Mean–Variance Optimization with Public and Private Asset Classes

Volume 14, Number 4, 2016
Yu (Ben) Meng, Pu (Paul) Zhang and Ryan Ong

Liquidity has long been of great interest to investment professionals as well as academic researchers. The estimation of the illiquidity premium for infrequently traded asset classes, such as real estate and private equity, presents a challenge to the industry because of opaque information and sporadic trading activities.We propose using the autocorrelations of returns as a tool to estimate the transaction costs and illiquidity premium of private assets. This tool can also be used to adjust the risk of illiquid asset classes. At the end of this article, we show through an example that after making these adjustments to the estimates of expected return and risk, private and illiquid assets can be reasonably compared with public and liquid assets in the standard mean–variance optimization (MVO) process.