An Econometric Model of Serial Correlation and Illiquidity in Hedge Fund Returns
University of Massachusetts at Amherst - Eugene M. Isenberg School of Management - Department of Finance & Operations Management
Andrew W. Lo
Massachusetts Institute of Technology (MIT) - Sloan School of Management; Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL); National Bureau of Economic Research (NBER)
London Business School
March 1, 2003
MIT Sloan Working Paper No. 4288-03; MIT Laboratory for Financial Engineering Working Paper No. LFE-1041A-03; EFMA 2003 Helsinki Meetings
The returns to hedge funds and other alternative investments are often highly serially correlated in sharp contrast to the returns of more traditional investment vehicles such as long-only equity portfolios and mutual funds. In this paper, we explore several sources of such serial correlation and show that the most likely explanation is illiquidity exposure, i.e., investments in securities that are not actively traded and for which market prices are not always readily available. For portfolios of illiquid securities, reported returns will tend to be smoother than true economic returns, which will understate volatility and increase risk-adjusted performance measures such as the Sharpe ratio. We propose an econometric model of illiquidity exposure and develop estimators for the smoothing profile as well as a smoothing-adjusted Sharpe ratio. For a sample of 908 hedge funds drawn from the TASS database, we show that our estimated smoothing coefficients vary considerably across hedge-fund style categories and may be a useful proxy for quantifying illiquidity exposure.
Number of Pages in PDF File: 92
Keywords: Hedge Funds, Serial Correlation, Market Efficiency, Performance Smoothing, Liquidity
JEL Classification: G12working papers series
Date posted: March 7, 2003
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