1 Being Locked Up Hurts

This paper examines multi-period asset allocation when portfolio adjustment is difficult or impossible for some assets due to the existence of lockup periods. Our empirical analysis shows that both unconditional and conditional portfolios benefit from adding hedge funds. More importantly, both unconditional and conditional portfolios overestimate their performance with stocks, bonds and hedge funds when we overlook the effect of a lockup period on performance. The annualized Sharpe ratio of an unconditional portfolio with a three-month hedge fund lockup period and monthly rebalancing of stocks and bonds is 1.225, which is significantly lower than the annualized Sharpe ratio of the same portfolio assuming no lockup period, 1.533. Investors compensate for the lockup period of hedge funds by making adjustments to their equity holdings. For conditional portfolios, the difference in Sharpe ratios and equity holdings due to a lockup period for hedge funds is also significant. Finally, the effect of a lockup period on portfolio performance is less pronounced when investing in funds of funds relative to investing in individual hedge funds, suggesting that funds of funds may help suppress the effect of a lockup period. JEL classification: G11; G12

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