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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 |
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