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Explain how the liquidity of asset classes affects asset allocation decisions

CFA® Level III · Asset Allocation · Principles of Asset Allocation · L3.AA.4.f

The idea

Private equity, private credit, real estate and infrastructure are hard to model and hard to trade. Their return series are appraisal-based, so reported volatility and correlations are understated, and there are few investable indices; performance depends heavily on manager selection. Options include excluding such classes from optimisation and setting their weights separately, using public-market proxies such as listed real estate or small-cap equities with adjusted inputs, or unsmoothing returns and adding explicit liquidity constraints. Investor size and horizon matter: a large endowment with modest spending can harvest illiquidity premiums, while a small investor may lack access and diversification across managers and vintages. The trap is letting an optimiser overallocate to private assets because their smoothed data make them look safe.

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