A conceptual framework for estimating the investor-specific value of liquidity can be used to inform asset allocation decisions. The central concept of the framework, the shadow price of liquidity, is the additional return required for accepting illiquidity risk. For the case study, the additional required return for taking on such risk is relatively low.
What’s Inside?
The authors develop a framework for including liquidity considerations in the asset allocation process. The shadow price of liquidity, the primary concept of the framework, expresses the utility gains, in terms of return and risk, an investor receives from using liquid assets and the utility losses associated with holding illiquid assets. The authors use the framework in a case study in which an investor considers allocations to private equity, real estate, and infrastructure combined with a public equity and bond portfolio to assess the shadow cost of liquidity.
How Is This Research Useful to Practitioners?
The question of illiquidity risk is relevant to investors considering the inclusion of alternative assets, which tend to be less liquid compared with publicly listed and easily tradable equities and bonds, in their portfolios.
The authors develop a coherent conceptual approach to assist in the decision-making process for whether to include alternative assets and the proportion of the portfolio to allocate to alternative assets. The approach takes into account the benefit of being invested in liquid assets and the cost of being invested in illiquid assets.
The authors’ case study of a sample portfolio quantifies the liquidity benefits of passive rebalancing as well as market timing based on a range of assumptions. They find that the shadow price of liquidity is relatively low and raises the required return of illiquid assets by less than 1%.
Importantly, the framework is flexible enough to model varying circumstances related to how an investor benefits from liquidity, such as when capital calls become more essential.
How Did the Authors Conduct This Research?
The authors specify a portfolio allocation and solve for the asset returns (implied returns) that make the allocation mean–variance optimal. Throughout the analysis, they consider a portfolio that consists of both liquid assets (equities and bonds) and illiquid assets (real estate, private equity, and infrastructure). The studied portfolio is allocated as follows: global equity (55%), global bonds (30%), global real estate (5%), global private equity (5%), and infrastructure (5%). For the specified portfolio, volatilities and correlations are estimated by using monthly return data from January 1990 to March 2012.
The authors estimate the value an investor derives from liquidity by comparing the results of two simulations: one in which assets are liquid and can be traded according to a specified rule and another in which assets are nontradable.
Returns are simulated by using four different return-generating processes, each of which is used to generate 10,000 hypothetical paths for asset returns. To quantify the benefit of liquidity, the “certainty equivalent” of the no-trading simulation is subtracted from that of the tradable simulation.
The authors specify four passive rebalancing heuristics to estimate the liquidity benefits associated with passively rebalancing the portfolio back to target weights as allocations drift over time. Suboptimality is calculated relative to the base case scenario, which assumes no rebalancing over the 10-year period.
Next, the authors assume that the investor uses market timing by varying the equity and bond weights around their strategic weights by at most 4%, according to seven active rebalancing heuristics. All other assumptions remain the same as in the passive rebalancing case.
They highlight that the results depend on specifications for the rebalancing rules, return processes, and portfolio weight allocations relative to the base case liquid 60/40 portfolio. As such, readers should not put too much weight on the exact figures for the shadow price of liquidity.
Abstractor’s Viewpoint
The question of illiquidity risk should be an important consideration for any investor who is evaluating the inclusion of alternative assets in his or her portfolio. The financial crisis exposed the risks of treating illiquid assets in the context of traditional mean–variance optimization when making asset allocation decisions. The authors provide a simple but rather interesting approach that takes into account the benefits from investing in liquid assets and the costs of allocating funds to illiquid assets.