Appraise the consequences of putting illiquid assets into a portfolio, for rebalancing and trading as well as for deciding how large a proportion of them is optimal.
The idea
Illiquid assets change how a portfolio is run. They cannot be rebalanced cheaply or quickly, so weights drift with relative performance, and when liquid assets fall the illiquid share rises without the investor choosing it. Rebalancing and any cash needs then fall on the liquid assets, which makes the liquid sleeve more volatile and sale-prone than its weight suggests. With high trading costs, sensible policy is wide tolerance bands and infrequent trading. The optimal allocation is smaller than a frictionless model would give, because the investor must keep a liquidity buffer for obligations and cannot exit in a bad market. It is larger for long-horizon investors with few liquidity needs. It is smaller once risk is measured with unsmoothed volatility and correlation. The exam point: the illiquidity premium must be weighed against lost rebalancing flexibility.
A practice question
How does the presence of illiquid assets affect portfolio rebalancing?
- Illiquid assets are rebalanced every month alongside the liquid assets at no extra cost.Why not: Illiquid assets are costly and slow to trade, so frequent rebalancing is not feasible.
- Illiquid holdings cannot be rebalanced cheaply, so weights drift and liquid assets bear the adjustment. - correct
- Illiquid assets remove the need to rebalance because their reported values are stable.Why not: Reported stability comes from smoothing, not from the asset's risk; weights still drift.
- Rebalancing becomes easier because there are fewer liquid positions to adjust.Why not: Fewer tradable positions concentrate rebalancing on the liquid sleeve, which makes it harder.
Weights drift as liquid assets move, and since the illiquid part cannot be adjusted cheaply, all adjustment must come from the liquid assets.
A harder one
Which investor should hold the largest proportion of illiquid assets, other things equal?
- An endowment with a perpetual horizon and few near-term cash needs. - correct
- A pension fund whose benefit payments are nearly equal to its contributions each year.Why not: Large near-term cash needs require liquid assets, so this investor should hold fewer illiquid assets.
- A leveraged fund whose lenders can impose margin calls on short notice.Why not: Margin calls demand liquidity, and holding illiquid assets raises the risk of forced sales.
- A fund that values its portfolio daily and faces redemption on weekly notice.Why not: Weekly redemptions require liquid holdings, so this fund should hold few illiquid assets.
Illiquidity is best borne by investors with long horizons, stable funding and little need to sell, since they can collect the premium without facing forced sales.
The hardest tier
A portfolio is 70 percent liquid equities with volatility 16 percent and 30 percent in an illiquid fund. Reported illiquid fund volatility is 6 percent with correlation to equities 0.3. After unsmoothing, its volatility is 12 percent with correlation 0.6. Portfolio volatility using unsmoothed inputs is closest to:
- 11.9 percentWhy not: Uses the reported, smoothed inputs, which understate the true portfolio risk.
- 12.8 percentWhy not: Uses the unsmoothed volatility but keeps the reported correlation of 0.3.
- 13.7 percent - correct
- 14.8 percentWhy not: Takes the weighted average of the volatilities, which ignores diversification and assumes a correlation of 1.
Variance = (0.7 x 16)² + (0.3 x 12)² + 2 x 0.7 x 0.3 x 16 x 12 x 0.6 = 125.44 + 12.96 + 48.38 = 186.78, so volatility is 13.67 percent. Reported inputs give only 11.86 percent.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Illiquid Assets
- Appraise the defining features of markets that are illiquid.
- Examine the link between imperfections in markets and a lack of liquidity.
- Weigh up how biases affect the returns reported for illiquid assets.
- Account for how returns are unsmoothed and what unsmoothing does.
- Set the premiums paid for bearing illiquidity risk against each other, both across asset categories and within a single category.