Strategic Asset Allocation with Private Assets: Untangling Illiquidity

🐍 This paper examines the asset allocation problem faced by long-term investors seeking exposure to illiquid private assets. Liquidity uncertainty hampers continuous rebalancing and withdrawals, while illiquidity risk premia can lead to unintended overallocation during extended periods of asset lock-ups, increasing the variability of portfolio consumption and shrinking investor welfare. Using a dynamic allocation model calibrated on analyst-based capital market expectations, I find that while adding private assets to the investment universe may offer benefits, ignoring illiquidity in the portfolio construction process leads to substantial welfare losses.

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🚀 Key takeaways:

• Long-term investors in private asset classes face the risk that asset illiquidity may limit portfolio withdrawals and rebalancing over time.
• This paper provides a dynamic portfolio choice model, incorporating liquidity uncertainty for private asset classes. The mode is calibrated to publicly available Capital Market Assumptions issued by JP Morgan.
• I find that while illiquid private assets can enhance investor welfare in certainty equivalent terms, the benefits are significantly tempered when liquidity risks are factored in.
• Ignoring illiquidity during the portfolio construction phase results in overallocation to private assets and substantial welfare losses.
• A fast, tractable numerical algorithm for solving dynamic portfolio optimization problems involving illiquid assets is also introduced.

Recommended citation: Dimitrov, Daniel, Untangling Illiquidity: Optimal Asset Allocation with Private Asset Classes (January 30, 2025). De Nederlandsche Bank Working Paper No. 827, Available at SSRN: https://ssrn.com/abstract=5118823 or http://dx.doi.org/10.2139/ssrn.5118823