illiquid assets ( Ang)

[saurabhpal49]

Hi David
Can you please explain the below mentioned paragragh from illiquid asset chapter
"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 rightskewed. 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"

Thanks

 

[David Harper CFA FRM]

Hi @saurabhpal49 I attached Ang's own paper to which he is referring (Portfolio Choice with Illiquid Assets, Ang et al) because, frankly, at first glance I can't fully connect the dots (I don't have current time to carefully read the paper which is quite technical). Hopefully, I will get a chance to read it soon ...

Superficially, I think he is saying that

• The return distribution of illiquid assets (or at least the wealth of illiquid assets) is positively (aka, right) skewed; e.g., "Furthermore, the distribution of portfolio holdings is positively skewed, since illiquid wealth grows faster on average than liquid wealth since only the latter is used to fund consumption." (That's from the academic paper) In most positive skew distributions, the mean is greater than the median, you might already know
  
• But the chief feature of illiquid assets is that you cannot trade them easily, from the assigned Ange: "I develop an asset allocation model in which the investor can transact illiquid assets only at randomly occurring liquidity events. This notion of illiquidity is that usually illiquid assets are just that—illiquid and cannot be traded. But when the liquidity event arrives, investors can trade."
  
• The optimal holding level of 0.20 is the investor's target and analogous (maybe even comparable) to the median. However, the actual ratio is volatile (time-varying) and moves within a range of, say, 0.10 to 0.35 but with positive skew: "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."
• So a rational allocation that targets a holding level of 0.20 (at the median) in order to be ready for the liquidity even, on inspection under a skewed distribution, will produce an average holding of 0.25. I can't quite tell if my median = optimal and mean = actual realizes is just a metaphor or if it's closer. I'd like to say that the optimal holdings are at the median and thefefore lower than the mean holdings (i.e., the ratio of illiquid asset) under a skewed distribution, but i'm not at all sure that's what the paper is saying.

When I first read this, I had a more intuitive explanation in mind: as in investor, assume my optimal ratio of illiquid holding is 0.20, when i get to the rare time intervals where i can trade illiquid to liquid positions. The text seems to suggest that what happens is that, during the in-between "waiting time," my illiquid positions being risk-skewed are likely to drag my average ratio up to something higher (hence "The optimal trading point of illiquid assets is lower than the long-run average holding.). However, on the other hand, if i am risk-averse, Ang's prior dynamic seems more relevant to me personally (Illiquidity Markedly Reduces Optimal Holdings): if the illiquid asset values are skewed and volatile, I would want to reduce the ratio in order to decrease the probability that i will get "stuck" at the trade interval with too many illiquid assets. So those are my thoughts, thanks,