Apples to Apples: the case for liquidity adjustments to hedge fund of funds returns
Sep 15th, 2008 | Filed under: Guest Posts, Today's PostIlliquidity premiums are often misidentified as alpha. So with their lock-ups and “gates”, hedge funds have recently come under the scrutiny of academics who wonder how much of their returns are simply a fair compensation for having to lock-up your investments for up to a couple of years. In a 1998 paper on liquidity and security prices, UCLA’s Francis Longstaff said “The extent to which liquidity affects security prices has itself become a controversial in asset pricing…it may take an extended period of time to accumulate or unwind a specific portfolio position.”
In a 1995 article for the Journal of Finance, Longstaff also predicted the appropriate illiquidity premium for a security given its volatility and the number of days it would take to unwind a position. Now this general approach has been applied to hedge funds by Pierre Laroche, head of R&D at Innocap, a subsidiary of the National Bank of Canada and a joint venture partner with BNP Paribas.
A simple model to adjust funds of funds returns for their illiquidity
Special to AllAboutAlpha.com by: Pierre Laroche, Managing Director, R&D, Innocap Investment Management.
We all know that the lack of liquidity can impact the performance of an investment in several ways:
- Liquidity constraints usually increase the bid-ask spread, hence lowering the expected return.
- A liquidity crisis usually raises the volatility.
- A longer time required to liquidate the position increases the uncertainty on the total amount that will finally be obtained.
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Interesting model, makes good intuitive sense. Would be great if someone banged up a calculator widget on the web. (To save me the pain of hacking together a spreadsheet!)