Illiquidity Premia in Asset Returns: An Empirical Analysis of Hedge Funds, Mutual Funds, and U.S. Equity Portfolios

59 Pages Posted: 29 Jun 2009

See all articles by Amir Khandani

Amir Khandani

Massachusetts Institute of Technology (MIT)

Andrew W. Lo

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER); Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL)

Date Written: June 25, 2009

Abstract

We establish a link between illiquidity and positive autocorrelation in asset returns among a sample of hedge funds, mutual funds, and various equity portfolios. For hedge funds, this link can be confirmed by comparing the return autocorrelations of funds with shorter vs. longer redemption-notice periods. We also document significant positive return-autocorrelation in portfolios of securities that are generally considered less liquid, e.g., small-cap stocks, corporate bonds, mortgage-backed securities, and emerging-market investments. Using a sample of 2,927 hedge funds, 15,654 mutual funds, and 100 size- and book-to-market-sorted portfolios of U.S. common stocks, we construct autocorrelation-sorted long/short portfolios and conclude that illiquidity premia are generally positive and significant, ranging from 2.74% to 9.91% per year among the various hedge funds and fixed-income mutual funds. We do not find evidence for this premium among equity and asset-allocation mutual funds, or among the 100 U.S. equity portfolios. The time variation in our aggregated illiquidity premium shows that while 1998 was a difficult year for most funds with large illiquidity exposure, the following four years yielded significantly higher illiquidity premia that led to greater competition in credit markets, contributing to much lower illiquidity premia in the years leading up to the Financial Crisis of 2007-2008.

Keywords: liquidity, illiquidity, hedge funds, mutual funds, equity premium, market microstructure

JEL Classification: G12, G11

Suggested Citation

Khandani, Amir E. and Lo, Andrew W., Illiquidity Premia in Asset Returns: An Empirical Analysis of Hedge Funds, Mutual Funds, and U.S. Equity Portfolios (June 25, 2009). Available at SSRN: https://ssrn.com/abstract=1425494 or http://dx.doi.org/10.2139/ssrn.1425494

Amir E. Khandani

Massachusetts Institute of Technology (MIT) ( email )

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Andrew W. Lo (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

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National Bureau of Economic Research (NBER) ( email )

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Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL)

Stata Center
Cambridge, MA 02142
United States

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