Untangling Illiquidity: Optimal Asset Allocation with Private Asset Classes

Abstract

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 Classification: D81, G11, G12, E21