Being Locked Up Hurts

Abstract

A lockup period for hedge funds restricts a multi-period investor’s ability to rebalance his portfolio and has non-trivial effects on the allocation decision and portfolio efficiency. Investors compensate for a hedge fund lockup period by making adjustments to their equity and bond holdings. Adding hedge funds with a lockup period to the portfolio of stocks and bonds generates large, negative hedge demands for stocks. More importantly, an investor with a portfolio of stocks, bonds and hedge funds under both the unconditional strategy and conditional strategy is hurt by the presence of a hedge fund lockup period. In an unconditional setting, we find a Sharpe ratio of 1.11 for the portfolio of stocks, bonds and hedge funds adjusted for stale pricing, with a three-month lockup period for hedge funds and monthly rebalancing of stocks and bonds. For the same portfolio, but without a hedge fund lockup period, we find a significantly higher Sharpe ratio of 1.43. The certainty equivalent is 4.11%, i.e. a three-month lockup costs the investor 4.11% per annum.

Keywords: Hedge funds, lockup period, multi-period asset allocation, timing portfolios

JEL Classification: G11, G12