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Opalesque Futures Intelligence

Futures Lab: A study by Andrew Lo and Amir Khandani showed a surprising result for managed futures returns.

Thursday, February 24, 2011

Andrew Lo

Liquidity and a Premium?
By Chidem Kurdas

This is a brief review of a surprising result from a working paper by Andrew Lo and Amir Khandani. Professor Lo is both a practitioner of managed futures and a professor of finance at MIT as well as director of MIT's Laboratory for Financial Engineering. He is the author of numerous academic papers and books, including Hedge Funds: An Analytic Perspective.
In 1999 he founded AlphaSimplex Group, now a subsidiary of Natixis Global Asset Management. He is co-portfolio manager of ASG Managed Futures Strategy Fund, a trend-following mutual fund launched in 2010, and of ASG Global Alternatives, a mutual fund that trades futures and forwards to obtain a similar return to a diversified portfolio of hedge funds.
The paper we draw on is titled "Illiquidity Premia in Asset Returns: An Empirical Analysis of Hedge Funds, Mutual Funds, And US Equity Portfolios". This highly technical article may not be everybody's cup of tea, but the findings include an intriguing result regarding returns from managed futures-namely that they carry a premium associated with illiquidity in other types of investment.

It should be noted that the study as a whole is not about managed futures and the particular finding reported here happened to show up in an analysis of liquidity-we are focusing on only a small part of the overall research.

Managed futures is one of the most liquid investments. One way of measuring this is by comparing redemption notice periods, shown for selected hedge fund sectors in the table below. The average withdrawal notice for managed futures is orders of magnitude shorter than that for all other strategies.

Hedge Funds' Redemption Notice Periods (averages, in days)



Fund of funds


Convertible arbitrage


Fixed Income Arbitrage


Long/short equity hedge


Emerging Markets


Global Macro


Managed futures


SOURCE: "Illiquidity Premia in Asset Returns: An Empirical Analysis of Hedge Funds, Mutual Funds, And US Equity Portfolios" working paper by Lo and Khandani.

Professor Lo has investigated this topic for some time. In previous studies he and others showed that autocorrelation (or serial correlation) is an indicator of the degree of liquidity-see references. Serial correlation means returns are predictable from earlier returns, a pattern not expected in an efficient market but explained by the presence of illiquidity.

Illiquid investments like private equity are typically autocorrelated. By contrast, managed futures returns have no significant autocorrelation-in other words, they're not predictable, an indication of high liquidity.

Illiquidity, like other risks, requires compensation. As expected, illiquid strategies have large risk premiums. For instance, Lo & Khandani estimate that convertible arbitrage has a risk premium of 9.9%.

Managed futures, being highly liquid, should not have any illiquidity premium. Surprisingly, Lo & Khandani find that managed futures returns do contain a premium of 4.9%. They suggest there is significant variability in liquidity among managed futures funds. But the study does not focus on explaining this finding.

Whether managed futures still earns a risk premium is unclear. Lo & Khandani's hedge fund data is for the 30-year period from 1986 to 2006. It is possible that this result does not extend beyond that period. But it is intriguing that there is an illiquidity premium built into the returns from a very liquid investment. It sounds like having your cake and eating it, too.

Lo, A., 2001. "Risk Management For Hedge Funds: Introduction and Overview", Financial Analysts Journal, 57, 16-33.

Getmansky, M., Lo, A., and I. Makarov. 2004. "An Econometric Model of Serial Correlation and Illiquidity in Hedge Fund Returns", Journal of Financial Economics, 74, 529-609.

This article was published in Opalesque Futures Intelligence.
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