A Practitioner's Guide to Asset Allocation

CHAPTER 11Illiquidity

THE CHALLENGE

One of the most vexing challenges of asset allocation is determining how to treat illiquid asset classes. For the most part, investors have employed arbitrary techniques to address this issue. For example, some investors impose a direct constraint on the allocation to illiquid asset classes. Others assign a liquidity score to asset classes and optimize subject to a constraint that this score meet a certain threshold. It has also been proposed that liquidity be added as the third dimension in the optimization process.¹ These approaches require investors to relate liquidity to expected return and risk in an arbitrary fashion. We describe an alternative technique that translates illiquidity directly into units of expected return and risk, so that investors need not address this trade‐off arbitrarily.

SHADOW ASSETS AND LIABILITIES

We begin by considering the many ways in which investors use liquidity. For example, investors depend on liquidity to meet capital demands. They rely on liquidity to rebalance their portfolios. To the extent investors are skillful at tactical asset allocation, they depend on liquidity to profit from this skill. Investors require liquidity to exploit new opportunities or to exit from strategies they no longer expect to add value. And they require liquidity to respond to shifts in their risk tolerance. These considerations reveal that liquidity has value beyond the need to meet demands for cash. Therefore, investors bear ...