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FRM Part II · FRM Exam Part II · Illiquid Assets

A pension fund holds a large allocation to private real estate and unlisted infrastructure. The investment committee notes that reported quarterly returns on these holdings show much lower volatility than listed equity returns. Which statement best explains the main reason for this feature of reported illiquid asset returns?

Reported illiquid asset returns look calm because appraisal-based valuations are smoothed and lag true market prices. This induces positive autocorrelation and understates volatility and correlation with public markets. The lower measured risk is a statistical artifact, not lower economic risk.

  1. AAppraisal-based valuations are smoothed and lag market prices, which understates measured volatility and correlationsCorrect
  2. BIlliquid assets have lower true economic risk because they cannot be traded
  3. CIlliquid assets are always priced using mark-to-market quotes that remove noise
  4. DPrivate asset managers hedge all market risk before reporting returns

Explanation

Valuations of illiquid assets rely on appraisals and models that update slowly, so reported returns are autocorrelated and smoothed. This understates volatility, correlation with public markets, and drawdowns. Inability to trade does not reduce economic risk, and quotes are generally unavailable.

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