|
THE BENEFITS AND COSTS OF ILLIQUIDITY
Hilary Till
INTRODUCTION
Illiquidity is a bit like the weather. We complain about it so much because we can’t really do much about it. The traders I speak with commonly struggle with challenges like, “I don’t want to have to move the price by a point if I want to get out,” or “everyone is a buyer out there, but me.”
For a trader, or an investor, understanding the potential effects of illiquidity on an investment is not an afterthought but rather an integral part of the trading decision. Trying to measure liquidity risk is not just about measuring the volatility of the bid-ask spread.
lliquidity is a complicated and changing thing. Despite significant advances in our thinking about illiquidity in the last few years, this measurement problem remains a significant challenge in risk management.
Till, in her paper, brings us up to date on what the talk is all about in a comprehensive tour of the subject. She tells us that, a greater part than we might have thought of the effects of illiquidity are behavioral, and in one important case at least an argument can be made that the behavioral implications may cause an investor to favor an illiquid investment (other things equal, of course).
Still, we are right to think of illiquidity as a cost on net.
Harry Kat has asked (and he is not alone in this) whether financial markets are really so far short of strong-form market efficiency that hedge fund managers can generate enough “alpha” to be able to charge fees of 2-and-20 (or more) and still have investors conclude that investment is expected utility enhancing. He suspects that in fact what is happening is that hedge fund returns in part reflect compensation for bearing illiquidity (or the obverse, supplying liquidity).
This line of thinking suggests that investors need to ask, not only what are the costs and benefits of illiquidity associated with hedge fund investing, but also, is the expected return to that investing sufficient compensation for both the price risk being taken and the illiquidity risks being borne. Till’s review will help clarify current thinking on these issues.
return to top
BIBLIOGRAPHY
- Abdulali, A., L. Rahl, and E. Weinstein, 2002, ?Phantom Prices, Valuation, and Liquidity: The Nuisance of Translucence,? Chapter 8, in A Guide to Fund of Hedge Funds Management and Investment, Leslie Rahl, Editor, (London: Alternative Investment Management Association).
- Asness, C., J. Liew, and R. Krail, 2001, ?Do Hedge Funds Hedge?,? Journal of Portfolio Management, Fall, pp. 6?19.
- Brewster, D., 2003, ?Investor Timing Decisions ?Key to Return From Fund,?? Financial Times, December 1, p. 27.
- Brooks, C. and H. Kat, 2002, ?The Statistical Properties of Hedge Fund Index Returns and Their Implications for Investors,? Journal of Alternative Investments, Fall, pp. 26-44.
- "Climbing Ivy," 2003, Barron?s, June 23, p. F3.
- Cochrane, J., 1999, ?New Facts in Finance,? Economic Perspectives, Federal Reserve Board of Chicago, Third Quarter.
http://www.GloriaMundi.org/picsresources/rb-jc.pdf
- Conner, A. et al., ?The Asset Allocation Effects of Adjusting Alternative Assets for Stale Pricing,? white paper, SEI Investments, January.
- "Contrary-wise," 2000, The Economist, May 13, pp. 77-78.
- De Souza, C., 2003, ?Leverage and Hedge Funds,? Remarks delivered at Riskinvest USA 2003, November 4.
- Getmansky, M., A. Lo, and I. Makarov, 2003, ?An Econometric Model of Serial Correlation and Illiquidity in Hedge Fund Returns,? working paper, MIT Laboratory for Financial Engineering, April.
http://www.GloriaMundi.org/picsresources/rb-glm.pdf
- Knapp, G., 2002, ?A Volatility Balanced Approach to Constructing a Diversified Hedge Fund Portfolio,? Presentation to Chicago QWAFAFEW, October, 24.
http://www.qwafafew.org/chicago.html
- Krishnan, H. and I. Nelken, 2003, ?A Liquidity Haircut for Hedge Funds,? Risk, April, pp. S18-S21.
- Lo, A., 2002, ?The Statistics of the Sharpe Ratio,? Financial Analysts Journal, July/August, pp. 36-52.
- Morgan Stanley Quantitative Strategies, 2001, ?Hedge Funds Strategy and Portfolio Insights,? working paper, December.
http://www.GloriaMundi.org/picsresources/rb-ms.pdf
- Okunev, J. and D. White, 2003, ?Hedge Fund Risk Factors and Value at Risk of Credit Trading Strategies,? Principal Global Investors (USA) and University of New South Wales, August.
http://www.GloriaMundi.org/picsresources/jodw.pdf
- Scholes, M., 2000, ?The Near Crash of 1998: Crisis and Risk Management,? AEA Papers and Proceedings, May, pp. 17-21.
- Securities and Exchange Commission, 2003, ?SEC v. Heartland Advisors? (03 C-1427), December 12.
http://www.GloriaMundi.org/picsresources/rb-SECHeartland.pdf
- Singer, B., R. Staub, and K. Terhaar, 2003, "Determining the Appropriate Allocation to Alternative Investments," Journal of Portfolio Management, Spring, pp. 101-110.
- Taleb, N., Fooled By Randomness, Texere (New York), 2001.
view at Amazon.com
- Till, H., 2004, "Risk Measurement of Investments in the Satellite Ring of a Core-Satellite Portfolio: Traditional versus Alternative Approaches," forthcoming, Singapore Economic Review.
download (pdf 439K)
- Weinstein, E. and A. Abdulali, 2002, "Hedge Fund Transparency: Quantifying Valuation Bias for Illiquid Assets," Risk, June, pp. S25-S28.
- Weisman, A., 2003, ?An Option-Based Methodology for Relative Evaluation of Manager Performance Across Strategies With Varying Liquidity Characteristics,? presentation at Risk Magazine?s 5th Annual Quantitative Trading and Investment Strategies for Global Derivatives, Quant 2003 Congress, New York, November 19.
- Weisman, A. and J. Abernathy, 2000, "The Dangers of Historical Hedge Fund Data," In L. Rahl, ed. Risk Budgeting, (London: Risk Books), pp. 65-81.
return to top
ERRATA AND OTHER MATERIAL
- Related research:
Stein, J. C., 2004, "Why Are Most Funds Open-End? Competition and the Limits of Arbitrage," working paper, Harvard University (January).
download (pdf 228K)
Zweig, J., 2002, "What Fund Investors Really Need to Know," Money Magazine 31(6).
download (pdf 98K)
return to top
|
