LO 65.6: Evaluate portfolio choice decisions on the inclusion of illiquid assets. * 1

LO 65.6: Evaluate portfolio choice decisions on the inclusion of illiquid assets. * 1
In determining the portfolio allocation to illiquid asset classes, or any asset class for that matter, investors must consider their personal circumstances. The illiquid asset allocation decision is influenced by different investment horizons, the lack of tradeable indices, the need to hire talented active portfolio managers, and the need to monitor those managers. Portfolio choice models that include illiquid assets must consider two important aspects of illiquidity that impact investors: 1. Long time horizons between trades (i.e., infrequent trading).
2. Large transaction costs.
Asset Allocation to Illiquid Asset Classes with Transaction Costs
The primary issue with asset allocation models that include transaction costs is that they assume an asset will always trade if the counterparty pays the transaction cost. However, this is not true in private equity, infrastructure, real estate, and timber markets. It is not (or may not) be possible to find a buyer in a short period of time. Counterparties, if identified, must perform due diligence, which takes time. In some cases, the counterparty, upon completion of due diligence, chooses not to buy the asset. In periods of stress, even liquid asset classes face liquidity freezes and it becomes impossible to find buyers at any price.
Asset Allocation to Illiquid Asset Classes with Infrequent Trading
As anyone trying to sell in a period of illiquidity knows, one cannot eat illiquid assets. Consider the example of Harvard University, briefly described earlier. The only way the university could generate cash for operations in a period of significant losses and illiquidity across what some would consider some of the most liquid assets (i.e., commercial paper and repurchase agreements), Harvard would have had to sell at huge discounts. Only liquid assets can be consumed. As a result, illiquidity has a major effect on investors portfolio choices. Illiquidity causes the following with respect to portfolio choice: Reduces optimal holdings. The less frequently a liquidity event is expected to occur, the
lower the allocation to the illiquid asset class.
Rebalancing illiquid assets (i.e., when there is infrequent trading in the asset class) causes allocations to vary significantly. The investor must wait until the liquidity event arrives. As such, the allocation prior to a liquidity event (or during nonrebalancing periods) can vary from too high to too low relative to the optimal allocation.
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Topic 65 Cross Reference to GARP Assigned Reading – Ang, Chapter 13

Investors cannot hedge against declining values when an asset cannot be traded. As a result, illiquid asset investors must consume less than liquid asset investors to offset the risk.
There are no illiquidity arbitrages. To construct an arbitrage, an asset must be
continuously traded. Illiquid assets are not continuously traded.
Due to infrequent trading, illiquid asset investors must demand an illiquidity risk
premium. The more frequently the asset is traded, the lower the premium. For example, one study indicates that private equity investments generate returns 6% higher than public markets to compensate investors for illiquidity.
The inclusion of illiquid assets in a portfolio is not as simple or desirable as it might seem. The following points should be considered: 1. Studies show that illiquid assets do not deliver higher risk-adjusted returns.
2.
Investors are subject to agency problems because one must rely on the talents and skills of the manager. It is difficult to monitor external managers (e.g., private equity managers).
3.
In many firms, illiquid assets are managed separately from the rest of the portfolio.
4.
Illiquid asset markets are less efficient than stock and bond markets. Illiquid asset investors face high idiosyncratic risks. There is no market portfolio of illiquid assets. Recall the example of the NCREIF versus the individual investor. It is not possible for most investors to hold thousands of properties, and small numbers of properties can lead to undiversified, property specific risks (but also returns, making illiquid assets compelling to investors). Illiquid assets are compelling because:
There are large information asymmetries in illiquid asset markets. High transaction costs keep many investors out of the market. Management skill is crucial and alpha opportunities are widely dispersed. All of these factors suggest there are great opportunities for the skilled investor to profit from investments in illiquid assets. Investors must have the skills and resources to find, evaluate, and monitor illiquid asset opportunities. Endowments like Harvard, Yale, and Stanford have the skills and resources. Unskilled investors, even those endowments at less sophisticated, skilled, and connected schools, can lose big in illiquid asset markets.
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Topic 65 Cross Reference to GARP Assigned Reading – Ang, Chapter 13
Ke y Co n c e pt s
LO 65.1 There are four main characteristics that describe illiquid asset markets, including: 1. Most asset classes are illiquid, at least to some degree.
2. Markets for illiquid assets are large.
3.
Illiquid assets comprise the bulk of most investors portfolios.
4. Liquidity dries up even in liquid asset markets.
LO 65.2 Market imperfections encourage illiquidity in asset markets. Specifically, market participation costs (i.e., clientele effects) and transaction costs give rise to illiquidity. Some academic models assume that all assets can be traded if one will pay the required (sometimes very high) transaction cost. However, this is not necessarily true in illiquid asset markets. There are search frictions (i.e., difficulties finding a counterparty and information asymmetries), price impacts, and funding constraints that may prevent trades from occurring, no matter how high the transaction cost.
LO 65.3 In general, investors should be skeptical of reported returns in illiquid asset markets as they are generally overstated. There are reporting biases that result in artificially inflated returns. The three main biases that impact reported illiquid asset returns are: 1. Survivorship bias: Poor performing funds often quit reporting results. Also, many poor
performing funds ultimately fail. Finally, some poor performing funds never begin reporting returns because performance is weak. All of these factors lead to survivorship bias. Survivorship bias leads to an overstatement of stated returns relative to true returns.
2. Selection bias: Asset values and returns tend to be reported when they are high. For example, houses and office buildings typically are sold when values are high. These higher selling prices are used to calculate returns. This results in sample selection bias, which again leads to overstated returns.
3.
Infrequent trading: Illiquid assets, by definition, trade infrequently. Infrequent trading results in underestimated risk. Betas, return volatilities, and correlations are too low when they are computed using the reported returns of infrequently traded assets.
LO 65.4 Unsmoothing adds noise back to reported returns to uncover the true, noisier returns. This process affects risk and return estimates and could have a dramatic effect on returns.
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Topic 65 Cross Reference to GARP Assigned Reading – Ang, Chapter 13
LO 65.5 There is little evidence that there are large illiquidity risk premiums across asset classes. However, there are large illiquidity risk premiums within asset classes.
There are four primary ways that investors can harvest illiquidity premiums: 1. Allocating a portion of the portfolio to illiquid asset classes like real estate. This is
passive allocation to illiquid asset classes.
2 . Choosing more illiquid assets within an asset class. This means engaging in liquidity
security selection.
3. Acting as a market maker for individual securities.
4. Engaging in dynamic factor strategies at the aggregate portfolio level. This means
taking long positions in illiquid assets and short positions in liquid assets to harvest the illiquidity risk premium. Of the four ways investors can harvest illiquidity premiums, this is the easiest to implement and can have the greatest effect on portfolio returns.
LO 65.6 There are several points to consider when deciding to allocate portfolio resources to illiquid assets: 1. Studies show that illiquid assets do not deliver higher risk-adjusted returns.
2.
Investors are subject to agency problems because one must rely on the talents and skills of portfolio managers. It is difficult to monitor external managers.
3.
In many firms, illiquid assets are managed separately from the rest of the portfolio.
4.
Illiquid asset investors face high idiosyncratic risks. There is no market portfolio of illiquid assets. Illiquid assets are compelling because illiquid asset markets are less efficient than stock and bond markets, there are large information asymmetries in illiquid asset markets, high transaction costs keep many investors out of the market, management skill is crucial, and alpha opportunities are widely dispersed.
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Topic 65 Cross Reference to GARP Assigned Reading – Ang, Chapter 13
Co n c e pt Ch e c k e r s
1.
2.
3.
4.
5.
Global liquidity crises generally occur because: A. governments choose not to engage in monetary policy actions to stimulate
economies. financial distress causes markets to freeze.
B. C. markets for illiquid assets shrink, causing liquidity issues to infect traditional
asset classes.
D. transaction costs increase as developing economies get stronger.
When an investor has difficulty finding a counterparty for a complicated credit product like a structured debt instrument, this is known as: A. market participation costs. B. agency costs. C. search frictions. D. selection bias.
Blue Sky Funds, a private equity fund, has suffered low returns for the last five years. As a result, the find has decided to quit reporting returns. The fund did report returns each year for the last 10 years when performance was strong. This problem of reporting leads to: A. survivorship bias. B. sample selection bias. C. D. attrition bias.
infrequent trading bias.
Which of the following variables is not an illiquidity factor that affects equity returns? A. Measures of adverse selection. B. The number of recorded positive returns. C. Turnover. D. Volume.
Rick Faircloth, a general partner and portfolio manager with Faircloth Funds, is considering ways in which his company can profit from illiquidity risk premiums. Fie has studied several alternative methods for harvesting illiquidity risk premiums. Which of the following strategies might Faircloth implement that will likely have the greatest effect on portfolio returns? A. Acting as a market maker for individual securities. B. Choosing the most illiquid assets within an asset class, even if the asset class is
generally considered to be liquid.
C. Allocating a portion of a portfolio to illiquid asset classes. D. Using dynamic factor strategies at the aggregate portfolio level.
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Topic 65 Cross Reference to GARP Assigned Reading – Ang, Chapter 13
Co n c e pt Ch e c k e r An s w e r s
1. B
In stressed economic periods, such as during the 2007-2009 financial crisis, liquidity can dry up. Major liquidity crises have occurred at least once every ten years across the globe, in conjunction with downturns and financial distress.
2. C Difficulties finding a counterparty are called search frictions. For example, it may be difficult to find someone to understand/purchase a complicated structured credit product. It may also be difficult to find buyers with sufficient capital to purchase multimillion dollar office towers in major metropolitan areas. No matter how high the transaction costs, it may take weeks, months, or years to transact in some situations. Asymmetric information can also be a type of search friction as investors search for non-predatory counterparties with which to transact.
3. A There are no requirements for certain types of funds, like private equity funds, to report
returns. As such, poorly performing funds have a tendency to stop reporting. Additionally, many poorly performing funds ultimately fail. Performance studies generally include only those funds that were successful enough to survive over the entire period of analysis, leaving out the returns of funds that no longer exist. Both of these factors result in reported returns that are too high. This is called survivorship bias.
4. B There are several variables related to illiquidity that are shown to impact equity returns. They are bid-ask spreads, volume, turnover, volume measured by whether the trade was initiated by buyers or sellers, the ratio of absolute returns to dollar volume, the price impact of large trades, informed trading measures (i.e., adverse selection), quote size and depth, the frequency of trades, the number of zero returns, and return autocorrelations. It is not the number of recorded positive returns, but the number of recorded zero returns, that are relevant.
5. D There are four primary ways that investors can harvest illiquidity premiums:
1. Allocating a portion of the portfolio to illiquid asset classes like real estate (i.e., passive
allocation to illiquid asset classes).
2. Choosing more illiquid assets within an asset class (i.e., liquidity security selection).
3. Acting as a market maker for individual securities.
4. Engaging in dynamic factor strategies at the aggregate portfolio level. This means
taking long positions in illiquid assets and short positions in liquid assets to harvest the illiquidity risk premium. Of the four ways investors can harvest illiquidity risk premiums, this is the easiest to implement and can have the greatest effect on portfolio returns.
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The following is a review of the Risk Management and Investment Management principles designed to address the learning objectives set forth by GARP. This topic is also covered in:
Po r t f o l i o C o n s t r u c t i o n
Topic 66
Ex a m Fo c u s
This topic addresses techniques for optimal portfolio construction. We will discuss important inputs into the portfolio construction process as well as ways to refine the alpha inputs as an alternative to imposing constraints directly into the portfolio optimization calculations. The role of transaction costs in determining optimal rebalancing is also explained. For the exam, pay attention to the discussions of refining alphas and the implications of transaction costs for both rebalancing and dispersion of returns across separately managed portfolios. Also, be prepared to compare and contrast the various methods of portfolio construction: screening, stratification, linear programming, and quadratic programming.
Th e Po r t f o l io C o n s t r u c t io n Pr o c e s s

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