This paper aims to explore the effects of illiquidity on portfolio weight and return dynamics.
Using a novel continuous-time framework, the paper makes two key contributions to the literature on asset pricing and illiquidity. The first is to study the effects of illiquidity on portfolio weight dynamics. The second contribution is to analyze how illiquidity affects the risk/return dynamics of a portfolio.
The numerical results highlight that investors should be prepared for potentially large and skewed variations in portfolio weights and can be away from optimal diversification for a long time when adding illiquid assets to a portfolio. Additionally, the paper shows that illiquidity increases portfolio risk. Interestingly, this effect gets more pronounced when the return correlation between the illiquid and liquid asset is low. Thus, there is a correlation effect in the sense that illiquidity costs, as measured by the increase in overall portfolio risk, are inversely related to the return correlation of the assets.
This is the first paper that highlights that the increase in portfolio risk caused by illiquidity is inversely related to the return correlation between the liquid and illiquid assets. This important economic result contrasts with the widely used argument that the benefit of adding illiquid (alternative) assets to a portfolio is their low correlation with (traditional) traded assets. The results imply that the benefits of adding illiquid assets to a portfolio can be much lower than typically perceived.
