Liquidity can be treated as a shadow allocation to a portfolio to enable investors to better account for liquidity’s effects. The authors provide a case study on a representative institutional portfolio to demonstrate such an approach. If liquidity is being used to increase a portfolio’s expected utility, then the authors attach a shadow asset to tradable assets. If it is being used to prevent a portfolio’s expected utility from decreasing, then the authors attach a shadow liability to nontradable assets. This approach improves on other methods of incorporating liquidity into portfolio decisions.

Investors often overlook or overestimate liquidity when forming portfolios. The authors’ method of incorporating liquidity can help investors enhance their decision-making processes in four ways. First, by treating liquidity as a shadow allocation to a portfolio, investors are better able to mirror what is actually occurring in the portfolio. Second, this method allows investors to map units of liquidity onto units of expected return and risk so that they can analyze liquidity in the same context as other portfolio decisions. Third, investors using this approach can address absolute illiquidity and partial illiquidity within a single, unifying framework. Fourth, this approach recognizes that liquidity serves not only to meet demands for capital but also to allow investors to exploit opportunities; that is, investors bear an illiquidity cost to the extent that any portion of a portfolio is immobile.

The analytical construct reveals how the required return for illiquid equity rises as corrections are made for the effects of performance fees, the smoothing that arises from fair-value pricing, and the opportunity cost of forgoing liquidity. The optimal allocation to illiquid equity falls as the illiquidity premium falls in relation to the required illiquidity premium.

The authors describe how treating liquidity as a shadow allocation improves on other methods of incorporating liquidity into portfolio decisions. They then provide an overview of the literature, followed by a discussion of the benefits of liquidity and the distinction between absolute and partial illiquidity. The analytical construct is presented, and performance fees and multiple funds are discussed. Before concluding, the authors provide a case study in which their approach is applied to a representative institutional portfolio.

The analytical construct consists of a mean–variance analysis that solves for the optimal allocation to liquid equity and liquid bonds, first without considering the effect of liquidity and then substituting illiquid equity for liquid equity. The authors then attach the shadow asset to the bond portion of the portfolio and restate the expected return, standard deviation, and correlation of bonds to account for the presence of the shadow asset. The required return for equities changes as liquid equities are replaced by illiquid equities; the authors then adjust for the effects of performance fees, smoothing, and the inclusion of the shadow asset.

In the case study, the authors apply the approach to a representative institutional portfolio. Their objective is to compare the optimal allocations that account for liquidity with those that ignore it. They use a simulation to estimate returns and risks of the shadow allocations because there are no data for shadow allocations. Many assumptions are made that, if relaxed, would further root the analysis in the real world.

When constructing portfolios, investors might falsely assume that the underlying positions can be liquidated at will. The authors recognize that if any fraction of a portfolio is immobile, investors bear an illiquidity cost that should be taken into account as they make portfolio decisions. This research helps investors to construct portfolios with more realistic required return expectations; investors should demand higher returns when portions of the portfolio are illiquid.