Illiquid Assets

1) Jude Wang, a portfolio manager, works at an investment management firm. She has
been recently asked to manage the endowment fund of a large university. She meets the
head of the university to discuss finer details about the fund, including the composition of
the endowment fund. The university head informs her that the university plans to
withdraw a substantial amount of the fund in next two years and use the money to
establish a state-of-the-art financial laboratory. He also adds that the university board
desires to keep the transaction cost as low as possible. After the discussion, Wang
meets her colleague, Jane Jones, with whom she explores the asset classes that can
possibly be included in the endowment fund. According to Jones, Wang should consider
including private equity and real estate in the endowment fund as these asset classes
have low correlation with stocks and bonds and can provide a better diversification effect
to the overall portfolio. Jones goes further to opine that private equity and real estate
would make it easier for Wang to generate an excess return compared to stocks and
bonds.

Which of the following does not support the idea of including private equity and real
estate in the portfolio?
A
It would provide a better diversification effect to the portfolio

B
It would help Wang to generate an excess return

C
The university needs a substantial amount of funds in next two years for the laboratory

D
It would improve the portfolio because of the assets’ low correlation with stocks and
bonds

The correct answer is: C).

Private equity and real estate fall under the category of illiquid assets. Large trades of illiquid
assets results in substantial market movement which may in turn trigger adverse price
movements. Thus, an investor trying to cash in on illiquid assets in a short time period may have
to suffer significant losses due to adverse price movement. Barring a change of plans by the
university, a substantial amount of money is needed in next two years – and that’s where the
problem lies. If the fund invests in illiquid assets, divesting such assets may force the institution
to accept a lower market price or incur substantial transaction costs. Therefore, investment in
illiquid assets must be avoided.

Which of the following statements is correct?

A
Jones may include private equity and real estate since they will reduce transaction costs

B
Jones must not include private equity and real estate because they may increase
transaction costs

C
 The inclusion of private equity and real estate in the portfolio will have no effect on
transaction costs

D
Private equity and real estate will make the portfolio more diversified and reduce
transaction costs

The correct answer is: B).

Illiquid assets are characterized by information asymmetry. As the information regarding
illiquid assets is not readily available, the cost of obtaining information on such assets is
very high. Therefore, this increases transaction costs.

Which of the following best supports the idea of including private equity and real estate in the
portfolio?
A
Endowment funds usually invest in equity and real estate

B
Endowment funds usually prefer a long investment horizon

C
Private equity and real estate – especially the latter – rarely decline in value, unless a
financial crisis occurs

D
The market for private equity and real estate is wide

The correct answer is: B).

Endowment funds are characterized by longer investment horizons compared to other investing
entities. Illiquid assets fit the bill because if divested after a short period of time, their prices may
move adversely, subjecting the investor to heavy losses.

2) Illiquid assets can generate excess return because:

A
They allow the transfer of idiosyncratic risk from liquid markets

B
They reduce transaction costs

C
They generate arbitrage opportunities

D
They require huge investments

The correct answer is: A).

Liquid asset markets are information efficient. Information regarding the assets is freely available
and every participant has equal access. This makes the generation of alpha (excess return) in
such markets a challenging task. However, the market for illiquid assets markets is fraught with
information asymmetry. This information asymmetry can be exploited to generate excess return.
Thus, the idiosyncratic risk of liquid assets can be transferred to illiquid assets and help generate
excess returns.
 Sam Kesler, a portfolio manager, is trying to select stocks for his portfolio. The investment policy
statement of the fund indicates that the portfolio must consist of only liquid stocks. Kesler has the
following investment options:

Categor
Stock Information
y
Mid Cap X Going by the latest trading information available, the stock
could be sold at $12.30 and purchased at $12.32.
Mid Cap Y The majority shareholding of the company rests with a
family. The daily turnover of the shares equals 100 stocks
only.
Large Z
The stock was last traded 2 days ago.
Cap
Small A Going by the latest trading information available, the stock
Cap could be sold at $4.65 and purchased at $8.25.

Which of the following statements is correct?

A
Stock Y must not be selected due to its large family holding

B
Stock Y must be selected due to its daily turnover

C
Stock Y must be selected due to its large family holding

D
Stock Y must not be selected as it belongs to the Mid Cap category

The correct answer is: A).

Due to Stock Y’s large family shareholding, the shares available for trading are significantly less.
Less number of shares for trading makes the stock illiquid. The stock must, therefore, not be
selected.

The stock(s) which must be included in the portfolio is (are):

A
X and Y

B
X only

C
Y only

D
X and A

The correct answer is: B).

Stock X: The difference between the purchase and sell price (bid-ask spread) of the stock is very
small which indicates high liquidity. The smaller the bid-ask spread, the more liquid a stock is.
Stock Y: Due to Stock Y’s large family shareholding, there are very few shares freely available
for trading.
Stock Z: That the stock was last traded 2 days ago is indicative of high illiquidity.
Stock A: The bid-ask spread of the stock is very large, indicating illiquidity.

Therefore, only Stock X must be selected.

The majority shareholding of Y decreases the:

A
Profitability of the company

B
Number of shares available for trading

C
Transaction costs

D
Both the number of shares available for trading and the transaction costs

The correct answer is: B).

Due to Stock Y’s large family shareholding, the shares available for trading are significantly less.
If only a small number of shares are available for trading, the stock is quite illiquid.

4) Jack Bowman plans to invest in mutual funds. The fact sheet below outlines the performance
of one of his prospective fund managers.

Fund manager John Cook

Number of funds managed 24
Average annual return of the funds managed 12%

In addition to the above information, the fact sheet indicates that the average return reported only
incorporates the fund currently being managed by the fund manager.

The reported performance of the fund manager is exposed to:

A
Selection bias

B
Survivorship bias

C
Infrequent sampling

D
None of the above

The correct answer is: B).

The fact sheet consists only of those schemes which are active, effectively excluding past
(closed) schemes. This creates a survivorship bias. The reported performance may change
drastically if the performance of the closed schemes is included.
5) A fund manager has quarterly and daily returns of stocks A and B. In order to calculate the
volatility of the two stocks, the fund manager utilizes the quarterly return of A and the daily return
of B. The computed volatility values are given below:

Stock A Stock B
Return frequency Quarterly Daily
Volatility 0.33 0.43

Based on the above result, the fund manager argues that stock A is less risker than stock B.

Which of the following statements is accurate?

A
The fund manager is correct

B
The fund manager is incorrect as the volatility is not a true measure of riskiness

C
The fund manager is incorrect as the quarterly return of stock A makes its volatility lower
than that of B

D
The fund manager is correct as the daily return of stock B makes its volatility higher than
that of A

The correct answer is: C).

The frequency of return reporting is different for the two stocks. This is usually the effect of
infrequent trading. The quarterly reporting frequency of stock A makes its volatility appear lower
compared to stock B.

6) Which of the following is one of the processes usually employed to account for infrequent
trading?

A
Unsmoothing

B
Noise reduction

C
Autocorrelation

D
Filtering

The correct answer is: A).

To account for the infrequent trading bias, we need to unsmoothing the returns. In the process,
the noise is added back to the reported returns to uncover the true return.

7) Alco Bank is contemplating creating an index to value artistic work. As art works are not
actively traded, the bank decides to create an index from data reported by its members. The
members include the major auction firms and art advisors situated in the city.
Sam Park is looking to invest in the art work space to diversify his portfolio. In order to make an
informed decision, he decides to use the index created by the bank to calculate the expected
return.

The returns as indicated by the bank’s index exhibit:

A
Autocorrelation

B
Unsmoothing

C
Auto regression

D
Filtering

The correct answer is: A).

The index is formed by information submitted by the members. The reported returns depend
mainly on subjective valuation procedures. Thus, the asset returns are auto correlated.

8) Alco Bank is contemplating creating an index to value artistic work. As art works are not
actively traded, the bank decides to create an index from data reported by its members. The
members include major auction firms and art advisors situated in the city.

Sam Park is looking to invest in the artworks space to diversify his portfolio. In order to make an
informed decision, he decides to use the index created by the bank to calculate the expected
return.

The index created by Alco Bank is an example of a (an):

A
True index

B
Appraisal index

C
Equal-weighted index

D
Transaction index

The correct answer is: B).

An index developed by the returns reported by the members and not the actual transactions is
known as an appraisal index.

9) Michael Bay is thinking to include real estate in his portfolio to generate excess returns and to
diversify his portfolio. He studies a report prepared by a big consultancy firm on the real estate
sector. The report outlines the future prospects of the sector and also contains the list of recent
transactions carried out and the return generated.

Date Return
Building A 12/2/2016 12.00%
Building B 13/06/2016 11.60%
Building C 12/1/2016 13.00%
Building D 4/9/2016 11.00%
Building E 9/10/2016 14.00%

The report also mentions that there has been an increase in real estate transactions in the recent
times due to increases in land prices. Furthermore, it adds that the number of transactions
increased from 3 in 2015 to 28 in 2016, indicating the changing fortunes of real estate.

Based on the returns contained in the report and by computing the corresponding market return,
Bay tries to calculate the beta (β) and alpha (α – also known as excess return) of the real estate
sector. β turns out to be 0.65 while α stands at 3.45%. Thus, Bay concludes that the real estate
sector is less risky than the market, and an excess return of 3.45% can be easily generated by
investing in real estate.

The report on real estate exhibits a:

A
Survivorship bias

B
Selection bias

C
Infrequent sampling bias

D
None of the above

The correct answer is: B).

The report contains the returns observed in the year 2016, the year in which the real estate
sector started performing well. Furthermore, the report also mentions that the number of
transactions increased from 3 in 2015 to 28 in 2016. Therefore, the returns were only observed
when the values of the underlying assets were high, which indicates a selection bias.

Which of the following statements is accurate?

A
Bay has overestimated the values of α and β

B
Bay has overestimated the value of α but the value of β is correctly estimated

C
Bay has overestimated the value of β but the value of α is correctly estimated

D
Bay has overestimated the value of α and understated the value of β

The correct answer is: D).

Due to selection bias, the returns were observed when the underlying asset values were high.
Therefore, the selection bias overestimates the value of α (excess return). The higher observed
returns result in an underestimation of β. The security market line, when plotted, gives a flatter
line instead of a steeper one.
The estimates of α and β can be made more robust by:
A
Increasing the number of observations

B
Using a multifactor risk model

C
Using daily returns

D
None of the above

The correct answer is: B).

The effect of the selection bias can be mitigated by using a multifactor risk model rather than just
using a market portfolio as the sole risk factor.

10) People tend to overstate expected returns and understate the risk of illiquid assets. This is
due to certain biases that affect their judgment. These biases include all of the following, except
the:

A
Survivorship bias

B
Infrequent sampling bias

C
Selection bias

D
Availability bias

The correct answer is: D).

The biases that cause people to overstate the expected returns and understate the risk of illiquid
assets include:

Survivorship bias: poor performance and failures are not reported

Infrequent sampling bias: due to infrequent trading the estimates of risk are too low when
computed using reported returns.

Selection bias: results from the tendency of returns only to be observed when underlying asset
values are high.

11) Which of these statements about illiquid markets is most likely to be true?

A
Very few asset classes are illiquid

B
 The market for illiquid assets is very small and limited

C
In a liquid market, the liquidity will never dry up

D
Illiquid assets form a major part of most investor’s portfolios

The correct answer is: D).

The majority of assets available to an investor are illiquid in nature. As a result, the market for
illiquid assets is a very large one and illiquid assets dominate most investor’s portfolios. Liquid
asset markets can also experience times of illiquidity as almost all assets have a degree of
illiquidity associated with them.

12) In 2012, a taxonomy of how illiquidity comes about in the market was given by Vayanos and
Wang. Which of the following is not a source of market illiquidity according to Vayanos and Wang
(2012)?

A
Costs of transaction

B
Symmetric information

C
The effect of prices

D
Search frictions

The correct answer is: B).

Asymmetric information rather than symmetric information leads to market illiquidity. This is due
to the fact that an investor may have superior knowledge as compared to other investors. The
other investors will, therefore, become reluctant to trade, since they may fear to be fleeced.

13) Expected returns can be overstated and the risk of illiquid assets understated due to some
key biases. Survivorship bias is one of these biases. How does survivorship bias arise?

A
Survivorship bias is be caused by infrequent trading where risk estimates like volatility,
correlations, and betas, get too low when calculated using reported returns

B
Survivorship bias results from the tendency of returns to be only observed as an
underlying value of assets get high

C
Survivorship bias results from the tendency of poorly performing funds to stop
performing.

D
All the above

The correct answer is: C).

The tendency of poorly performing funds to stop reporting leads to the survivorship bias.
Ultimately, most of these funds will fail, although their failures are rarely counted. Therefore, as
compared to the reported data, the true illiquid asset returns are worse due to this fact.