Mastering Illiquidity: Risk management for portfolios of limited partnership funds

5

Returns, Risk Premiums and Risk Factor Allocation

Investors who invest in illiquid asset classes expect to achieve higher returns, compensating them for the lack of liquidity they have to accept. From a portfolio standpoint, the illiquid nature of investments in limited partnership funds makes it difficult, if not impossible, to continuously rebalance an investor's portfolio – a key assumption in standard asset allocation models (Ang and Sorensen, 2011; Ang et al., 2011). Shares in limited partnership funds cannot easily be liquidated, despite the development of a secondary market in recent years, as we discuss in Chapter 6. In addition to market liquidity risk, investors face funding risk, or commitment risk, as they have to be able to respond to capital calls at any given point in time. Since capital calls and distributions are stochastic, investors may suddenly become overcommitted or undercommitted, moving investors away from their optimal portfolio and reducing diversification benefits (Phalippou and Westerfield, 2012). Measuring and managing funding and market liquidity risk is essential for investors in illiquid asset classes, an issue we return to in the second part of this book.

Quantifying the risk premium in illiquid asset classes is subject to considerable conceptual and statistical challenges. While the literature on investment returns of illiquid assets has expanded significantly in recent years as more data have become available, most studies have focused on comparing ...