During the Autumn Seminar in Valencia, Andrei Gonçalves from Ohio State University gave a tutorial titled: ‘Illiquid assets and Smoothed Returns’; for those of you who missed it we have taken the liberty to summarize some of the key takeaways.
The significant question one must ask themselves before investing in alternative assets is: once you are in, how tough is it to get out?
“Illiquidity induces at least two major issues”, said Gonçalves “The first major issue is that we don’t observe the true market values, so it becomes very hard to measure performance. The other issue is that it’s not that easy to trade them.” He contrasted the market value volatility with the “smooth” appraisal values, which seem stable due to infrequent trading or updates, making them appealing to investors seeking lower volatility.
However, the smoothness can be problematic for performance evaluation. Gonçalves warned, “Illiquidity yields artificially smooth returns and can therefore lead to artificially low betas and high alphas when using standard risk-adjusted return methods.”
“Smooth returns are returns that have less volatility than if they were market-to-market […] we detect this by looking for excessive autocorrelation in returns,” Gonçalves explains. Excessive autocorrelation is a clear signal of smoothing, as it reflects the persistence of returns over time, which is a hallmark of illiquid assets.
He emphasized that smoothness arises not only from potential price manipulation but also fundamentally from market illiquidity is a key factor. He further clarifies that this phenomenon is widespread, noting that “the signs of smooth returns are not limited to real estate…this pattern is observed in private real estate, venture capital, and buyouts but not in public equities.”
The tutorial highlights how investors can adjust for smooth returns in their performance assessments. “This is not about private versus public markets. In fact, it’s about illiquidity. You can have the same thing in a public market… The autocorrelations of hedge fund returns tend to be much higher than those of liquid alternatives […] because hedge funds invest in these illiquid assets.” Hedge funds, in particular, invest in illiquid assets, which can create a smoothing effect in reported returns.
Gonçalves went on to explain the economic factors behind this smoothing effect, emphasizing that “the primary economic factor behind it seems to be illiquidity, rather than intentional manipulation[…] Here’s what I mean: fund managers report their asset values based on estimates, as they don’t always have a clear view of actual market values.” For instance, self-reported hedge fund valuations show a somewhat higher autocorrelation (0.18) compared to third-party valuations (0.12), while real estate properties also demonstrate more smoothness with internal rather than external appraisals. However, even third-party valuations remain heavily smoothed.This smoothing of returns can lead to a distortion of performance metrics, such as betas and alphas.
One of the central points Gonçalves made is that the true risk of an asset is reflected in its economic beta, not the smoothed version. He explained that while private assets may appear smoother due to infrequent updates, the true risk is tied to the economic beta, which reflects the covariance of the asset with systematic market factors. In this context, funds implement measures like queue limits to prevent investors from making decisions based on short-term fluctuations, emphasizing the importance of multi-period beta over short-term volatility.
View the research in full via : Autumn Seminar 2024, Valencia, Spain • Inquire Europe