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P2.T8. Liquidity and Treasury Risk Measurement and

Management

Andrew Ang, Asset Management: A Systematic

Approach to Factor Investing

Bionic Turtle FRM Practice Questions

By David Harper, CFA FRM CIPM
www.bionicturtle.com
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Chapter 13: Illiquid Assets

P2.T8.707. THE BIASES OF ILLIQUID MARKETS ........................................................................... 3

P2.T8.708.ILLIQUIDITY RISK PREMIUM & PORTFOLIO CHOICE DECISION ON THE INCLUSION OF
ILLIQUID ASSETS ...................................................................................................................... 7

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Chapter 13: Illiquid Assets

P2.T8.707. The biases of illiquid markets
P2.T8.708.Illiquidity risk premium & portfolio choice decision on the inclusion of illiquid
assets

P2.T8.707. The biases of illiquid markets

Learning objectives: Evaluate the characteristics of illiquid markets. Examine the
relationship between market imperfections and illiquidity. Assess the impact of biases on
reported returns for illiquid assets. Describe the unsmoothing of returns and its
properties.

707.1. According to Andrew Ang, illiquidity can arise due to the following market imperfections:
Clientèle effects and participation costs, transaction costs, search frictions, asymmetric
information, price impact or funding constraints. He characterizes the effects of these
imperfections as "illiquidity." In regard to the CHARACTERISTICS of illiquid markets, based on
Ang's research, which of the following statements is TRUE (such that the other statements are
generally false)?
a) Normally liquid markets periodically become illiquid
b) Most individuals hold the majority of their wealth in liquid or highly liquid assets
c) Most asset classes are liquid such that genuinely illiquid markets tend to be small and
temporary
d) Technology has virtually eliminated the following frictions: transaction costs, search
friction, asymmetric information, price impact, and funding constraints

707.2. Andrew Ang makes an important, provocative statement when he writes "Reported
illiquid asset returns are not returns." He claims that people overstate the expected returns and
understate the risk of illiquid assets, and he attributes this to three key biases. According to Ang,
each of the following is a bias that overstates the expected returns (and/or understates the risk)
of illiquid assets EXCEPT which is not accurate?
a) Survivorship bias can inflate returns by 4.0% or more
b) Infrequent sampling (aka, infrequent trading) artificially reduces risk and risk-related
metrics such as volatility, correlation and beta
c) Turnover bias decreases the typical time between transactions and tends to artificially
increase the expected return by 5.0% or more
d) Selection bias (aka, reporting bias) is a distortion of the sample that artificially increases
(ie, overestimates) alpha and artificially decreases (ie, underestimates) beta

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707.3. To adjust the infrequent trading bias introduced that is introduced into reported returns,
we can "unsmooth" or "de-smooth" the reported returns. Ang suggests this is a filtering problem:
"Filtering algorithms are normally used to separate signals from noise. When we’re driving on a
freeway and talking on a cell phone, our phone call encounters interference—from highway
overpasses and tall buildings—or the reception becomes patchy when we pass through an area
without enough cell phone towers. Telecommunication engineers use clever algorithms to
enhance the signal, which carries our voice, against all the static. The full transmission contains
both the signal and noise, and so the true signal is less volatile than the full transmission. Thus
standard filtering problems are designed to remove noise. The key difference is that
unsmoothing adds noise back to the reported returns to uncover the true returns."

The essence of unsmoothing of returns is illustrated by Ang's formulas 13.1, 13.2 and 13.4
below:

∗ ∗
= +∅ + (Ang 13.1)

∗ ∅ ∗
= − (Ang 13.2)
∅ ∅
∗ ∗
= (1 − ∅) + ∅ (Ang 13.4)
In these formulas r*(t) is the reported (aka, observed) return and r(t) is the true but unobserved
return. Importantly, as is almost always the case in finance, the model used in this particular
unsmoothing process makes key assumptions. However, if the assumptions are correct, then
each of the following statements about the unsmoothing process is true EXCEPT which is
false?
a) Unsmoothing affects only risk estimates and not expected returns
b) Unsmoothing has no effect if the observed returns are uncorrelated.
c) The true returns implied by the "transfer function" and equation 13.2, r(t), should have
zero autocorrelation and generally should not be themselves forecastable
d) Due to the autocorrelation assumption, |φ| <1, the variance of the true returns will be
less than the variance of the observed returns; i.e., variance[r(t)] < i.e., variance[r*(t)]

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Answers:

707.1. A. True: Normally liquid markets periodically become illiquid. In regard to (B), (C)
and (D), each is generally FALSE.

Ang's characteristics of illiquid markets include the following:

 "Most Asset Classes Are Illiquid [ie, choice C is false]: Except for plain-vanilla public
equities and fixed income, most asset markets are characterized by long periods,
sometimes decades, between trades, and they have very low turnover. Even among
stocks and bonds, some subasset classes are highly illiquid. Equities trading in pink-
sheet over-the-counter markets may go for a week or more without trading. The average
municipal bond trades only twice per year, and the entire muni-bond market has an
annual turnover of less than 10% (see also chapter 11). In real estate markets, the
typical holding period is four to five years for single-family homes and eight to eleven
years for institutional properties. Holding periods for institutional infrastructure can be
fifty years or longer, and works of art sell every forty to seventy years, on average. Thus
most asset markets are illiquid in the sense that they trade infrequently and turnover is
low.
 Illiquid Asset Markets Are Large: The illiquid asset classes are large and rival the
public equity market in size. In 2012, the market capitalization of the NYSE and
NASDAQ was approximately $17 trillion. The estimated size of the U.S. residential real
estate market is $16 trillion, and the direct institutional real estate market is $9 trillion. In
fact, the traditional public, liquid markets of stocks and bonds are smaller than the total
wealth held in illiquid assets.
 Investors Hold Lots of Illiquid Assets [ie, choice B is false]: Illiquid assets dominate
most investors’ portfolios. For individuals, illiquid assets represent 90% of their total
wealth, which is mostly tied up in their house—and this is before counting the largest
and least liquid component of individuals’ wealth, human capital (see chapter 5). There
are high proportions of illiquid assets in rich investors’ portfolios, too. High net worth
individuals in the United States allocate 10% of their portfolios to treasure assets like fine
art and jewelry. This rises to 20% for high net worth individuals in other countries. The
share of illiquid assets in institutional portfolios has increased dramatically over the past
twenty years. The National Association of College and University Business Officers
reported that, in 2011, the average endowment held a portfolio weight of more than 25%
in alternative assets versus roughly 5% in the early 1990s. A similar trend is evident
among pension funds. In 1995, they held less than 5% of their portfolios in illiquid
alternatives, but today the figure is close to 20%.
 Liquidity Dries Up: Many normally liquid asset markets periodically become illiquid.
During the 2008 to 2009 financial crisis, the market for commercial paper (or the money
market)—usually very liquid –experienced buyers’ strikes by investors unwilling to trade
at any price ... Illiquidity crises occur regularly because liquidity tends to dry up during
periods of severe market distress. The Latin American debt crisis in the 1980s, the Asian
emerging market crisis in the 1990s, the Russian default crisis in 1998, and of course
the financial crisis of 2008 to 2009 were all characterized by sharply reduced liquidity,
and in some cases liquidity completed evaporated in some markets. Major illiquidity
crises have occurred at least once every ten years, most in tandem with large downturns
in asset markets."

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707.2. C. False. Turnover bias is made-up.

In regard to (A), (B) and (D), each is TRUE.

Ang: "As Faust and Forst note in their memo to Harvard’s Council of Deans, the true illiquid
asset losses were greater than the reported ones, which leads us to an important corollary.
Reported illiquid asset returns are not returns. Three key biases cause people to overstate
expected returns and understate the risk of illiquid assets:
Survivorship bias,
Infrequent sampling, and
Selection bias.
In illiquid asset markets, investors must be highly skeptical of reported returns."

707.3. D. The true statement, instead, is: Due to the autocorrelation assumption, |φ| <1,
the variance of the true returns is HIGHER than the variance of the observed returns; i.e.,
variance[r(t)] ≥ i.e., variance[r*(t)]

In regard to (A), (B) and (C), each is TRUE.

Ang: "The unsmoothing process has several important properties:

1. Unsmoothing affects only risk estimates and not expected returns. Intuitively,
estimates of the mean require only the first and last price observation (with dividends
take “total prices,” which count reinvested dividends).12 Smoothing spreads the shocks
over several periods, but it still counts all the shocks. In Figure 13.2, we can see that the
first and last observations are unchanged by infrequent sampling; thus unsmoothing
changes only the volatility estimates.
2. Unsmoothing has no effect if the observed returns are uncorrelated. In many
cases, reported illiquid asset returns are autocorrelated because illiquid asset values are
appraised. The appraisal process induces smoothing because appraisers use, as they
should, both the most recent and comparable sales (which are transactions) together
with past appraised values (which are estimated, or perceived, values). The artificial
smoothness from the appraisal process has pushed many in real estate to develop pure
transactions-based, rather than appraisal-based indexes. Autocorrelation also results
from more shady aspects of subjective valuation procedures—the reluctance of
managers to mark to market in down markets."
In regard to true (C), Ang "Equation (13.2) unsmooths the observed returns. If our assumption
on the transfer function is right, the observed returns implied by equation (13.2) should have
zero autocorrelation. Thus, the filter takes an autocorrelated series of observed returns and
produces true returns that are close to IID (or not forecastable)."

Discuss here in forum: https://www.bionicturtle.com/forum/threads/p2-t8-707-the-biases-of-

illiquid-markets-ang.10265/

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P2.T8.708.Illiquidity risk premium & portfolio choice decision on the

inclusion of illiquid assets
Learning Objectives: Compare illiquidity risk premiums across and within asset
categories. Evaluate portfolio choice decisions on the inclusion of illiquid assets.

708.1. In order to identify the presence of illiquidity risk premium(s), Andrew Ang references
data presented by Antti Ilmanen in his well-regarded book Expected Returns (An Investor's
Guide to Harvesting Market Rewards). This data is displayed below as a scatterplot where the
y-axis is the long-run average return of the asset class and the x-asset is an index of illiquidity.
A higher index (ie, to the right) implies less liquidity. For example, the venture capital as an
asset class is assigned to the least liquid (most illiquid) asset class but it also plots the highest
long-run average return.

In regard to the illiquidity risk premium, which of the following statements it TRUE?
a) In general illiquid asset classes offer high risk-adjusted returns
b) These charts demonstrate that there do exists large illiquidity risk premiums ACROSS
asset classes
c) There do exist large illiquidity risk premiums WITHIN many asset classes, but not
ACROSS asset classes
d) Illiquid equities earn the same returns as liquid equities; and illiquid bonds earn the same
returns as liquid bonds

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708.2. Illiquidity risk premiums compensate investors for the inability to access capital
immediately and/or for the market's withdrawal of liquidity during a crisis. Andrew Ang details
four different ways that an investor (asset owner) might capture or "harvest" the illiquidity
premium. However, among these four, which is the simplest to implement and has the greatest
impact on portfolio returns?
a) Dynamic rebalancing at the aggregate level
b) Market making at the individual security level
c) Holding less liquid securities within asset classes
d) Holding passive allocations to illiquid asset classes

708.3. You are consulting to a large endowment fund that is in the process of determining its
asset allocation budget. An important sub-project in this process is a recommendation for the
definition of, target allocation to, and hurdle rates associated with, illiquid assets. In short, you
need to help develop the endowment's Portfolio Choice Model for illiquid assets. In regard to
this sub-project, members of your staff (Phillip, Debra, Peter, and Mary) makes suggestions that
include the following four assertions. According to Ang, each of these is true EXCEPT which is
probably false?
a) Phillip says: The longer the time between liquidity events for an asset--ie, the less liquid
the asset--the LOWER its optimal allocation in the portfolio
b) Debra says: The longer we need to wait to exit an investment--ie, the later the arrival of
liquidity events--the HIGHER should be our illiquidity hurdle rate
c) Peter says: Due to the nature of factor risk and idiosyncratic risk in illiquid markets, to
the extend we allocate to illiquid assets, it is really important for us to assign (or delegate
to) genuinely skilled investors to this asset class
d) Mary says: It's actually not very important that we identify skill in the illiquid asset class
because we can rather easily benchmark against tradeable indexes which will allow us
to separate factor risk from manager skill (aka, alpha)

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Answers:

708.1. C. True: There do exist large illiquidity risk premiums WITHIN many asset classes,
but not ACROSS asset classes. This is Ang's essential point in section four of Chapter 14:
"But while there do not seem to be significant illiquidity risk premiums across classes, there are
large illiquidity risk premiums within asset classes."

Specifically (selected):
 US Treasuries: "A well-known liquidity phenomenon in the U.S. Treasury market is the
on-the-run/off-the-run bond spread. Newly auctioned Treasuries (which are on-the-run)
are more liquid and have higher prices, and hence lower yields, than seasoned
Treasuries (which are off-the-run) [The on-the-run bonds are more expensive because
they can be used as collateral for borrowing funds in the repo market. This is called
specialness.] The spread between these two types of bonds varies over time reflecting
liquidity conditions in Treasury markets."
 Corporate bonds: "Corporate bonds that trade less frequently or have larger bid–ask
spreads have higher returns. Chen, Lesmond, and Wei (2007) find that illiquidity risk
explains 7% of the variation across yields of investment-grade bonds. Illiquidity accounts
for 22% of the variation in junk bond yields; for these bonds, a one basis point rise in
bid–ask spreads increases yield spreads by more than two basis points."
 Equities: "A large literature finds that many illiquidity variables predict returns in equity
markets, with less liquid stocks having higher returns. These variables include bid–ask
spreads, volume, volume signed by whether trades are buyer or seller initiated, turnover,
the ratio of absolute returns to dollar volume (commonly called the Amihud measure
based on his paper of 2002), the price impact of large trades, informed trading
measures, quote size and depth, the frequency of trades ... Estimates of illiquidity risk
premiums in the literature range between 1% and 8% depending on which measure of
illiquidity is used. However, Ben-Rephael, Kadan, and Wohl (2008) report that these
equity illiquidity premiums have diminished considerably—for some illiquidity measures
the risk premiums are now zero! In pink sheet stock markets, which are over-the-counter
equity markets, Ang, Shtauber, and Tetlock (2013) find an illiquidity risk premium of
almost 20% compared to about 1% for comparable listed equities."
 Illiquid Assets: "There are higher returns to hedge funds that are more illiquid, in the
sense that they place more restrictions on the withdrawal of capital (called lockups) or
for hedge funds whose returns fall when liquidity dries up. Franzon et al report that there
are significant illiquidity premiums in private equity funds—typically 3%. In real estate,
Liu and Qian (2012) construct illiquidity measures of price impact and search costs for
U.S. office buildings. They find a 10% increase in these illiquidity measures leads to a
4% increase in expected returns."
In regard to (A), (B) and (D), each is FALSE.

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708.2. A. Dynamic rebalancing at the aggregate level

Ang: "Harvesting Illiquidity Risk Premiums: There are four ways an asset owner can capture
illiquidity premiums:
1. By setting a passive allocation to illiquid asset classes, like real estate;
2. By choosing securities within an asset class that are more illiquid, that is by engaging in
liquidity security selection;
3. By acting as a market maker at the individual security level; and
4. By engaging in dynamic strategies at the aggregate portfolio level."
In regard to this fourth way, Ang writes (emphasis ours): "4.4. Rebalancing: The last way an
asset owner can supply liquidity is through dynamic portfolio strategies. This has a far larger
impact on the asset owner’s total portfolio than liquidity security selection or market
making because it is a top-down asset allocation decision (see chapter 14 for factor attribution).
Rebalancing is the simplest way to provide liquidity, as well as the foundation of all long-horizon
strategies (see chapter 4). Rebalancing forces asset owners to buy at low prices when others
want to sell. Conversely, rebalancing automatically sheds assets at high prices, transferring
them to investors who want to buy at elevated levels. Since rebalancing is counter-cyclical, it
supplies liquidity. Dynamic portfolio rules, especially those anchored by simple valuation rules
(see chapters 4 and 14), extend this further—as long as they buy when others want to sell and
vice versa. It is especially important to rebalance illiquid asset holdings too, when given the
chance ...

4.5. Summary: Of all the four ways to collect an illiquidity premium: (i) holding passive
allocations to illiquid asset classes, (ii) holding less liquid securities within asset classes, (iii)
market making at the individual security level, and (iv) dynamic rebalancing at the aggregate
level; the last of these is simplest to implement and has the greatest impact on portfolio
returns."

708.3. D. False, Mary probably isn't an FRM! According to Ang, a key difference
associated with illiquid asset classes is a relative INABILITY to separate factor risk from
manager skill ("there is no market index for illiquid asset classes") such that investment
manager talent is very important. Recall that an ideal benchmark is tradeable, and alpha is
measured relative to tradeable benchmarks. But Ang says "No investor receives the returns on
illiquid indexes. An asset owner never receives the NCREIF return on a real estate portfolio, for
example. The same is true for most hedge fund indexes and private equity indexes. In liquid
public markets, large investors can receive index market returns and pay close to zero in fees.
In contrast, NCREIF is not investable as it is impossible to buy all the underlying properties in
that index."

- continued on next page -

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In regard to (A), (B) and (C) each is TRUE. According to Ange, especially true is choice (B):
Investors should demand high illiquidity risk premiums, he says.
 lliquidity Markedly Reduces Optimal Holdings: "... If the risky asset can be traded on
average every six months, which is the second to last line, the optimal holding of the
illiquid asset contingent on the arrival of the liquidity event is 44%. When the average
interval between trades is five years, the optimal allocation is 11%. For ten years, this
reduces to 5%. Illiquidity risk has a huge effect on portfolio choice."
 Rebalance Illiquid Assets to Positions Below the Long-Run Average Holding: "In
the presence of infrequent trading, illiquid asset wealth can vary substantially and is
right-skewed. Suppose the optimal holding of illiquid assets is 0.2 when the liquidity
event arrives. The investor could easily expect illiquid holdings to vary from 0.1 to 0.35,
say, during nonrebalancing periods. Because of the right-skew, the average holding of
the illiquid asset is 0.25, say, and is greater than the optimal rebalanced holding. The
optimal trading point of illiquid assets is lower than the long-run average holding."
 Consume Less with Illiquid Assets: "Payouts, or consumption rates, are lower in the
presence of illiquid assets than when only comparable liquid assets are held by the
investor. The investor cannot offset the risk of illiquid assets declining when these assets
cannot be traded. This is an unhedgeable source of risk. The investor offsets that risk by
eating less.
 There Are No Illiquidity Arbitrages: In a mean-variance model, two assets with
different Sharpe ratios and perfect correlations produce positions of plus or minus
infinity. This is a well-known bane of mean-variance models, and professionals employ
lots of ad hoc fixes, and arbitrary constraints, to prevent this from happening. This does
not happen when one as set is illiquid—there is no arbitrage. Investors do not load up on
illiquid assets because these assets have illiquidity risk and cannot be continuously
traded to construct an arbitrage.
 Investors Must Demand High Illiquidity Hurdle Rates: How much does an investor
need to be compensated for illiquidity? ... When liquidity events arrive every six months,
on average, an investor should demand an extra 70 basis points. (Some hedge funds
have lockups around this ho rizon.) When the illiquid asset can be traded once a year,
on average, the illiquidity premium is approximately 1%. When you need to wait ten
years, on average, to exit an investment, you should demand a 6% illiquidity premium.
That is, investors should insist that private equity funds generate returns 6% greater than
public markets to compensate for illiquidity."

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