Being Locked Up Hurts

Abstract

This paper examines multi-period asset allocation when portfolio rebalancing is difficult or impossible for some assets due to the existence of a lockup period. A lockup period restricts an investor’s ability to rebalance his portfolio and has non-trivial effects on the allocation decision and portfolio efficiency. Our empirical analysis shows that both the unconditional strategy and conditional strategy benefit from adding hedge funds. More importantly, both the unconditional strategy and conditional strategy are hurt by the presence of a hedge fund lockup period. In an unconditional setting, we find a Sharpe ratio of 1.23 for the portfolio of stocks, bonds and hedge funds, with a three-month lockup period for hedge funds and monthly rebalancing of stocks and bonds. For the same portfolio, but without a lockup, we find a significantly higher Sharpe ratio of 1.53. The certainty equivalent is 4.2%, i.e. a threemonth lockup costs the investor 4.2% per annum. Therefore, the economic significance of a lockup period is also evident. Investors compensate for the lockup period of hedge funds by making adjustments to their equity and bond holdings. Adding hedge funds to the portfolio of stocks and bonds reduces the allocation to stocks and increases the allocation to bonds in each month. Finally, the effect of a lockup period on portfolio performance is less pronounced when investing in funds of hedge funds relative to investing in individual hedge funds when the investment horizon is short, suggesting that funds of funds are able to suppress the effect of a lockup period.