Every investors wants low volatility and low correlation with good returns. This low volatility/low correlation "holy grail" is the critical objective of many hedge funds and alternative investments. Even if returns do not meet some pre-set target, the hedge fund manager will always point to the diversification benefit, but the diversification benefit could be illusory. An artifact of low liquidity is low volatility and correlation. Diversification "skill" should not be confused with holding illiquid investments.
Take a very simple example. If you hold an asset that does not move in price because there is no market, it will have by construction low volatility and will be uncorrelated with any alternative. Of course this is an extreme example, but if there less liquidity it will create the illusion of diversification. Should an investor pay for diversification that comes from illiquidity?
illiquid assets will have more memory since prices changes may occur slowly over time and there is a an induced serial correlation. Volatility is smoothed or lower than compared with more liquid investments. Hence, to get a good idea of what is the true volatility there has to be an adjustment for serial correlation.
The volatility of an illiquid can be roughed-up through an adjustment process. The order of magnitude increase in volatility can be quite large when this adjustment is made. Roughing up the volatility will not affect returns, but it will impact correlation and the information ratio. Low vol strategies will be riskier and great information ratios will be forced lower.
One method for volatility adjustment of an illiquid asset:
The key investment issue is whether you are compensated for a lack of liquidity. If there a liquidity premium, what is its size? This is not very clear. If there is illiquidity and there is an illiquidity premium, how much liquidity should an investor give up in the form of gates or lock-ups? These may be critical issues if there is a market downturn.
These liquidity issues may also have to be addressed very quickly in a rising interest rate environment. There could be problems with holding a credit portfolio that loses liquidity.
illiquid assets will have more memory since prices changes may occur slowly over time and there is a an induced serial correlation. Volatility is smoothed or lower than compared with more liquid investments. Hence, to get a good idea of what is the true volatility there has to be an adjustment for serial correlation.
The volatility of an illiquid can be roughed-up through an adjustment process. The order of magnitude increase in volatility can be quite large when this adjustment is made. Roughing up the volatility will not affect returns, but it will impact correlation and the information ratio. Low vol strategies will be riskier and great information ratios will be forced lower.
One method for volatility adjustment of an illiquid asset:
The key investment issue is whether you are compensated for a lack of liquidity. If there a liquidity premium, what is its size? This is not very clear. If there is illiquidity and there is an illiquidity premium, how much liquidity should an investor give up in the form of gates or lock-ups? These may be critical issues if there is a market downturn.
These liquidity issues may also have to be addressed very quickly in a rising interest rate environment. There could be problems with holding a credit portfolio that loses liquidity.
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