant),
David Dicks, David Easley (discussant), Bing Han, Stefan Nagel, Olivia Mitchell, Michael Sockin (discus-
sant), Avanidhar Subrahmanyam (discussant), Stijn Van Nieuwerburgh, Laura Veldkamp, Yajun Wang
(discussant), Liyan Yang, Jianfeng Yu, and seminar and conference participants at UC Irvine, University
of Toronto, National University of Singapore, Hong Kong Polytechnic University, the 6th Miami Behav-
ioral Finance Conference, the 2016 Stern Microstructure Meeting, the 27th Annual Conference on Financial
Economics and Accounting, the American Finance Association 2017 Annual Meeting, and the 12th Annual
Conference of the Financial Intermediation Research Society for very helpful comments.
1 Introduction
Index investing has been recommended publicly by legendary investors. For example,
Mark Cuban in an interview suggested that “If you don’t know too much about markets,
the best way to invest your money is to put it in a cheap S&P 500 SPX fund.” Warren
Buffett agreed and argued that consistently buying an S&P 500 low-cost index fund
makes the most sense practically all of the time. These turned out to be great suggestions
during the strong upward trend of U.S. equity market in the last ten years. According to
Morningstar’s commentary, net flows into actively managed U.S. equity funds fell $211
billion for the 12 months ended January 2018; in contrast, net flows into passive U.S.
equity funds rose by $233.5 billion in the same period.
However, it seems that when the financial market becomes intangible, investors give
up the index investing strategy. For example, Morningstar estimated that when the U.S.
stock market behaved like a roller-coaster in February 2018, investors pulled $8.4 billion
out of US equity passive funds.
Such a huge outflow is attributed to investor ambiguity aversion about the market
volatility. In such an argument, investors do not know perfectly the variance of the
distribution of stock returns—they face model uncertainty. Then, in making investment
decisions, ambiguity averse investors place heavy weight upon worst-case scenarios
(which is the extremely volatile financial market) and thus run away from the stock
market to avoid unbounded risks.
In this paper, we first provide a rational expectations equilibrium model to analyze
the index investing strategy when investors are ambiguity averse about assets’ idiosyn-
cratic volatilities. Consistent with the argument above, we show that index investing
strategy becomes unattractive to ambiguity averse investors, especially when the mar-
ket seesaws dramatically. We then ask whether it is possible to design a new index, such
that if a passive fund commits to offering it, even extremely ambiguity averse investors
are willing to hold the fund and indirectly participate in the financial market.
The new index design is indeed the smart beta investing strategy, which is gaining
increasing popularity.1 However, ambiguity averse investor do not have the informa-
tion needed to implement the smart beta strategy themselves. So the question of how
investors who do not know the ambiguous parameters form optimal portfolios that in-
1 Smart
beta strategies seek to passively follow indices, while also taking into account alternative
weighting schemes such as volatility to the traditional market capitalization.

1
clude the smart beta fund and other assets is economically meaningful and determinate.
Further interesting questions are how the investor’s degree of knowledge about the am-
biguous parameter of the economy, or the investor’s private information, affects the
optimal holdings in the smart beta fund; and how the existence of the smart beta fund
affects asset risk premia.
The newly designed index is different from the value-weighted market portfolio in
that it includes less shares of more volatile stocks. Hence, it is indeed related to the de-
fensive (low-volatility) investing strategy. We show that with the smart beta fund, all
investors hold identical positions in the fund as a common component of their portfo-
lios and hence participate in all assets’ markets. In consequence, a well-designed smart
beta strategy can prevent ambiguity averse investors from fleeing the financial market
and thus promote the market efficiency. In developing our analysis, we also provide a
new separation theorem for optimal security holdings under asymmetric information,
and a version of the CAPM that holds under ambiguity aversion and asymmetric infor-
mation.2
Specifically, in our setting there is a continuum of investors with strictly positive
endowments of all risky assets. Investors hold a common uninformative prior about
risky asset payoffs, so based upon the prior, holding non-zero positions of the assets is
infinitely risky. Security endowments are subject to random supply shocks. Prices are set
to clear the markets for all assets. For each asset, investors are divided into two groups.
Members of one group receive conditionally independent private signals about the asset
2 This separation theorem is the reason that delegation to a fund induces participation in our model. In

general an individual will be willing to delegate to an agent who credibly commits to a contingent strategy
(based on the agent’s knowledge) of doing whatever the individual himself would have done based on
that knowledge. But it does not follow that the nonparticipation problem is cured by delegating to a fund
whose manager knows the model parameters. The problem is that different potential investors in the fund
have different information sets (as well as different degrees of ignorance about model parameters). So in
general (without imposing the equilibrium condition, and without our portfolio information separation
theorem) there is no guarantee that a single fund (or fund of funds) can persuade different investors that
the fund is offering part or all of what each investor would have chosen herself (knowing what the fund
knows). (In the model, in equilibrium the fund does not offer each investor the overall portfolio that she
would want to hold, only a key component of such a portfolio.) It is only in equilibrium, and by virtue
of our new separation theorem, that we can conclude that there is a single fund (which we characterize)
which offers a key common component of the portfolios that the diverse investors themselves would have
chosen if they knew what the fund knows.
It might further be suggested that even without imposing the equilibrium condition, the problem of
nonparticipation could be solved by offering a separate tailored fund to each investor consisting of the
portfolio that this investor would have chosen if the investor knew the ambiguous model parameters.
However, even if this were a relevant option in practice, this approach does not solve the problem because
it is not clear exactly what portfolios such funds should offer.

2
payoff and know the precision of the supply shock. Members of the other group neither
receive any private signals about the asset payoff, nor know the precision of the supply
shock.3 In particular, the uninformed investors’ subjective belief about the precision of
the supply shock includes the possibility of precisions that are arbitrarily close to zero.
As a result, since the uninformed investors cannot extract information about the asset
payoff from its price when the precision of the supply shock is arbitrarily close to zero,
they may perceive the assets to be extremely risky.
Ambiguity averse investors choose optimal portfolio to maximize expected utility
under worst-case assumptions for the values of the supply volatility parameters that
they are uncertain about. So for any portfolio contemplated by an investor, expected
utility is calculated contingent on the unknown parameters having values that minimize
traditional CARA expected utility (following the max-min expected utility proposed by
Gilboa and Schmeidler (1989)).
There is a passive fund whose manager knows the supply shock precisions of all as-
sets. The assumption that fund managers observe parameters that individual investors
do not is based on the idea that fund managers are professionals who understand finan-
cial markets.4 The fund offers all investors a single portfolio which is a deterministic
function of the exogenous parameters, including the supply volatilities of all the assets.
Though investors who face model uncertainty do not know the exact weights of the
portfolio, the function used for constructing the portfolio is common knowledge. We
refer to the portfolio offered as ‘the fund.’
The key intuition derives from a new separation theorem which applies in the setting
with no model uncertainty. In this setting, there is a rational expectations equilibrium
in which any investor’s equilibrium risky asset holding can be decomposed into two
components. The first is a common deterministic component that plays a role in our
model somewhat similar to the market portfolio in the CAPM, but is distinct from the
endowed market portfolio. We call this component the Risk-Adjusted Market Portfolio
3 Most of the literature considers ambiguity aversion about asset payoffs, with the exception of Watan-
abe (2016), who assumes that investors are ambiguous about the mean of the asset’s random supply
shock. For tractability, we similarly assume that investors are ambiguous about precisions of assets’ sup-
ply shocks. However, our main result that all investors in equilibrium hold the passive fund holds even
when investors are ambiguous about other asset market parameters.
4 In particular, we assume that for each asset, there is a positive measure of investors who know the

precision of its random supply shock. Hence, the knowledge needed to construct an appropriate fund is
available in the economy. In Section 6, we discuss how the passive fund can be implemented by a fund of
funds.

3
(RAMP). The second is the investor’s information-based portfolio, which includes a non-
zero position in an asset if and only if she receives a private signal about the asset.
This new separation theorem differs from the separation theorem derived in the lit-
erature in that any individual investor’s optimal portfolio is separated by the differ-
ent parts of her information set. We therefore call it the Information Separation Theorem.
Specifically, RAMP is constructed based only on the information extracted from asset
prices, and is independent of the investor’s private signal. So another name for it is
the learning-from-price-based portfolio. Obversely, the information-based portfolio de-
pends only on the information derived from the private signal; it is independent of the
information extracted from asset prices.
This separation derives from the model assumptions of CARA utilities and normal
random variables. As is standard in such settings, any investor’s optimal position in
each asset is proportional to the product of her information precision about the asset
payoff and the difference between the conditional expectation of the asset payoff (given
her information) and the asset price. The precision of the investor’s overall information
about an asset is the sum of the precisions of the price signal and her private signal.
Because of normality, her conditional expectation of the asset payoff is the average of
the conditional expectations based on each of her two signals, weighted by the signal
precisions. Hence, the investor’s optimal position is the sum of two components. Each
is the product of the precision of one signal and the difference between the conditional
expectation of the asset payoff, based on only this signal, and the asset price. RAPM
is the investor’s optimal portfolio based only on the price signal, and her information-
based portfolio is her optimal portfolio based only on her private signal.
The Information Separation Theorem provides new insight into how ambiguity averse
investors will participate in asset markets when there is model uncertainty. Consider
again a setting where investors are subject to model uncertainty and a passive fund of-
fers RAMP. One share of the passive fund represents one unit of RAMP. Consider the
following proposed strategy profile: each investor holds exactly one share of the fund,
and additionally holds her investor-specific information-based portfolio (which could
be a nullity). Given that all other investors behave as prescribed, no investor has an
incentive to deviate.
The key insight is that the fund uses its knowledge to do precisely what each in-
vestor would choose in her non-information-based portfolio if she knew what the fund
knows. Consider, for example, an investor named Lucy and a vector of precisions of

4
assets’ supply shocks that is possible according to her subjective belief. Given the value
of this vector, she would be in a possible world without model uncertainty. In such
a possible world, since all other investors are holding exactly one share of the passive
fund and their own information-based portfolios, they are holding the same portfolios
as they would in the rational expectations equilibrium in this world. Hence, the market
clearing condition implies that the pricing function is the same as the one in the rational
expectations equilibrium. Therefore, if Lucy knew the parameter values that character-
ize this possible world, her optimal portfolio choice would consist of RAMP and her
own information-based portfolio.
By holding the passive fund and her own information-based portfolio, Lucy imple-
ments exactly such an investment strategy in every possible world. In each possible
world, RAMP, and therefore the composition of the passive fund, differ. But Lucy’s
information-based portfolio does not. So even when Lucy is ambiguous about some or
all assets, her optimal portfolio choice is to hold exactly one share of the passive fund
together with her own information-based portfolio.
In the above argument, given other investors’ strategies, we first fix a possible world,
and then calculate Lucy’s optimal investment strategy. Hence, we are implicitly assum-
ing that Lucy has a min-max utility. However, since Lucy’s optimal investment strategy,
holding one unit of the fund and her own information-based portfolio, is constant across
all possible worlds in her belief support, her min-max utility is the same as her max-min
utility. Put differently, a strong min-max property holds in the equilibrium, and thus
holding one unit of the fund and her own information-based portfolio is also the opti-
mal investment strategy with her max-min utility.
This argument for the optimality of investing in the fund (if all other investors behave
according to the proposed equilibrium) is a powerful one, as it requires only that an
ambiguity averse investor’s investment strategy be time-consistent. Imagine that Lucy
could pay a fee to learn the precise values of all parameters that she does not know.
This would eliminate her ambiguity aversion, so she would subsequently trade as an
uninformed investor who is not subject to model uncertainty. The fund is doing just
what Lucy herself would do if she were to pay the fee. So by time consistency, given
equilibrium behavior of all other investors, Lucy would strictly prefer holding the fund
over paying the fee, however small, to learn the parameters. In other words, delegation
can replace information acquisition as a means of addressing ambiguity aversion.5
5 Mele and Sangiorgi (2015) analyze a model in which ambiguity averse investors can acquire costly

5
 The presence of the fund affects asset risk premia. The fact that an investor with no
private information optimally holds the passive fund implies that it is mean-variance
efficient, so that the CAPM security market line holds with RAMP as the pricing port-
folio. Because the pricing portfolio does not depend on the realization of the random
supply shock, and the weight of each asset in the pricing portfolio are conditional on
asset prices, which are publicly observable, the portfolio is potentially observed by an
econometrician. This makes the model empirically testable.
Lucy’s willingness to hold the passive fund is an equilibrium outcome; the reason-
ing relies on her conjecture about the willingness of all other investors to hold the fund
and their own information-based portfolios. Otherwise, to consider an off-equilibrium
possibility, if other investors’ trading were to lead to asset prices that are almost unin-
formative, Lucy would not hold the passive fund, because RAMP would be extremely
risky to her in this case. We consider such a scenario in detail in Subsection 4.1.
This setting endogenizes investor trust in fund managers (Gennaioli, Shleifer, and
Vishny 2015). One subtle point that this approach reveals is that inducing investors to
participate requires more than investor trust in the honesty and superior knowledge of
fund managers about the financial market. It is crucial that investors foresee an equilib-
rium in which other investors also trust the fund managers and trade accordingly: as we
discuss in Subsection 4.1, off the equilibrium, it is possible that an investor is not willing
to hold the fund, even if she trusts the fund manager.
The equilibrium argument also highlights the fact that investors hold RAMP for risk-
sharing rather than mere individual-level diversification reasons, which would apply
even without analysis of market clearing. As further indication that diversification in-
centives are not at the heart of the result, we show that an equilibrium with ‘fund’ del-
egation exists even in the special case in which only one risky asset is traded in the
market.6
It may seem surprising that all investors take the same position in the passive fund,
even though their beliefs about the precisions of supply shocks and thus the fund com-
position have different supports. Investors with different priors have different worst-
case scenarios, and therefore differ in how risky they view the fund. However, owing to
the Information Separation Theorem, in equilibrium all investors agree that it is good to
information about model parameters. They show that, without a fund, investors have strong incentives
to do so.
6 We consider a multi-asset setting in order to derive cross-sectional asset pricing implications.

6
delegate their non-information-based investments to a fund that has access to the true
values of the supply volatilities. RAMP is based upon those actual values.
Overall, these findings suggest that when an appropriate passive fund is available,
investors’ ambiguity aversion alone does not explain nonparticipation. Since in fact
there is limited participation, this means that our model is not an accurate description
of reality. We view the primary contributions of this model as four-fold. First is pro-
viding conceptual clarification that ambiguity aversion does not, in a fairly standard
setting, explain the nonparticipation puzzle unless there is also a failure of the market
to offer an appropriate passive mutual fund. Second, when the fund is available, there
exists an equilibrium with several strong and interesting properties. For example, a ver-
sion of CAPM holds with the fund being the pricing portfolio. Third is the Information
Separation Theorem. Fourth is offering normative implications, about the possible ben-
efits of investor education and of funds offering RAMP. In particular, the index fund
industry has been growing rapidly in recent decades, yet the nonparticipation puzzle
remains. So the model raises the possibility that innovation in the fund industry, and in
particular the introduction of funds that offer RAMP, can benefit investors.

2 A Model of Financial Markets

The model has two dates, date 0 and date 1. The economy is populated by a continuum
of investors with measure one, who are indexed by i and uniformly distributed over
[0, 1]. All investors trade at date 0 and consume at date 1.

Assets. Any investor i invests in a riskfree asset and N ≥ 2 independent risky assets by
herself. Denote by Q the set of all risky assets. The riskfree asset pays r units, and risky
asset n pays f n units of the single consumption good. In addition to trading directly,
investors can also hold individual risky assets through a passive fund that commits to
offering a portfolio X, which is an N-dimension column vector with the nth element
being the shares of the nth risky asset in X.
Hence, if we denote by Di the vector of shares of the risky assets held by investor i
and by di (a scalar) the shares of the fund held by investor i, investor i’s effective risky
assets holdings are di X + Di .

Return Information. Let F = ( f 1 , f 2 , . . . , f N )0 be the vector of risky assets’ returns.

We assume that all investors share a common uniform improper prior of F, and so no

7
investor has prior information about any risky asset’s return.7
Each investor i, however, receives a vector of private signals Si about asset returns.
In particular, Si = F + ei , where F and ei are independent; and ei and e j are also inde-
pendent. Each ei is normally distributed, with mean zero and precision matrix Ωi . We
assume that Ωi is diagonal for all i ∈ [0, 1], and so investor i’s private signal about asset
n’s return is uninformative about asset k’s payoff.
We call investor i an informed investor of asset n if and only if the nth diagonal
entry of Ωi is strictly positive. Let the n-dimension column vector λ summarize the
measures of informed investors of each asset, with the nth element being the measure of
the informed investors of asset n; we assume λn ∈ (0, 1). Let Diag(λ) be the diagonal
matrix with the nth diagonal entry being the nth element of λ. We call an investor i with
precision matrix Ωi = 0 an uninformed investor. We assume that γ ∈ (0, 1) fraction of


investors are uninformed, so γ ≤ min j 1 − λ j .
For simplicity, we assume that the private signals of all informed investors of asset
n have the same precision κn > 0. Let Ω be the N × N diagonal matrix with the nth
diagonal entry being κn . Denote by Σ the matrix of the average precision of private
signals, we have
Z 1
Σ= Ωi di = ΩDiag(λ) (1)
0
As is standard, the independence of the errors implies that in the economy as a whole
signal errors average out, so that the equilibrium pricing function does not depend on
the error realizations (though it does depend on their distributions).

Random Supply. Let Z denote the random vector of supplies of all risky assets. We
assume that Z is independent of F and of ei (for all i ∈ [0, 1]). We further assume that
Z is normally distributed with mean 0 and the precision matrix U. By independence of
assets, U is diagonal and positive definite, with the nth diagonal entry being τn .
Investors commonly know all parameters except U. Specifically, we assume that only
informed investors of asset n know τn ; any uninformed investor i of asset n will have
her own subjective prior belief about τn with the support τ in , τ̄ni , where τ̄ni > τ in ≥ 0.

Denote by Ui the set of investor i’s belief about U, and by Ui a typical element in Ui . We
7 Inthe financial market, very few investors know all traded assets. Hence, it is reasonable to assume
that an investor holds uninformative priors about the assets that they don’t even know the names. In the
model, we still allow an investor to hold the assets that she does not know directly or indirectly through
the fund.

8
allow different uninformed investors of a particular asset n to have different supports
of their beliefs about τn .

Ambiguity Aversion. Taking the riskfree asset to be the numeraire, let P be the price
vector of the risky assets. Also, let Wi = (wi1 , wi2 , . . . , wiN )0 be the endowed sharehold-
ings of investor i (we assume that the aggregate endowments of shares of each stock is
R1
strictly positive; that is, W = 0 Wi di >> 0.) Then, investor i’s final wealth at date 1 is

Πi = r Wi0 − di X 0 + Di0 P + di X 0 + Di0 F.




(2)

The first term in (2) is the return of investor i’s investment in the riskfree asset, and the
second term is the total return from her investments in risky assets.
All investors are risk averse, so when all model parameters are common knowledge,
at date 0 their expected utility is CARA,

Π
  
Ei u ( Π i ) = Ei − exp − i . (3)
ρ

The expectation in equation (3) is taken based on investor i’s information about asset
returns. Because the common prior about asset returns is uninformative, any investor
i’s information consists of the equilibrium price vector and the realization of a private
information signal Si only.
However, investor i may be subject to model uncertainty about the precisions of
some assets’ random supplies, and will choose an investment strategy (di , Di ) to max-
imize the infimum of her CARA utility. Formally, each investor i’s decision problem
is8
Π
  
max inf Ei − exp − i . (4)
di ,Di Ui ∈Ui ρ

Equilibrium We are interested in a rational expectations equilibrium defined as fol-

lows.

Definition 1 A pricing vector P∗ and a profile of all investors’ risky assets holdings {di∗ , Di∗ }i∈[0,1]
constitute a rational expectations equilibrium, if
8 An
investor’s utility in this paper differs slightly from that defined in Gilboa and Schmeidler (1989).
Because any investor’s subjective prior about the precision of the random supply shock has a non-compact
support, the investor maximizes the infimum, rather than the minimum, of her CARA utility among all
possible precisions.

9
 1. Given P∗ , (di∗ , Di∗ ) solves investor i’s maximization problem in equation (4), for all i ∈
[0, 1]; and

2. P∗ clears the market, that is,

Z 1
(di∗ X + Di∗ ) di = W + Z, for any realizations of F and Z. (5)
0

As in the literature on rational expectations models, equilibrium prices play two

roles: clearing the market and partially aggregating private information. Hence, a ra-
tional expectations equilibrium differs from a Walrasian equilibrium mainly in that the
asset prices convey information about the asset payoffs to investors. This is especially
important in our setting with ambiguity averse investors. Since they hold neither in-
formative priors nor private signals about the asset payoffs, observation of asset prices
is what allows them to update their beliefs to have finite conditional variances, making
them willing to participate in the markets for risky assets. When the precision of the sup-
ply shock of an asset is arbitrarily close to zero, the asset price becomes uninformative,
and so ambiguity averse investors will hold a zero position of the asset.

3 Ambiguity Aversion and Index Investing

In this section, we discuss ambiguity averse investors’ asset holdings when the index
fund is offering the value-weighted market portfolio. We first provides a model of in-
vestor unawareness to argue that when the financial market swings dramatically, news
can lead investors who are subject to model uncertainties to form extreme priors about
random supply precisions. We then show that such extreme priors cause the investors
to flee from the market of the assets they are ambiguity averse about. Importantly, if an
investor is ambiguity averse about at least one asset, he does not hold the index fund.

3.1 News and Investor Knowledge Update

In this section, we argue that media news can cause investors to update their knowledge,
and such knowledge updating may lead to extreme ambiguity aversion. We provide an
intuitive argument here, and we refer the readers who are interested in a formal state
space model of investor unawareness to Appendix A.
Following Li (2009), we model a state of the world as the combination of a question
and the affirmative and negative answers to it. Specifically, for asset q, the state contains

10
the question “Can the random supplies in the asset q’s market be extremely volatile?”
Before realizing the question, the answer to this question is dropped in an investor i’s
knowledge set. That is, without realizing the question q, investor i is at her subjective
state space where she does not know the possibility of extremely volatile random sup-
plies and, more importantly, she does not know she does not know such a possibility.
In such a scenario, we say that investor i is unaware of the possibility that τ q = 0, and
investor i has a subjective belief that the asset q’s random supply precision is τ̃pi > 0.
When the market swings dramatically, newspapers and TV news discuss how volatile
the market could be. Take the market swing in early February 2018 as an example. Al-
most all media, including The Wall Street Journal, Financial Times, CNN, and CNBC, dis-
cussed the market volatility as headlines. Such discussions will make investors realize
the question about the asset about which they are uncertain. Since any investor cannot
exclude the possibility that τ q = 0, the investor’s answer to question q will be affirma-
tive, and her knowledge is updated to τ iq = 0. That is, the investor will have the lower
bound of the support be zero, which implies that she becomes extremely ambiguity
averse about asset q.
We emphasize that because of the maxmin representation of investor ambiguity aver-
sion preference, only the lower bound of an investor’s prior support of the random sup-
ply precision matters. In particular, even though the lower bound of an investor’s prior
support of the random supply precision is zero, the investor need not believe that the
random supply precision is very close to zero. Indeed, the investor may still have a prior
that the random supply precision is relatively high; however, if the lower bound of the
prior is τq = 0, our results hold. In Appendix A, we provide an example to illustrate this
point.

3.2 Unattractive Index Investing

Investor i is risk averse, so she will not hold any non-zero position of asset n, unless her
subjective belief of asset n’s payoff has a finite variance, conditional on her information.
When investor i is uninformed about asset n, however, she has neither prior information
nor private information about asset n’s payoff. Hence, she estimates the payoff based
only on the price, which partially aggregates informed investors’ private information.
The informativeness of price increases in the precision of the random supply. When
the precision of the random supply is arbitrarily close to zero, price becomes almost
uninformative.

11
 Investor i does not know the precision of asset n’s random supply. In particular,
when the market volatility is high, investor i becomes extremely ambiguity averse, as
we argue in Section 3.1. That is, investor i’s subjective prior about τn has the support
0, τ̄ni . Investor i may extract some information about τn from the price of asset n. How-

ever, because all random variables in our model are normally distributed, the support of
investor i’s belief about τn does not change. So as she considers the worst-case scenario
in making the investment decision, investor i focuses on the possibility that the true τn
is very close to 0, since in such a case, asset n’s price is almost uninformative.
Suppose that investor i holds a non-zero position of asset n. As the price becomes
almost uninformative, the payoff variance conditional upon price diverges to infinity.
So holding a non-zero position is extremely risky in the worst-case scenario. To avoid
this risk, investor i optimally chooses a zero position. Proposition 1 below summarizes
the argument above.

Proposition 1 If an investor i is uninformed about asset n, and τ in = 0, then investor i will

hold a zero position of asset n.

Proposition 1 emphasizes that if investor i is extremely ambiguity averse about asset

n, she will hold a zero position of such an asset, including the positions held through the
index fund. Indeed, the value-weighted market portfolio in our model is equivalent to
the portfolio W, which includes a deterministic positive number of shares of each asset.
Hence, when the index fund offers the value-weighted market portfolio, holding a non-
zero position of the index fund means holding a non-zero position of all assets (unless
the investor intentionally hold the opposite positions of some assets directly to offset the
holdings through the index fund). Therefore, if investor i is extremely ambiguity averse
about at least one asset, holding a non-zero position of the index fund will bring her
infinitely high risks. As a result, investor i will avoid the index fund, if she is extremely
ambiguity averse about at least one asset.

Corollary 1 When the index fund offers the value-weighted market portfolio W, an investor i
will not hold it if τ in = 0 for at least one n ∈ Q.

Corollary 1 helps explain why the stock-market tumble in February 2018 sent in-
vestors fleeing index funds and ETFs. At the beginning of the market swing, media
news reported huge volatilities of the market, making investors review the question
how volatile the market of each stock could be. This leads to their extreme ambiguity

12
aversion. Investors then avoided the stocks about which they are ambiguity averse and
index funds or ETFs that follow the value-weighted market portfolio.
Corollary 1 also identifies a shortcoming of the traditional index, the value-weighted
market portfolio. In particular, since the stocks in the value-weighted market portfolio
are weighted by their market capitalizations only, many other important factors, such as
volatility, are not included. Therefore, when investors are ambiguous about the volatil-
ities of stocks, the index fund that offers the value-weighted market portfolio becomes
less attractive, and so it cannot help encourage investors to participate in the financial
market through it and thus increase the financial market efficiency.

4 Smart-beta Design and Full Participation

Since traditional index investing is less attractive when investors are ambiguity averse,
it becomes interesting and important to design a new index that could attract ambiguity
averse investors. Such a new design is one of smart beta strategies, which receive increas-
ing popularity recently.9
We design an index as
  −1
1
X = I + 2 (ΣU )−1 W (6)
ρ
and name it the “risk-adjusted market portfolio” (RAMP). We assume that a fund that
offers RAMP is publicly available to all investors. Ambiguity averse investors do not
know U and hence do not know the exact composition of X. However, all investors
commonly know X as a function of U that is specified in equation (6). This is consistent
with the practice in the smart beta fund industry.
We show that in equilibrium, such a smart beta fund induces all investors to partic-
ipate in all asset markets. We also show how investors will allocate their initial wealth
among the fund, their direct holdings of risky assets, and the riskfree asset, even when
investors do not know the exact composition of the fund. We then argue that the full par-
ticipation with the fund follows from the Information Separation Theorem that applies
in financial markets without a fund and without ambiguity aversion.
Before the equilibrium analysis, we want to emphasize that RAMP echoes the “de-
fensive investment strategy” in practice. Specifically, RAMP differs from the ex-ante
9 One
evidence is that by the end of December 2017, smart beta funds have hit the $1 trillion of assets
milestone.

13
endowed market portfolio W in that it is also influenced by the assets’ idiosyncratic
volatilities ((ΣU )−1 ). Investigating equation (6) carefully, we find that assets’ idiosyn-
cratic volatilities enter RAMP negatively. That is, RAMP includes less shares of more
volatile assets. Therefore, offering RAMP will be a passive asset management strategy
that can largely reduce the risk of loss.

4.1 An Equilibrium with Full Participation

In the model with a fund that offers the portfolio X, any investor i’s investment strategy
(di , Di ) leads to effective asset holdings di X + Di . Proposition 2 below then shows that
in an equilibrium, all investors, including those who are extremely ambiguity averse,
hold exactly one share of the fund and thus participate in all asset markets.

Proposition 2 In the model with a passive fund that commits to offering the portfolio X specified
in equation (6), there is an equilibrium in which

1. All investors will buy one share of the passive fund, and so di∗ = 1 for all i ∈ [0, 1];

2. Any investor i will hold an extra portfolio ρΩi (Si − rP); and

3. For any given F and Z, the equilibrium price is

  −1 
1 1 1 −1
P= F− Σ + ρ ΣUΣ
2
W− Σ Z . (7)
r ρ ρ

The intuition of Proposition 2 arises from a new separation theorem that applies in
the setting without ambiguity aversion and the passive fund. Since such an intuition is
not straightforward, we discuss it in detail in Section 4.2. In the rest of this subsection,
we discuss some properties of the equilibrium characterized in Proposition 2.
First, in equilibrium, uninformed investors are indifferent between holding the pas-
sive fund and not participating in asset markets. When contemplating a position in the
passive fund, uninformed investors believe that the fund’s holdings of all assets are very
close to zero, when the precisions of all assets’ supply shocks are almost zero. Hence,
by holding the fund, the infima of the uninformed investors’ utilities are the same as the
utility from not participating.
Nevertheless, the only reasonable conclusion is that an uninformed investor who is
ambiguity averse and otherwise-rational holds the passive fund (when other investors
follow equilibrium behavior). In particular, since any uninformed investor i’s subjective

14
prior about the precision of any asset n’s supply shock is (0, τ̄ni ), she knows for sure that
τn > 0. For any given τn , holding the passive fund is strictly better than not partici-
pating. So while investor i has the same (infimum) utility ex ante, once τn is realized,
she knows she will be strictly better off holding the passive fund. So only holding the
passive fund is time-consistent.
Given this, it is not surprising that there are ways to express preferences that cap-
ture formally the fact that an investor is not indifferent, even ex ante, as to whether to
invest in the fund. This can be done by considering perturbations of the model. Con-
sider a sequence of perturbed models in which all uninformed investors’ priors about
U have strictly positive lower bounds. When the perturbed lower bounds converge to
zero, the perturbed models converge to our original model. In any of these perturbed
models, strictly positive lower bounds of investors’ priors about U imply that holding
the passive fund is investor i’s unique best response to other investors’ strategies in an
equilibrium, as shown in the proof of Proposition 2. Hence, when investor i’s prior
knowledge about model parameters switches a little bit, investor i strictly prefers to
hold the passive fund; then, by the revealed preference, investors would like to choose
the passive fund in the original model, given all other investors’ strategies. Therefore,
the equilibrium characterized in Proposition 2 is near strict, an equilibrium refinement
concept defined by Fudenberg, Kreps, and Levine (1988).10
Second, while investors have heterogeneous priors about U and thus different be-
liefs about the fund’s composition, they all hold exactly one share of the fund. Take two
investors, Lucy and Martin, for an example. Lucy is uninformed and believes that τn
(for any n) could be arbitrarily close to 0; Martin does not receive private information
about asset payoffs either, but he knows the true precisions of all supply shocks. Ac-
cording to Proposition 2, both Lucy and Martin will hold one share of the passive fund,
but neither Lucy nor Martin holds any extra positions because they don’t have any pri-
vate information about assets’ payoffs. Hence, Lucy and Martin are effectively holding
the same portfolio. So differences in investors’ holdings arise only from differences in
their information signals, not from differences in their model uncertainty or ambiguity
aversion.
Third, Proposition 2 shows the importance of risk sharing among investors in their
10 Formally, a strategy profile σ is near strict in a game Γ if there exists a sequence of games {Γn } and a
sequence of strategy profiles {σn }, such that (i) limn Γn = Γ; (ii) for each n, σn is a strict equilibrium of
Γn ; and (iii) limn σn = σ. Here, a strict equilibrium is an equilibrium in which any investor’s strategy is her
unique best response to all other investors’ strategies in the equilibrium.

15
optimal portfolio choices. Specifically, consider an investor who faces model uncertainty
about a subset of traded assets, and views the return distributions as exogenous. Even
if she can indirectly trade those assets through a passive fund, it may not be optimal for
her to do so, because she cannot calculate the fund’s expected return and risk. Therefore,
arguments based on the incentive of individuals to diversify do not, under radical ig-
norance, justify holding of the fund. In contrast, in our equilibrium setting, an investor
optimally holds the fund, given her belief that other investors will also do so (together
with their direct portfolios). Hence, she is willing to hold the fund too, which achieves
the benefit of optimally sharing risk with other investors.
The fact that equilibrium rather than just diversification considerations are crucial
for the full participation result can be seen more concretely by considering the off-
equilibrium possibility that other investors trade in a fashion that causes asset prices
to be almost uninformative. In such a scenario, an ambiguity averse investor (Lucy)
would not hold the passive fund, because RAMP would be perceived as extremely risky.
Specifically, suppose that the off-equilibrium trading strategy profile of other investors
leads asset price informativeness to converge to zero as the random supply shock preci-
sions go to zero. This convergence could be even faster than the convergence of the asset
positions in RAMP to zero. Hence, taking any non-zero position of the passive fund will
give Lucy infinite risks in the worst-case scenario, since she believes that random sup-
ply shock precisions could be extremely close to zero. Therefore, Lucy will not hold the
fund. In contrast, in such a case, an uninformed investor who knows the supply shock
precisions may still hold asset positions that are bounded away from zero, because the
investor can extract asset payoff information from asset prices, resulting in finite risk.
Proposition 2 more broadly suggests that the reason why actual investors often fail
to diversify goes beyond investor ambiguity aversion. In particular, for an investor to
hold the fund, all other investors need to behave according to the prescribed equilib-
rium strategy profile. If imperfectly rational investors reason about possible portfolios
based solely on partial equilibrium risk and return arguments, portfolios containing as-
sets that investors are ambiguous about might seem extremely risky (or in the limiting
case, infinitely risky). Proposition 2 shows that, owing to equilibrium considerations,
even ambiguity averse investors, if otherwise rational, will hold such assets. But actual
investors may not understand the equilibrium reasoning which underlies this result.

16
4.2 The Information Separation Theorem
Proposition 2 is a surprising result. It is true that investors are willing to hold the fund
because the fund knows the precisions of all assets’ supply shocks. However, the result
is not driven by any overall informational superiority of the fund over investors. Off
equilibrium, if few informed investors trade, an ambiguity averse investors will not
hold the fund, because the prices are still rather uninformative.
Nor is the fund offering investors great safety. For the strategy profile described in
Proposition 2 to be an equilibrium, the fund has to offer the portfolio X, specified in
equation (6). We verify that if the fund offers another portfolio

1    −1
1 −1
0
X = I + 2 ΣU 4 W,
ρ
which is also a function of U and will converge to 0 as U converges to zero, ambiguity
averse investors will not hold the fund and will refrain from participating in the markets
of the assets they are uncertain about. This is because when U converges to 0, X 0 con-
verges to 0 much slower than U. But the conditional variance of holding any non-zero
positions diverges to infinity at the same speed as U converges to 0. Hence, the risk of
holding X 0 diverges to infinity as U converges to 0, implying that holding the passive
fund is extremely risky for uninformed investors in the worst-case scenarios.
Hence, the intuition of Proposition 2 must go beyond the passive fund’s superior
knowledge about the financial markets. We now provide greater insight into this result
based upon a new separation theorem for financial markets with asymmetric informa-
tion, but without model uncertainty or funds.
We now modify the model described in Section 2 by assuming that U is common
knowledge among all investors and that there is no passive fund.11 Then the model is a
traditional rational expectations equilibrium model with multiple risky assets, analyzed
by Admati (1985). Proposition 3 characterizes a linear rational expectations equilibrium
11 The theorem we are about to state does not require the assumption of an uninformative prior. Also,
the assumption of independent assets in our model is without loss of generality. We could allow for
correlated assets with full rank prior variance-covariance matrix; in such a case, asset payoffs can be
decomposed into orthogonal risk factors, and investors’ private signals are about these risk factors.
Van Nieuwerburgh and Veldkamp (2009), Van Nieuwerburgh and Veldkamp (2010) and Kacperczyk,
Van Nieuwerburgh, and Veldkamp (2016) show that such a model has the same solution (but with dif-
ferent interpretations) as in the setting with independent assets. Hence, we prove a general version of
Proposition 3 in the appendix for the case of independent assets with normal priors. Since both the equi-
librium pricing function and investors’ equilibrium holdings are continuous in the prior precisions of
assets’ payoffs, substituting zero prior precisions will lead to exact Proposition 3.

17
and shows investors’ optimal risky assets holding when all parameters are common
knowledge.

Proposition 3 In the model whose parameters are all common knowledge among investors, there
exists an equilibrium with the pricing function

P = B−1 [ F − A − CZ ] , (8)

where
1h 2 i −1
A = ρ (ΣUΣ) + Σ W (9)
ρ
B = rI (10)
1 −1
C = Σ . (11)
ρ

Any investor i’s risky asset holding is

  −1
1
Di = I + 2 (ΣU )−1 W + ρΩi (Si − rP) . (12)
ρ

Owing to supply shocks, asset prices are not fully revealing, so information asym-
metry persists in equilibrium and different investors have different asset holdings. An
investor’s asset holding is the sum of two components. The first term in equation (12),
  −1
1
I + 2 (ΣU )−1 W
ρ

is just RAMP, which is deterministic.

The second component of any investor’s risky asset holding, the second term in (12),
is what we call information-based portfolio. This position, ρΩi (Si − rP), consists of
extra holdings in the securities about which the investor has information. Investor i
holds such an extra position of an asset n if and only if the nth diagonal entry of Ωi is
κn > 0. This suggests that any investor i holds direct positions of a risky asset because
possessing an informative signal about such an asset reduces its conditional volatility
(independent of the signal realization). Investor i’s direct positions of a risky asset also
come from her speculation, which is taken to exploit superior information. Different
investors, even if they are informed about asset n, hold different speculative portfolios,
because they receive heterogeneous private signals.

18
 A critical feature of any investor’s equilibrium asset holdings in equation (12) is that
its two components are influenced differently by investors’ information sets. The first
component, RAMP, is formed based only on the information that the investor gleans
from asset prices; it is independent of the investor’s private information. In contrast,
the second component, the information-based portfolio, can be formed based only on
the investor’s own private information; it is independent of the information content of
the market price. Since the supply shock precisions do not affect the distributions of the
private signals, it follows that the information-based portfolio is independent of the supply
shock precisions. The reason for this independence is that private signals and the random
supply shocks are normally distributed, so that the conditional expectation of the asset
payoffs is linear in private signals and the price signal.12
This independence implies a new separation theorem under asymmetric informa-
tion.

Theorem 1 (The Information Separation Theorem) When the characteristics of all assets
are common knowledge, equilibrium portfolios have three components: a deterministic risk-
adjusted market portfolio (RAMP); an information-based portfolio based upon private informa-
tion and equilibrium prices but no extraction of information from prices; and the riskfree asset.

This separation turns out to be important for understanding market participation and
asset prices when ambiguity averse investor face model uncertainty, and can hold the
risky assets through a passive fund, as analyzed in Subsection 4.1. In particular, infor-
mation separation implies in that setting that the unknown model parameter, the noise
supply shock precision, does not affect the information-based portfolio, so that investor
holdings outside their fund holdings can be analyzed simply.
Theorem 1 indicates that investors can form an optimal portfolios in separate steps:
(1) buy one share of RAMP; (2) buy the information-based portfolio using only private
information, not the information extracted from price; and (3) put any left-over funds
into the riskfree asset. This separation theorem derives from market equilibrium as well
as optimization considerations. This differs from those (non-informational) separation
theorems in the literature that are based solely on individual optimization arguments.13
12 Vives (2008) derives investors’ equilibrium asset holdings in a single-asset environment with a normal

prior and zero aggregate endowment. Therefore, his result cannot be directly used in our analysis when
investors are ambiguity averse about some assets.
13 It may seem puzzling that none of the three portfolio components depend on the information that an

investor extracts from price. How then does this information enter into the investor’s portfolio decision?

19
 In our model, the fund can provide RAMP because it knows all the model param-
eters, and RAMP does not include any investor’s private information. Meanwhile, the
information-based portfolio is exactly the same as the direct holdings of the risky assets
in Proposition 2. To form the information-based portfolio, an investor does not need to
extract information from the equilibrium price: she can treat the equilibrium prices as
given parameters, and solve for the information-based portfolio from her CARA utility
maximization problem as in a partial equilibrium model.
The Information Separation Theorem provides the intuition of investors’ equilibrium
investment strategies in the setting with model uncertainties. Consider the model in
which investors are uncertain about the precisions of some assets’ supply shocks. For
each possible world Ui ∈ Ui , investor i can solve her optimal risky assets holdings, as-
suming that the equilibrium pricing function is the one in equation (7) with U being Ui .
Importantly, because all other investors are holding one share of the fund and their own
direct information-based portfolio, they are effectively holding the risky assets as in the
world with Ui being common knowledge. Therefore, in the possible world Ui , the mar-
ket clearing condition implies that the pricing function is the one specified in equation
(7) with U being Ui . That is, investor i’s belief about the pricing function is correct. So,
she would like to hold the risky assets as in the world Ui . Such risky assets holdings
can be implemented by holding one share of the passive fund and her information-
based portfolio, so investor i would like to use the investment strategy in Proposition 2.
Furthermore, investor i is still uncertain about U, so holding the risk-adjusted market
portfolio through holding one share of the fund is strictly preferred.
In the above, investor i chooses the investment strategy to maximize her expected
CARA utility for any fixed possible world (given that all other investors trade according
to the prescribed strategy profile). Here, we indeed implicitly assume that investor i has
a min-max utility. However, because investor i’s optimal investment strategy, holding
one share of the fund and her own information-based portfolio, is a constant across all
possible worlds, her max-min utility is the same as her min-max utility. That is, a strong
max-min property holds in the equilibrium, and hence, in our model with investor i hav-
ing max-min utilities, holding one share of the fund and the information-based portfolio
is also investor i’s optimal investment strategy.
The answer is that RAMP is optimal precisely because of the ability of investors to extract information
from price. As mentioned before, RAMP is deterministic; it does not depend on the private signals. But
the fact that RAMP is an optimal choice is true only because investors update their beliefs based on price.
So the optimal portfolio choice is indeed influenced by such information extraction.

20
 The argument above shows how the Information Separation Theorem helps under-
stand the full participation of ambiguity averse investors in an equilibrium. Indeed, the
same argument can also be applied when investors are unaware of some assets or when
investors have heterogeneous risk tolerances. In the online appendix, we extend our
model to allow for investor unawareness (defined as a diffuse prior over the parameter
values that characterize the capital market) or for heterogeneous risk tolerances. We find
that in each of these extensions, there exists an equilibrium with full participation.

5 CAPM Pricing with a RAMP Fund

Propositions 2 and 3 indicate that the model with ambiguity aversion and a fund that
offers RAMP has an equilibrium in which investors’ effective risky assets holdings are
exactly the same as in the rational expectations equilibrium in the setting without model
uncertainties. Therefore, the fund induces full participation even with ambiguity aver-
sion. It can also reduce asset risk premia, because in the equilibrium, uninformed in-
vestors are sharing risks with informed ones.
In order to analyze the effect of the fund on risk premia, we first return to the setting
without model uncertainty. In such a model, the supply shocks make the asset prices
in equilibrium imperfectly revealing, and so in the equilibrium, there are information
asymmetries among investors and different risky asset holdings. Hence, the setting is
very different from the classic CAPM setting, which assumes identical beliefs and has
the implication that all investors hold the same risky asset portfolio.
Since holding the market is equivalent to the CAPM pricing relation, it might seems
that in our setting there would not be a way to identify a portfolio that prices all assets
and is identifiable ex ante based upon publicly available information. Nevertheless,
even with information asymmetry, we identify an efficient portfolio in the model and
therefore an implementable version of the CAPM pricing relationship.
From Proposition 3, we know that in the setting without model uncertainties, in-
vestors hold RAMP as a common component of their holdings. Therefore, it is natural
to consider RAMP as a candidate for CAPM pricing. From equation (8), the equilibrium
pricing function is  
1 1 −1
P= F−A− Σ Z , (13)
r ρ
where A = 1ρ [ρ2 (ΣUΣ) + Σ]−1 W.

21
 Given any realized equilibrium price P, the volatility of asset payoffs derives from
the supply shock only. Let diag( P) be an N × N diagonal matrix, whose off-diagonal
elements are all zero and whose nth diagonal element is just the nth element of the vector
P. Generically, as no asset has a zero price, diag( P) is invertible. Then, by the definition
of diag( P),
diag( P)−1 P = 1, (14)

where 1 = (1, 1, . . . , 1)0 . From the equilibrium pricing (equation (13)), we have

diag( P)−1 E( F ) − r1 = diag( P)−1 A. (15)

Here, E( F ) is the expected payoff conditional on the equilibrium price. The LHS of
equation (15) is just the vector of the risky assets’ equilibrium risk premia.
Given a realized equilibrium price, the risk-adjusted market portfolio X has value
P0 X. Then the vector of the weights of risky assets in the risk-adjusted market portfolio
is
1
ω= diag( P) X.
P0 X
Hence, conditional on the price P, the difference between the expected return of RAMP
and the riskfree rate is

E( R X ) − r = ω 0 diag( P)−1 E( F ) − r
1
= X 0 diag( P)diag( P)−1 ( A + rP) − r
P0 X
1
= X 0 A, (16)
P0 X
where the expectations are all conditional on the equilibrium price.
The variance of RAMP is
   0   1 2
0 −1 0 −1
V( R X ) = E ω diag( P) CZ ω diag( P) CZ = X 0 CU −1 CX, (17)
P0 X

and the covariance between all risky assets and RAMP is

1
Cov( R, R X ) = diag( P)−1 CU −1 CX. (18)
P0 X
Let α be the CAPM alpha. From equations (15)-(18), and since X = ρ(CU −1 C )−1 A,
we have the following proposition.

22
Proposition 4 (Risk Premia with Supply Shocks) In the model with all parameters being
common knowledge, asset risk premia satisfy the CAPM where the relevant market portfolio for
pricing is the risk-adjusted market portfolio.

This result may seem surprising, since investors have heterogeneous asset holdings,
and since the portfolios held by informed investors are not mean-variance efficient with
respect to the public information set. Nevertheless, in equilibrium, there are no extra
risk premia incremental to those predicted by the CAPM using RAMP.
The CAPM pricing relation using RAMP is equivalent to the assertion that RAMP
is mean-variance efficient conditional only on asset prices. This efficiency can be seen
from the utility maximization problem of an investor who is uninformed about all as-
sets. Such an investor balances the expected returns and the risks of her holdings, and
her information consists of the equilibrium price only. In equilibrium, such an investor
holds RAMP, implying that RAMP is mean-variance efficient conditional only on equi-
librium prices.
Privately informed investors also hold RAMP as a component of their portfolios; this
is the piece that does not depend upon their private signals (except to the extent that
their signals are incorporated into the publicly observable market price). In addition,
they have other asset holdings taking advantage of the greater safety of assets they have
more information about, and for speculative reasons based upon their private informa-
tion. RAMP is not mean-variance efficient with respect to their private information sets,
but it is efficient with respect to the information set that contains only publicly available
information.
A very different version of the CAPM has been derived in somewhat similar model
setups (see, for example, Easley and O’Hara (2004), Biais, Bossaerts, and Spatt (2010),
and the online appendix of Van Nieuwerburgh and Veldkamp (2010)). In these models,
the market portfolio for CAPM pricing is the ex-post total supply of the risky assets,
the sum of the endowed risky assets and the random supply of risky assets (W + Z in
our model). This market portfolio is mean-variance efficient conditional on the average
investor’s information set, and so the CAPM return-covariance relation holds from the
perspective of the average investor. The version of the CAPM presented in Proposition
4 differs in that the pricing portfolio is determined ex ante (prior to the realization of the
random supply shocks) and that risk premia are conditional only upon the public infor-
mation set (market prices). This makes the market portfolio more directly observable to
an econometrician.

23
 In the model whose parameters are all common knowledge among investors, RAMP
is a natural candidate for the CAPM pricing portfolio, because it is the common com-
ponent in all investors’ risky asset holdings. We show that RAMP is mean-variance
efficient unconditional on any investor’s private information. Therefore, the CAPM
security market line relation holds without conditioning on private information, with
respect to RAMP. One of the further contributions here is to establish that increasing
information asymmetry, and its effect on investor participation, does not clearly predict
whether there will be an increase versus decrease in risk premium.
We are now in a position to see how a passive fund that offers RAMP affects asset
risk premia in the setting with model uncertainty. Proposition 2 shows that in the model
where investors are uncertain about the precisions of asset supply shocks, they all hold
one share of the passive fund. Therefore, the passive fund makes assets’ risk premia
satisfy the CAPM, even if investors have heterogeneous information and are uncertain
about different model parameters. Corollary 2 presents this even more surprising result.

Corollary 2 In the model where investors are uncertain about the precisions of some assets’
supply shocks, and a passive fund offering portfolio X specified in equation (6), asset risk premia
satisfy the CAPM using X as the pricing portfolio.

6 Implementation of the Passive Fund

We have designed a new index, RAMP, such that if a passive fund commits to following
it, there exists an equilibrium in which all investors hold exactly one share of the fund.
Since RAMP includes positive positions of all traded assets, investors participate in all
assets markets via the fund in the equilibrium. However, the fund needs to have full
knowledge about the parameter values of the capital market to construct RAMP. Hence,
if there is no single individual in the economy who knows all the parameter values, then
this knowledge is dispersed. As we have assumed, for each asset, there is a positive
measure of investors who know the parameter value for that asset. In this section, we
show that the passive fund can still be implemented via a fund of funds.
Suppose that the set of all traded assets can be partitioned into M subsets. In the
partition j, there are m j ≥ 1 assets. We assume that there is a positive measure of in-
vestors, who know all parameters about assets in partition j but do not have any private
signals about the payoffs of such assets. We call these investors “Group j uninformed

24
investors.” (In the extreme case, M = N, and so, in each partition, there is only one
asset. Then, we are in the setting described in Section 2.)
We consider the following equilibrium. Each of the Group j uninformed investors
commits to offering a portfolio Yj . Here, Yj can be seen as a “local” fund, which includes
only assets in partition j. For each asset n included in asset partition j, Yj includes exactly
the same position as in the portfolio X.
First, the fund fee will be zero in an equilibrium. Since there are infinitely many
funds who are committing to offering Yj , the jth local fund industry is perfectly compet-
itive. Hence, the fund fee should be the same as the marginal cost of offering Yj , which
is zero.
Second, and more importantly, as required in the existing index fund industry, all
local funds are required to disclose their asset holdings at the end of the period. Then, if
a local fund of Group j that deviates from Yj , its portfolio holding will differ from other
Group j local funds portfolio holdings. Hence, such a deviation is observable ex post
and verifiable. Ex post, once a fund’s deviation is detected, We assume that the fund
will be heavily punished or incur a large reputation cost. It follows that no local fund is
willing to deviate from its commitment to invest in Yj .
Finally, any investor will first buy one share of the Group j local fund, for each j.
By doing so, any investor will form an asset holding (Y10 , Y20 , . . . , YM
0 )0 = X 0 , which is

exactly the passive fund specified in equation (6). Then, investors will hold their own
information-based portfolios. Obviously, investors are effectively holding one share of
the passive fund and their own information-based portfolios, which are their optimal
investment strategies in the equilibrium described in Proposition 2.

7 Concluding remarks
A leading explanation for nonparticipation puzzles is investor ambiguity aversion. This
literature focuses on direct trading of assets by investors in the face of model uncer-
tainty. We study here whether ambiguity aversion can still solve the puzzle when an
appropriately designed passive fund is available run by a manager who observes the
model parameters that investors are uncertain about (though the manager does not ob-
serve any private information signals about fundamentals). We show that when there
is a passive fund that offers the risk-adjusted market portfolio (RAMP), all investors prefer
to hold the fund and thus participate in all asset markets, even if they do not know the

25
passive fund’s composition. This conclusion arises from applying a new portfolio in-
formation separation theorem which holds in a setting without model uncertainty and
implies that assets’ equilibrium risk premia conditional only on public information sat-
isfy the CAPM, with the passive fund (i.e., RAMP) as the pricing portfolio.
Since ambiguity aversion does not, by itself, explain the limited market participa-
tion puzzle, what does? Dimmock et al. (2016) find that ambiguity aversion is asso-
ciated with lower stock market participation. Their tests do not distinguish participa-
tion via funds versus direct investment in individual stocks, so their finding does not
speak specifically to how ambiguity aversion affects the choice between these alterna-
tives. However, our findings suggest that to understand the Dimmock et al. evidence,
it is important to investigate what additional frictions or irrationalities might contribute
to nonparticipation and prevent the passive fund solution to ambiguity aversion from
working perfectly.
With regard to frictions, there could be heavy trading costs, though as discussed in
the introduction, it seems unlikely that this is the full explanation for nonparticipation
puzzles.
A second possibility is that existing funds may not offer RAMP, so that our solution
to nonparticipation is unavailable to investors. This may be because, prior to this paper,
it was not understood that RAMP solves the problem. (Most existing index funds offer
proxies for the value weighted market rather than RAMP.) Each active fund provides
a different portfolio strategy, so at most only one of these (and probably none) closely
matches RAMP. This possibility suggests a policy implication of our approach: that fund
firms should introduce RAMP portfolios as a service to ambiguity averse investors who
can benefit from diversification and risk sharing.
A third, and related, possibility derives from agency problems. If investors cannot
be sure that a fund manager who claims to hold RAMP really does, then our conclusion
of full participation does not follow. Whether disclosure policies could address agencies
problems is an open question.
Finally, it could be that imperfect rationality explains the puzzle. This possibility
has a bearing on the argument that providing investors with better information might
encourage market participation. Unfortunately, when there is psychological bias, pro-
viding more information could make the problem worse. More information does not
always debias decision makers, since extraneous information can be distracting or over-
whelming. For example, providing extensive information about numerous assets could

26
make investors feel less competent about evaluating their investments. This could ex-
acerbate ambiguity aversion. Similarly, such information might push investors toward
the use of simple judgment heuristics such as narrow framing, which is another leading
possible explanation for nonparticipation.
Other forms of irrationality provide a further possible reason for nonparticipation.
Our finding that the availability of RAMP induces full participation is based on the
premise that ambiguity aversion is their only mistake. However, investors may make
psychological errors other than those that come just from ambiguity aversion. If, for ex-
ample, some investors do not perfectly understand the concept of a market equilibrium,
they may regard participation as too risky even if RAMP is available. Furthermore, if
it is common knowledge that some investors will fail to hold the fund, the equilibrium
will be different. We can no longer conclude that other ambiguity averse investors (even
those who do understand the concept of equilibrium) will be willing to participate via a
fund.
This suggests a further normative implication, that it is valuable to educate investors
more deeply about the concept of market equilibrium. Specifically, as our model makes
clear, in equilibrium participation can be much safer than it might otherwise seem. It
would be possible to explain to investors at a nontechnical level why holding even assets
that one knows little about can sometimes improve reward/risk ratios. In particular, it is
intuitive that in equilibrium prices need to be set so that even a very risky asset becomes
attractive enough for some investors to want to hold it. Finally, even if there is some
aspect of the world that an investor feels she knows almost nothing about, it is intuitive
that a trustworthy agent (the caveat ‘trustworthy’ being crucial) could choose on the
investor’s behalf the weights on the affected assets that the investor would herself have
chosen if she knew what the agent knows.

27
A A Formal Model of Investor Knowledge Updates
In this appendix, We introduce a formal model of investor unawareness. Following Li
(2009), we denote by q the question “For asset q, is τ q = 0?” We further denote by 1q and
0q the affirmative answer and the negative answer to question q, respectively. Then, the
full state space can be written as

∏ 1q , 0q × { ∆ } ,

B= (19)
q∈Q

where ∆ stands for “cogito ergo sum,” and {∆} is an investor’s subjective state space at
the state 1q , ∆ .


Consider an investor, Lucy, who is subject to model uncertainty. Denote by Q L the set
of assets that Lucy knows. That is, for any q ∈ Q L , Lucy knows τq > 0 and, therefore, her
information partition about asset q is {{(1q , ∆)}, {(0q , ∆)}}. Obviously, since q ∈ Q L ,
Lucy knows the true state is (0q , ∆).
However, for any asset q ∈ Q \ Q L , Lucy does not know τq . Therefore, for such an
asset, she has the state space {∆}, where the answer to question q is dropped. That is,
because Lucy does not realize question q, she is unaware of the answer to such a ques-
tion. Hence, having the subjective state space {∆}, Lucy does not know the possibility
of τ q = 0. And more importantly, she does not know she does not know the possibility
of τ q = 0.
In Section 3.1, we argue that before the news in Television and Newspapers, the
investors do not realize question q, and therefore they don’t know they don’t know that
the random supply of asset q could be extremely volatile. In such a case, we say that
the investors are unaware of the possibility that the random supplies of asset q could be
extremely volatile.
The discussion about the market volatility in the media will then make Lucy’s knowl-
edge about asset q update from {∆} to {(1q , ∆), (0q , ∆)}. Since Lucy, after realizing the
question q, cannot exclude the possibility that τ q = 0, Lucy’s subjective knowledge is
(1q , ∆) where her belief support about τq becomes (0, τ̄qL ).

We now provide an example of Lucy’s prior about τq , the precision of the random
supply of asset q about which she is subject to model uncertainty. This example helps
illustrate that despite of the specific distribution, if the lower bound of support of an
investor’s prior about τq is 0, the investor is extremely ambiguity averse.

28
 Consider the following sequence of the priors of Lucy:
(
∼ U (0, 1), with probability 1k ;
τpL
= 1, with probability 1 − 1k .

In this example, along the sequence, the lower bound of the support of Lucy’s prior
about τq is 0, while the mean is
 
1 1 1
+ 1− = 1− .
2K K K

Obviously, as K increases, such a mean is monotonically increasing and converges to 1.

That is, when K becomes larger, Lucy believes that τq is more and more likely to be close
to 1. However, in the sequence, the lower bound of her prior support is always 0. In
the paper, we show that to Lucy, τq → 0 is the worst-case scenario. Therefore, only the
lower bound matters, and the specific distribution of Lucy’s prior does not matter for
Lucy’s investment decision.

29
B Omitted Proofs
Proof of Proposition 1:

Because investor i is uniformed about asset n, by assumption, κi = 0. Hence, in-

vestor i’s only information about the distribution of asset n’s payoff is its price, which
may partially aggregate informed investors’ private signals. Suppose the uninformed
investors’ aggregate demand for asset n is (1 − λn ) D ( pn ). Since uninformed investors
do not observe τn , D ( pn ) is not a function of τn .
Given any P and any τn ∈ 0, τ̄ni , we derive investor i’s expected utility conditional

on Pn as follows. Suppose asset n’s pricing function in a linear equilibrium is

f n = a + bpn + czn ,

where a, b, and c are undetermined parameters. Since informed investors know τn , they
can extract information from the price without any ambiguity. Therefore, any informed
investor j’s demand is
h τn τn i
D j = ρ κn s j + 2 a + 2 (b − r ) pn − rκn pn .
c c
Then, the informed investors’ aggregate demand will be
h τn τn i
λn ρ κn f n + 2 a + 2 (b − r ) pn − rκn pn .
c c
Then, the market clearing condition implies that
h τn τn i
λn ρ κn f n + 2 a + 2 (b − r ) pn − rκn pn + (1 − λn ) D ( Pn ) = wn + zn .
c c
Matching the coefficient of the market clearing condition and the pricing function, we
have
wn τn
a = − 2 a
λn κn ρ c κn
(1 − λ n ) D ( p n ) τn
bpn = − − 2 (b − r ) pn + rpn
λn κn ρ c κn
1
c =
λn κn ρ
Therefore, for any given τn ∈ 0, τ̄ni , conditional on the price Pn , |E( f n − rpn | pn )| <

+∞. On the other hand, the variance of asset n’s payoff conditional on pn is

V ( f n | pn ) = c2 τn−1 ,

30
which diverges to +∞ as τn goes to 0. Hence, any non-zero position Di of asset n brings
investor i a utility
" #
Di2
 
1 1
− exp − wi rpn exp − Di E ( f n − rpn | pn ) + 2 V ( f n | pn ) , (20)
ρ ρ 2ρ

which goes to −∞ as τn goes to 0. Therefore, if investor i is uninformed about asset n,

and τ in = 0, investor i refrains from participating in the market of asset n.
Q.E.D.

Proof of Proposition 2:

We first verify that the market clearing condition holds. Each investor i’s effective
risky assets holding is
  −1
1
di∗ X + Di∗ = I + 2 (ΣU )−1 W + ρΩi (Si − rP) .
ρ
Then, using the pricing function (equation (7)), the aggregate demand can be calculated
as
Z 1
(di∗ X + Di∗ ) di
0
  −1
1 −1
= I + 2 (ΣU ) W + ρΣ ( F − rP)
ρ
  −1    −1 
1 −1 1 1 −1
= I + 2 (ΣU ) W + ρΣ Σ + ρ ΣUΣ
2
W+ Σ Z
ρ ρ ρ
  −1
1 h i −1
= I + 2 (ΣU )−1 W + I + ρ2 ΣU W+Z
ρ
h i −1 h i −1
= ρ ΣU I + ρ ΣU
2 2
W + I + ρ ΣU
2
W+Z
= W + Z.

Therefore, the market clears.

Now, for any investor i, we consider a general investment strategy di X + Di . Denote
by Din investor i’s direct holding of asset n. Suppose that investor i is informed about
asset n. Then, the pricing function (7) implies that investor i’s optimal holding of asset
n is   −1
1
1 + 2 (λn κn τn )−1 wn + ρκn (sin − rpn ) = xn + ρκn (sin − rpn ) .
ρ

31
Therefore, any combination of di and Din such that

di xn + Din = xn + ρκn (sin − rpn )

can lead to the optimal holding of asset n for investor i.

Now, consider an asset n that investor i is uninformed about. For any given di and
Din , investor i is effectively holding a position di xn + Din of asset n. Then, for any given
τn Such a holding will bring invest i a utility
" #
  2
1 1 (d xn + Din )
− exp − win rpn exp − (di xn + Din ) E ( f n − rpn | pn ) + i V ( f n | pn ) .
ρ ρ 2ρ2
(21)
i
There are two cases. In the first case where τ n = 0, similarly to Proposition 1, if Din 6=
0, the infimum of such a utility is −∞, since V( f n | Pn ) → +∞ as τn → 0. Therefore,
∗ = 0. Next, substituting X into equation (21), the investor’s utility given τ is
Din n
"  #
ρτn λ2n κn2 w2n
  
1 1 2
− exp − win rpn exp − di − di 2
. (22)
ρ 2 [λn κn + ρ2 τn λ2n κn2 ]
It follows from  (22) that for any di , the infimum of the investor’s utility is at
 equation 
1 1
most − exp − ρ win rPn . Since the investor can get the utility at least − exp − ρ win rPn
by employing the investment strategy di∗ = 1, there is no profitable deviation.
In the second case, τ in > 0. We first assume that any investor i has min-max utility,
and then finally show that her max-min utility is the same as her min-max utility, which
implies a strong min-max property. Then, investor i’s optimal investment strategy with
a max-min utility is the same as the optimal investment strategy with a min-max utility.
Since investor i does not know τn , di and Din are not functions of τn . For any given
τn , we can solve di∗ and Din
∗ by the first order condition of the following maximization

problem:

wn (di xn + Din )2 1
max (di xn + Din ) 2 2 2
− . (23)
di ,Din ρ [λn κn + ρ τn λn κn ] 2ρ ρ λn κn2 τn
2 2

The second order condition of such a maximization problem holds, because the utility
function in equation (23) is strictly concave.
Differentiating the utility function in equation (23) with respect to di , we get one of
the first-order conditions:
wn (d xn + Din ) xn 1
xn 2 2 2
− i = 0.
ρ [λn κn + ρ τn λn κn ] ρ ρ λn κn2 τn
2 2

32
So,
ρ2 τn λ2n κn2 ρ2 τn λ2n κn2
di xn + Din = di w n + D in = wn + Din .
λn κn + ρ2 τn λ2n κn2 λn κn + ρ2 τn λ2n κn2
Then, di∗ = 1 and Di∗ = 0, because they are not functions of τn . Therefore, with a min-
max utility, if an investor i is uninformed about asset n, she will hold exactly one share
of the passive fund and a zero position of asset n.
Because investor i’s optimal investment strategy (di∗ , Din
∗ ) = (1, 0) is constant across

all possible τn , we have

min max u((di , Din ), τn ) = min u((1, 0), τn ) ≤ max min u((di , Din ), τn ).
τn di ,Din τn di ,Din τn

Generally, by the min-max utility, we have

min max u((di , Din ), τn ) ≥ max min u((di , Din ), τn ).

τn di ,Din di ,Din τn

Then, we have

min max u((di , Din ), τn ) = max min u((di , Din ), τn ).

τn di ,Din di ,Din τn

This implies a strong min-max property, and hence, (di∗ , Din

∗ ) = (1, 0) is also the optimal

investment strategy of investor i, when she has a max-min utility.

In sum, given the pricing function specified in equation (7), it is optimal for any
investor i to choose the investment strategy di∗ = 1 and
(
∗ 0, if she is uninformed about asset n;
Din =
ρκn (Sin − rPn ) , if she is informed about asset n.

Q.E.D.

Proof of Theorem 3:

Let’s first prove a more general version of Proposition 3, when investors hold a com-


mon prior belief about F, F ∼ N F, V . As is standard in the literature of rational
expectations equilibrium, we consider the linear pricing function

F = A + BP + CZ, with C nonsingular. (24)

33
If and only if B is nonsingular, equation (24) can be rearranged to

P = − B−1 A + B−1 F − B−1 CZ, (25)

which solves for prices. Recall that Si = F + ei , so conditional on F, P and Si are inde-
pendent. Therefore, we can write down assets’ payoffs’ posterior means and posterior
variances conditional on all information that are available to investor i as follows.
First consider investor i’s belief about F conditional on P. Conditional on P, F is
normally distributed with mean A + BP and precision [CU −1 C 0 ]−1 . On the other hand,
conditional on Si , investor i’s belief about F is also normally distributed, with mean Si
and precision Ωi . Therefore, investor i’s belief about F conditional on what the investor
observes, P and Si , is also normally distributed. The mean of the conditional distribution
of F is the weighted average of the expectation conditional on the price P, the expecta-
tion conditional on investor i’s private signal Si , and the prior mean F. Therefore, the
conditional mean of F is
h i −1 h i
(CU −1 C 0 )−1 + Ωi + V −1 (CU −1 C 0 )−1 ( A + BP) + Ωi Si + V −1 F . (26)

The precision of the conditional distribution of F is

(CU −1 C 0 )−1 + Ωi + V −1 . (27)

Then, from any investor i’s first order condition, investor i’s demand is
h i
−1 0 −1 −1
Di = ρ (CU C ) + Ωi + V
h i −1 h i 
−1 0 −1 −1 −1 0 −1 −1
(CU C ) + Ωi + V (CU C ) ( A + BP) + Ωi Si + V F − rP
nh i h i o
= ρ (CU −1 C 0 )−1 ( A + BP) + Ωi Si + V −1 F − (CU −1 C 0 )−1 + Ωi + V −1 rP
n o
= ρ (CU −1 C 0 )−1 ( B − rI ) − rΩi − rV −1 P
+ρΩi Si + ρ[(CU −1 C 0 )−1 A + V −1 F ]. (28)

Integrating across all investors’ demands gives the aggregated demand as

Z 1  Z 1  
−1 0 −1 −1
Di di =ρ (CU C ) ( B − rI ) − r Ωi di − rV P
0 0
Z 1 
+ρ Ωi Si di + ρ[(CU −1 C 0 )−1 A + V −1 F ]. (29)
0

34
 R1
By equation (1), we have 0 Ωi di = Σ. Also, note that
Z 1
Ωi Si di = ΣF.
0

Therefore, from the market clearing condition, we have

Z 1
Di di = Z + W. (30)
0

In an equilibrium, both equation (24) and equation (30) hold simultaneously for any
realized F and Z, therefore, by matching coefficients in these two equations, we have
h i
ρ (CU −1 C 0 )−1 A + V −1 F − W = −C −1 A (31)
h i
ρ (CU −1 C 0 )−1 ( B − rI ) − rΣ − rV −1 = −C −1 B (32)
ρΣ = C −1 (33)

Therefore, from equation (33), we have

1 −1
C= Σ
ρ

Obviously, C is positive definite and symmetric. Then from equation (31), we have

1
[ρ2 (ΣUΣ) + Σ] A = W − V −1 F.
ρ

Because both (ΣUΣ) and Σ are both positive definite, we have

 
−1 1 −1
A = [ρ (ΣUΣ) + Σ]
2
W−V F .
ρ

From equation (32), we have

[ρ2 (ΣUΣ) + Σ]( B − rI ) = rV −1 .

Again, because [ρ2 (ΣUΣ) + Σ] is positive definite, we have

B = rI + r [ρ2 (ΣUΣ) + Σ]−1 V −1 .

Obviously, B is invertible. By substituting A, B, and C into equation (25), we solve the

equilibrium pricing function.

35
 Now, let’s look at any investor i’s holding. Substituting the coefficients into investor
i’s holding function (28), we have
  −1 i −1
1 h
Di = I + 2 (ΣU )−1 W + ρ I + ρ ΣU
2
V −1 ( F − rP) + ρΩi (Si − rP).
ρ

Finally, because the pricing function P and any investor i’s demand function Di are
continuous in V −1 , we can substitute V −1 = 0 to get Proposition 3.
Q.E.D.

Proof of Proposition 4:

By equations (16), (17), and (18), we have

1 −1 −1
P0 X diag( P ) CU CX X0 A
P0 X
 2
1
P0 X X 0 CU −1 CX
diag( P)−1 CU −1 CX 0
= X A.
X 0 CU −1 CX
This is the RHS of the Security Market Line relation. We want to show that this equals
the difference between the risky assets’ rates of return and the riskfree asset’s rate of
return, which is shown to be diag( P)−1 A from equation (15).
Then, we have

diag( P)−1 CU −1 CX 0
0 − 1
X A = diag( P)−1 A
X CU CX
⇔ diag( P)−1 CU −1 CXX 0 A = diag( P)−1 AX 0 CU −1 CX
⇔ CU −1 CXX 0 A = AX 0 CU −1 CX.

The last equation holds because X = ρ(CU −1 C )−1 A and (CU −1 C )−1 is a symmetric
matrix.
Q.E.D.

36
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37
C Online Appendix
To evaluate the robustness of our conclusions about investor participation, we now con-
sider two possible model generalizations. First, investors may be unaware of certain
traded assets, making it unattractive or infeasible for them to hold such assets. Previous
literature considers this another important possible reason for limited participation. Sec-
ond, investors may have heterogeneous risk tolerances. These cases also suggest further
empirical implications.

C.1 Uncertainty about Other Parameters and Unawareness

Section 2 assumed that investors were uncertain about the precisions of assets’ supply
shocks, and maximized their CARA utilities based upon worst-case scenarios. In addi-
tion, we assumed that the number of the risky assets is common knowledge. Hence, all
investors know the existence of all assets, and can observe their prices.
Investors unawareness is an important alternative possible explanation for nonpar-
ticipation. Specifically, investors may not know certain traded risky assets, and so they
do not observe such assets’ prices. It is infeasible for investors to directly hold assets
they are unaware of (Merton 1987; Easley and O’Hara 2004). For example, if an investor
has never heard of FLIR Systems (an S&P 500 firm), it seems natural for the investor not
to participate in this market.
Such a definition of investor unawareness is rather restricted. We relax the defini-
tion of investor unawareness to allow for extreme ignorance about some of the asset’s
characteristics, even when the investor can observe its price. This makes it physically
possible (though not necessarily attractive) for an investor to hold an asset the investor
is unaware of.
Formally, we say that investor i is unaware of asset n, if she holds a diffuse uniform
prior about the precision of asset n’s supply shock;14 that is, τn ∼ U (0, +∞). Here, we
allow investor i to know all characteristics of asset n (other than the precision of the
supply shock) and observe asset n’s price.
Since our focus is now on unawareness, not ambiguity aversion, instead of maxi-
mizing her CARA utility in the worst case scenario, investor i maximizes her ‘average’
CARA utility over the set of all possible precisions of asset n’s supply shock. Proposition
5 below shows that in this setting, the investor will not hold asset n directly.

Proposition 5 When there is no passive fund, investors will not participate in the markets of
assets they are unaware of.

Proof of Proposition 5:
14 If we assume that the prior about τn is τn ∼ U (0, τ̄n ) for some τ̄n ∈ R++ , Proposition 5 below still
holds.

38
 Because there is no passive fund, di = 0. Consider Di 6= 0 (any non-zero direct hold-
ing of asset n). For any given τn ∈ (0, +∞), conditional on asset n’s price Pn , investor i’s
utility is
" #
Di2
 
1 1
− exp − wi rPn exp − Di E ( f n − rPn | Pn ) + 2 V ( f n | Pn ) .
ρ ρ 2ρ

Similarly to the proof of Proposition 1, |E( f n − rPn | Pn )| is bounded, and the variance
of asset n’s payoff conditional on Pn is

V ( f n | Pn ) = c2 τn−1 ,

where c = 1/(λn κn ρ) is independent of τn . Then, by Jensen’s inequality, we have

Zh
" #
Di2
 
1 1 1
lim − exp − wi rPn exp − Di E ( f n − rPn | Pn ) + 2 V ( f n | Pn ) dτn
h→+∞ h ρ ρ 2ρ
0
 
Zh
!
 
D 2
1 1 1
≤ − exp − wi rPn exp  lim − Di E ( f n − rPn | Pn ) + i2 V ( f n | Pn ) dτn  .
ρ h→+∞ h ρ 2ρ
0

The right-hand side of this inequality diverges to −∞, implying that the left-hand side,
which is the investor’s average CARA utility, is also −∞. Therefore, Di 6= 0 is dominated
by Di = 0; hence, investors will not directly hold the assets they are unaware of.
Q.E.D.

We now analyze whether a passive fund that offers RAMP can lead to full partic-
ipation in the setting with investors’ unawareness. This is not a trivial question, since
investors still need to assess the expected return and the risk of holding the passive fund,
when they allocate their initial wealth among the passive fund, the risky assets they are
aware of, and the riskfree asset.
We assume that any investor i believes that the number of all traded assets is equally
likely to be any integer that is greater than or equal to the number of assets she is aware
of. For an asset investor i is unaware of, investor i holds diffuse uniform priors about
all its parameters she does not know.15 These priors consist of a uniform uninformative
prior about its endowment over the support (0, +∞), a uniform uninformative prior
about the precision of the average private information about its payoff over the support
(0, +∞), and a uniform uninformative prior about the precision of the supply shock in
its market over the support (0, +∞). Investors know that all random variables about
assets’ characteristics are independent.
We further assume that all investors are aware of the riskfree asset, and that there
is a fund that invests in the risky assets. Investors know the existence and name of the
15 Theassumption of diffuse uniform priors is not necessary for Proposition 6 below. Indeed, from its
proof, we can see that Proposition 6 holds for any subjective priors investors may have.

39
fund and are aware of its price, but are unaware of (have diffuse priors about) its return
characteristics. So an investor who is unaware of some assets can have extremely poor
information about the distribution of returns on this fund.
The fund manager observes the characteristics and prices of all assets and therefore
is able to construct and offer to investors the portfolio X as specified in equation (6). It
is common knowledge that this is the portfolio offered by the fund.
In such a setting, an investor i’s investment strategy is a function mapping from her
information set to positions in the passive fund and the other assets. As we argue above,
if investor i is unaware of asset n, and decides not to hold the passive fund, then investor
i will have a zero holding of asset n, because either it is infeasible for investor i to hold
asset n, or holding asset n is infinitely risky to the investor.
We define an admissible world of an investor as the union of the set of assets she is
informed about and a possible set of assets she is uninformed about or unaware of and
hypothesized possible characteristics for these assets. Specifically, consider any investor
i. We divide all traded assets into two groups, Γi1 and Γi2 . Suppose that investor i is
informed about Γi1 assets only, and so she knows all characteristics of Γi1 assets. How-
ever, she is uninformed about or unaware of Γi2 assets. In particular, she knows the
existence of Γi20 assets and she can contemplate a possible set of assets Γ00 . Denote by Γ
i2
ei2
the union of Γi2 and Γi2 . The combined asset set Γi1 ∪ Γ
0 00 ei2 , together with an hypothesized
vector of characteristics for each asset in Γ ei2 , constitutes an admissible world. The set
Γi2 is associated with a number N ≥ # Γi2 of assets in Γ
0 ei2 . For each asset n ∈ Γ


e e ei2 , the
possible world specifies the specific parameters values characterizing asset n: the en-
dowment W fn > 0, the average precision of private information λ fn κen , and the precision
of the supply shock τen .
We assume that conditional upon an admissible world, the investor has the CARA
utility function. However, investors maximize their average CARA utilities over all
admissible worlds, when making investment decisions.
Proposition 6 below shows that in such a general case, investors will hold exactly
one share of the passive fund, and thus participate in all assets’ markets.

Proposition 6 In the general model where investors are uncertain about several characteristics
of the traded assets, including the number of assets:
1. There exists an equilibrium in which all investors hold one share of the passive fund and
their own information-based portfolios.
2. Asset prices and investors’ effective risky assets holdings are identical to those in the model
without any model uncertainty.
3. Generically all investors take non-zero positions in all traded assets.

Proof of Proposition 6:

40
 Consider any investor i, who is aware of assets in Γi1 but is uninformed about or
unaware of assets in Γi2 . Then, any of investor i’s admissible world Γ e consists of Γi1
assets and possible Γei2 assets; that is, Γ
e = Γi1 ∪ Γ
ei2 .
The strategy profile under consideration prescribes that all investors buy one share
of the fund and hold their own information-based portfolios. Hence, in Γ, e by The In-
formation Separation Theorem, all other investors’ portfolio choices are effectively the
same as in equation (12), because the fund offers the risk-adjusted market portfolio in Γ.e
Therefore, in Γ,
e the pricing function will be the same as in equation (8). Then, for any
given price vector, investor i’s optimal portfolio choice will be the same as in equation
(12) too. Such a portfolio choice can be implemented by holding the passive fund and
investor i’s own information-based portfolio based only on her knowledge about Γi1
assets. Therefore, in Γ,
e it is optimal for investor i to hold the fund and her information-
based portfolio, when all other investors do the same thing.
Since the admissible world Γ e is constructed arbitrarily, the arguments above show
that it is optimal for investor i to hold one share of the fund and her own information-
based portfolio, when all other investors hold the fund and their own information-based
portfolio. By similar arguments, when all other investors hold the fund and their own
information-based portfolios, any investor will optimally hold the fund and her own
information-based portfolio. Therefore, the strategy under consideration is an equilib-
rium.
Then, for any realized world, since all investors’ effective holdings are exactly same
as in equation (8), the market clearing condition implies that the equilibrium price func-
tion is same as in the case where all parameters are common knowledge. In addition,
since all investors hold the fund who offers the risk-adjusted market portfolio, all in-
vestors will have strictly positive positions of all assets.
Q.E.D.

From information separation, the portfolio constructed by the fund described in

Proposition 6 is implementable using only public information. So if a passive fund
wants to provide investors with RAMP, it does not need to know the private signal
of any investor. For investors, buying a fund share is the same as holding RAMP—the
first component described by the information separation theorem. Therefore, intuitively,
all investors are satisfied to buy fund shares, despite their extreme ignorance about the
return distribution of the fund and its assets.
Since we have assumed a uniform uninformative prior for an investor on the number
of assets of which he is not aware, one might suspect that this would interfere severely
with the investor’s attempt to speculate even on the assets the individual is aware of.
However, investors do not need to know the number of assets traded in the market
when forming their information-based portfolios. Consider for example any investor i.
Denote by Ni the number of assets that she is informed about. For any given N̂ ≥ Ni ,
except the Ni × Ni block Ωi , all other blocks in the N̂ × N̂ matrix Ωi are 0. So lack of
knowledge about the number N does not affect investors’ information-based trading.

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C.2 Heterogeneous Risk Tolerances
In the model described in Section 2, investors share a same risk aversion coefficient
ρ. Such an assumption leads to investors’ homogeneous holdings of the passive fund.
Indeed, in the equilibrium characterized in Proposition 2, all investors hold one share
of the passive fund. However, it is conceivably that differences in risk tolerances, and
investor unawareness of other investors’ risk tolerances, could resurrect investors’ het-
erogeneous holdings of the passive fund. We extend the model in Section 2 by assuming
that any investor i (i ∈ [0, 1]) has the risk aversion coefficient ρi . Here, ρi is a continuous
function of i. Let Z 1 Z 1
ρ= ρi di and Σ= ρi Ωi di.
0 0

Here, ρ is the average risk tolerance, and Σ is the average precision of investors’ private
information that is weighted by their risk tolerances. We assume that any investor i
knows ρi , but she does not know the distribution of ρ j and thus the average risk toler-
ance ρ. The passive fund cannot evaluate each individual investor’s risk tolerance, but
it has accurate information about the distribution of investors’ risk tolerances; hence, it
knows ρ and Σ. Then, the passive fund offers the portfolio
h
−1 i −1
X = ρ + ΣU W. (34)

to all investors. Proposition 7 shows that investors with different risk tolerances hold
different numbers of shares of the passive fund.

Proposition 7 In the model with investors’ heterogeneous risk tolerances, there exists an equi-
librium in which any investor i with the risk tolerance ρi holds ρi shares of the passive fund and
her own information-based portfolio ρi Ωi (Si − rP).

Proof of Proposition 7:

We first analyze the model in which investors have heterogeneous risk tolerances and
all parameters are common knowledge. We again consider the linear pricing function as
in equation (24),
F = A + BP + CZ, with C nonsingular.
Therefore, conditional on the price, assets’ payoffs have the conditional distribution is
 
F | P ∼ N A + BP, CU −1 C 0 .

An investor i gleans such information from the price. Therefore, an investor i’s demand
is h i
Di = ρi (CU C ) ( B − rI ) − rΩi P + ρi Ωi Si + ρi (CU −1 C 0 ) A.
−1 0 −1
(35)

42
Then, by integrating all investors’ demands and equalizing the aggregate demand and
the total supply (the aggregate endowments and the supply shocks), we can derive the
pricing function
P = B−1 [ F − A − CZ ] , (36)
where
h
−1 i −1
A = Σ + ρ ΣUΣ W (37)
B = rI (38)
−1
C = Σ . (39)

Any investor i’s risky asset holding is

h
−1 i −1
Di = ρi ρ + ΣU W + ρi Ωi (Si − rP) . (40)

Because the passive fund provides the portfolio X specified in equation (34), Equa-
tion (40) can be rewritten as

Di = ρi X + ρi Ωi (Si − rP) . (41)

Then, when investors are uncertain about some parameters and thus are subject to am-
biguity aversions, they still want to hold the passive fund. In particular, investor i first
buys ρi shares of a passive fund and then use her own private information to form the
information-based portfolio ρi Ωi−1 (Si − rP). Finally, investor i invests the rest of her
endowments in the riskfree asset.
Q.E.D.

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