An Econometric Model of Serial Correlation and Illiquidity in Hedge Fund Returns

Mila Getmansky, Andrew Lo () and Igor Makarov

No 9571, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: The returns to hedge funds and other alternative investments are often highly serially correlated in sharp contrast to the returns of more traditional investment vehicles such as long-only equity portfolios and mutual funds. In this paper, we explore several sources of such serial correlation and show that the most likely explanation is illiquidity exposure, i.e., investments in securities that are not actively traded and for which market prices are not always readily available. For portfolios of illiquid securities, reported returns will tend to be smoother than true economic returns, which will understate volatility and increase risk-adjusted performance measures such as the Sharpe ratio. We propose an econometric model of illiquidity exposure and develop estimators for the smoothing profile as well as a smoothing-adjusted Sharpe ratio. For a sample of 908 hedge funds drawn from the TASS database, we show that our estimated smoothing coefficients vary considerably across hedge-fund style categories and may be a useful proxy for quantifying illiquidity exposure.

JEL-codes: E0 E5 (search for similar items in EconPapers)
Date: 2003-03
New Economics Papers: this item is included in nep-ets, nep-fmk and nep-rmg
Note: AP
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Citations: View citations in EconPapers (11)

Published as Getmansky, Mila, Andrew W. Lo and Igor Makarov. "An Econometric Model Of Serial Correlation And Illiquidity In Hedge Fund Returns," Journal of Financial Economics, 2004, v74(3,Dec), 529-609.

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Journal Article: An econometric model of serial correlation and illiquidity in hedge fund returns (2004)
Working Paper: An Econometric Model of Serial Correlation and Illiquidity In Hedge Fund Returns (2003)
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