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An Econometric Model of Serial Correlation and Illiquidity in Hedge Fund Returns

Mila Getmansky
University of Massachusetts at Amherst - Department of Finance & Operations Management

Andrew W. Lo
MIT Sloan School of Management; National Bureau of Economic Research (NBER)

Igor Makarov
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

Abstract:     
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.

Keywords: Hedge Funds, Serial Correlation, Market Efficiency, Performance Smoothing, Liquidity

JEL Classifications: G12

Working Paper Series

Date posted: March 07, 2003 ; Last revised: June 01, 2003

Contact Information

Andrew W. Lo (Contact Author)
MIT Sloan School of Management ( email )
50 Memorial Drive
E52-454
Cambridge, MA 02142
United States
617-253-0920 (Phone)
781 891-9783 (Fax)
HOME PAGE: http://web.mit.edu/alo/www
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Mila Getmansky
University of Massachusetts at Amherst - Department of Finance & Operations Management ( email )
Amherst, MA 01003
United States
413-577-3308 (Phone)
413-545-3858 (Fax)
HOME PAGE: http://intra.som.umass.edu/msherman
Igor Makarov
London Business School ( email )
Sussex Place
Regent's Park
London NW1 4SA NW1 4SA
United Kingdom
+44 (0)20 7000 8265 (Phone)
+44 (0)20 7000 8201 (Fax)
Feedback to SSRN (Beta)


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