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Mastering Illiquidity: Risk management for portfolios of limited partnership funds by Didier Guennoc, Christian Diller, Peter Cornelius, Thomas Meyer

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7

Illiquid Assets and Risk

Investors who seek higher returns generally have to accept higher risk. To the extent that the efficient market hypothesis holds, it is impossible for investors to find risk-adjusted excess returns, with risk being defined in the standard CAPM context. In practice, of course, “…no market prices assets precisely at fair value all of the time”. However, “most markets price most assets with reasonable efficiency most of the time, providing few opportunities for easy gains” (Swensen, 2009). Any mispricing of risk gives rise to relative-value trading strategies, which help ensure that excess returns are arbitraged away.

The high degree of efficiency in markets for marketable assets encourages investors to seek investment opportunities in less transparent and efficient markets. As Swensen (2009, p. 82) argues, these markets are typically illiquid, “…since rewarding investments tend to reside in dark corners, not in the glare of floodlights”. However, as long-term investors venture into illiquid markets, such as private equity and real assets, the question immediately arises as to how risk should be defined and measured, an issue we already discussed in Chapter 5. To begin with, market prices are not observable. Instead, quarterly returns reported by limited partnership funds are based on subjective NAVs, which poses substantial challenges in terms of estimating risk-adjusted returns. And even if researchers find ways to get around this issue, for example, ...

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