A Penalty Cost Approach to Strategic Asset Allocation with Illiquid Asset Classes

Abstract

Traditional approaches to asset allocation do not directly address the issue of liquidity. The financial crisis brought liquidity management to the forefront for several large university endowments—investors who heretofore had been considered thought leaders in their approaches to asset allocation. The authors discuss a new approach developed at Stanford University that modifies the familiar mean–variance optimization framework by incorporating an illiquidity-related marginal penalty function that varies with each investor’s liquidity needs. The new methodology allows for an explicit, easily communicated, and natural specification of illiquidity preferences that works in conjunction with the standard Markowitz approach to solve the asset-allocation problem faced by today’s institutional investors.