Smoothness of return and positve serial correlation

[laura1987]

Hi all,
I came across this question and would like to discuss with you all.
Hedge fund XYZ has monthly returns that are extremely smooth. Which if the following of the smoohness of the reurn is false:
A. Increase calculated Sharpse ratio
B. lower the volatility and market beta
C. introduce negative serial correlation
D. It is typical of investments in illiquid assets

Since I knew that A,B, D are all correct, I chose D. However I did not understand why a smoothness of return may introduce negative serial correlation.

I really appreciate any help from you all.

 

[David Harper CFA FRM]

Hi Laura,

(c) is false because Andrew Lo (who is assigned in 2009 current issues) has conducted much research where he uses *positive* autocorrelation as a proxy (or test of) illiquidity exposure in hedge funds; the actual reading (hedge fund replication is not 2009 assigned). From Lo

"Valuation issues arise mainly when a fund is invested in illiquid assets, i.e., assets that do not trade frequently and cannot easily be traded in large quantities without signicant price concessions. For portfolios of illiquid assets, a hedge-fund manager often has considerable discretion in marking the portfolio's value at the end of each month to arrive at the fund's net asset value. Given the nature of hedge-fund compensation contracts and performance statistics, managers may have an incentive to smooth" their returns by marking their portfolios to less than their actual value in months with large positive returns so as to create a cushion" for those months with lower returns. Such return-smoothing behavior yields a more consistent set of returns over time, with lower volatility, lower market beta, and a higher Sharpe ratio, but it also produces positive serial correlation as a side effect."

source: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=622521
(never assigned but a more succint Andrew Lo reference, IMO)

David