Investors new to alternative investing shouldn’t shy away from illiquid and opaque assets to avoid trading costs, according to research.
Instead, inexperienced asset owners would do best to dive head first into alternatives and increase their initial holdings, “even if one is more pessimistic about its growth rate than the experienced investor,” the paper said.
According to the authors’ research, more experienced investors are likely to have a better estimate of expected returns from alternatives than their beginner peers. Without such skill, inexperienced investors tend to tilt their portfolio away from alternatives and toward liquid assets.
“The interaction between opaqueness and illiquidity raises fundamental questions about asset allocation, asset pricing, and their dynamics,” argued Adrian Buss of INSEAD, Raman Uppal of the EDHEC Business School, and Grigory Vilkov of the Frankfurt School of Finance & Management.
The authors compared the phenomenon to large endowments fund that have upped their exposure to alternative assets after seeing positive returns to even being overweight in the asset class.
And as they gain more knowledge, skill, and experience, they were likely to bump their allocation to private equity and hedge funds, often having to pay considerable rebalancing fees.
“If the transaction cost dominates, it is optimal for such investors to invest more initially,” the paper said.
These costs for trading alternatives could also impact its pricing, the authors proposed. The research found for a transaction cost of 5%, there were an average price discount of more than 4% and a maximum discount of more than 12%.
Still, the paper said prices of equities were likely to jump in the presence of alternative asset trading costs, as investors buy up equity indices as a low-cost substitute to alternatives.
Read the full paper: “Asset Allocation and Asset Pricing with Illiquid and Opaque Assets”
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