Consistent Risk Modeling of Liquid and Illiquid Asset Returns

Abstract

The authors link liquid assets like exchange-traded real estate investment trusts and public equity, which have relatively high volatilities and low autocorrelations, to illiquid assets like real estate and private equity, which have relatively low volatilities and high autocorrelations. A suitable weighted moving-average or smoothing function applied to public market proxies can yield risk estimates similar to their private market equivalents. Going in the opposite direction, the inverted lag polynomial, or desmoothing function, can transform illiquid alternative asset returns to have risk characteristics similar to those of public market proxies. Using the transform function to express liquid and illiquid views enables more consistent modeling of risk attribution and risk management for portfolios with illiquid assets.

TOPICS: Real estate, exchange-traded funds and applications, risk management