Yesterday, we covered the first half of an interesting academic study on hedge fund redemption terms.  We learned that the auto-correlation of monthly returns was positively related to the actual redemption terms of a fund.  Today, we cover the second half of this paper by MIT’s Amir Khandani and Andrew Lo – in which the duo estimate an actual premium associated with redemption terms.

Rather than comparing actual redemption terms to see if illiquid funds perform better than liquid ones, the duo can now compare autocorrelation to (risk adjusted) returns.  In the table from their paper reproduced below, they create 5 separate hypothetical portfolios based on autocorrelation buckets (click to enlarge).  Lo and behold (pardon the pun), the funds with the highest autocorrelation of returns generally also had the highest risk-adjusted returns.

Note that while  high auto-correlation is generally associated with higher risk-adjusted returns, there are some exceptions.  In particular, Khandani and Lo highlight the fact that the Global Macro funds with the highest auto-correlation (lowest liquidity) actually posted below average results.  Also, we noted that very few of the relationships were monotonic (with the best performing funds of funds, for example, being the ones with the second lowest autocorrelation).

Okay.  So you read yesterday’s post and you get the idea above.  But so what, right? More…