(February 2, 2012) — Without accounting for selection bias, expected returns are overstated and risk is underestimated when it comes to illiquidity, without accounting for selection bias, according to a newly released whitepaper by a Columbia Business School professor. 

“Illiquidity risk is poorly captured by traditional models,” the paper by Andrew Ang, professor of business, finance and economics at Columbia University, asserts. “In portfolio choice models with illiquidity risk, the optimal holding of illiquid assets is small and the premium required to compensate for illiquidity is high.”

Ang highlights three main areas of concern to understand the effective use of illiquid assets in portfolio management: 

1) Computing risks and returns on illiquid assets, 

2) Determining optimal allocation of illiquid assets in a portfolio, and

3) Dealing with agency contracting issues when employing intermediaries to manage illiquid assets.

According to the research, illiquidity generates endogenous risk aversion, as “the presence of illiquidity induces an investor to behave in a more risk-averse way than the coefficient of risk aversion in the investor’s utility function, and this risk aversion varies over time”.

Therefore, as the proportion of illiquid assets increases, the investor acts in a more risk-averse manner because the investor cannot “eat” illiquid assets, Ang writes. 

Last year, Ang published another report on the topic of liquidity, noting that endowments ignore liquidity risk. According to Ang, endowments around the country need to do a better job at figuring out how to allocate money among liquid and illiquid assets. “For Harvard, the main problem during the financial crisis was that about 1/3 of the university operating revenues came from the endowment. In 2008, that endowment, like every university portfolio, had large losses,” Ang told aiCIO in May of last year, explaining that the four ways to fill the hole is to cut expenses, liquidate the portfolio, issue debt, or increase donations.

Ang’s papers draw attention to the central question — which he describes as a philosophical one — among endowment heads: How should you be allocating your money when you have liquid and illiquid assets in your portfolio? “Harvard’s endowment fell and they couldn’t meet their cash requirement because they tied up a majority of their portfolio in investments that were illiquid. They couldn’t sell at short notice or raise cash when required,” Ang said. 

Ang’s recent research is also especially relevant following a newly released report by the National Association of College and University Business Officers (NACUBO) and Commonfund that showed that while college endowments grew in fiscal year 2011, they are still struggling to overcome losses. 

The data — compiled from 823 colleges and universities in the US — showed that institutions’ endowments returned an average of 19.2% for the 2011 fiscal year, up from 11.9% in fiscal year 2010. Nevertheless, NACUBO President John Walda said 47% of the institutions have endowment market values below what they reported in 2008. 

“The study reflects the heightened importance that institutions are paying to liquidity, cash reserves, and investment policies,” William E. Jarvis, managing director of the Commonfund Institute, told aiCIO. “The changes you’re seeing with endowments reflects the fact that the endowment model is alive and well, despite commentators over the last few years who have questioned the model,” he said, noting that while endowments are still below their pre-crisis peaks in terms of size, highly diversified portfolios have enabled endowments around the country to weather the financial storm.

Related Article: “Harvard Has a Cold”