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Unsmoothing Returns of Illiquid Funds

Spencer J. Couts, Andrei S. Goncalves, Andrea Rossi
Funds that invest in illiquid assets report returns with spurious autocorrelation. Conse-quently, investors need to unsmooth returns when evaluating the risk exposures of these funds. We show that funds investing in similar assets have a common source of spuri-ous autocorrelation, which is not addressed by commonly-used unsmoothing methods, leading to underestimation of systematic risk. To address this issue, we propose a gener-alization of these unsmoothing techniques and apply it to hedge funds and commercial real estate funds. Our empirical results indicate our method signi´Čücantly improves the measurement of risk exposures and risk-adjusted performance, with stronger results for more illiquid funds.