We propose a simple analytical construct for incorporating liquidity into portfolio choice. We treat liquidity as a shadow asset which is attached to assets that are easily tradable and absent from those that are not. The expected return and risk of the shadow liquidity asset depend on the manner in which investors exploit liquidity, but these values are no more difficult to estimate than the expected return and risk of explicit assets. We show how to correct for the effect of performance fees and fair value pricing on the observed risk of illiquid assets.

We also show how to correct for the impact of performance fees on the collective expected return of multiple illiquid assets. These corrections, together with inclusion of the shadow liquidity asset in a portfolio, enable us to estimate the liquidity premium required of an illiquid asset. Alternatively, we can employ this construct to determine the optimal allocation to an illiquid asset, or the return required of the shadow liquidity asset.

We illustrate our approach with a straightforward numerical example. We then identify the empirical liquidity premiums of several hedge fund indexes, and we use this information to evaluate the impact of illiquidity on a representative institutional portfolio. Our analysis suggests that the historical liquidity premiums of many illiquid funds may be insufficient to justify significant allocations to them, given even conservative assumptions of the extent to which investors benefit from liquidity, and especially if investors employ multiple funds.