Illiquidity

Abstract

Illiquidity is a common feature of alternative investments, whether one chooses venture capital, private equity, or hedge funds. For hedge funds, the illiquidity can arise from the contracts an investor enters into, which may have one year or longer lock-ups or can arise from the type of investments that a hedge fund specializes in. A hedge fund’s investments may include over-the-counter derivatives instruments, which may be difficult to value, or small-capitalization stocks, which may trade infrequently, for example.

This article will discuss how to explicitly take into consideration the illiquid nature of alternative investments, particularly including hedge funds. This article will specifically discuss the benefits and costs of illiquidity along with proposed quantitative adjustments that enable one to compare illiquid investments on a level playing field with liquid investments.

Keywords: hedge funds, liquidity, illiquidity

JEL Classification: G11, G23