TY  - JOUR
AU  - Getmansky,Mila
AU  - Lo,Andrew W.
AU  - Makarov,Igor
TI  - An Econometric Model of Serial Correlation and Illiquidity in Hedge Fund Returns
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 9571
PY  - 2003
Y2  - March 2003
UR  - http://www.nber.org/papers/w9571
L1  - http://www.nber.org/papers/w9571.pdf
N1  - Author contact info:
Mila Getmansky
Isenberg School of Management
Room 308C
Universtiy of Massachusetts
121 Presidents Drive, Amherst, MA 01003
Tel: 413-577-3308
Fax: 413-545-3858
E-Mail: msherman@isenberg.umass.edu

Andrew W. Lo
MIT Sloan School of Management
100 Main Street, E62-618
Cambridge, MA  02142
Tel: 617/253-0920
Fax: 781/891-9783
E-Mail: alo@mit.edu

Igor Makarov
London School of Business
Regent's Park
London NW1 4SA  UK
Tel: 44-0-20-7000-8265
Fax: 44-0-20-7000-8201
E-Mail: imakarov@london.edu
AB  - 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.
ER  -