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Untangling Illiquidity: Optimal Asset Allocation with Private Asset Classes

Working paper 827
Working Papers
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Published: 30 January 2025

By: Daniel Dimitrov

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.

Keywords: asset allocation; (il)liquidity; private assets; model misspecification
JEL codes D81;G11;G12;E21

Working paper no. 827

827 - Untangling Illiquidity: Optimal Asset Allocation with Private Asset Classes

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Key research highlights:

  • 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.

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