Explanation:
For illiquid assets, pricing is often stale or smoothed, meaning returns are not fully reflecting current market movements. This return smoothing leads to positive autocorrelation in the fund's returns. Consequently, the observed volatility, correlations with other liquid asset classes, and systematic risk (beta) will all be artificially low. To correct for this bias and properly estimate systematic risk, analysts often use enlarged regressions that include lagged market returns (e.g., Dimson or Scholes-Williams methods) and sum the beta coefficients across the lags. Thus, Option D is the correct assessment.
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A
Volatility will be artificially high, giving the appearance of high total risk, which can be corrected by taking into account the resulting positive autocorrelation of returns.
B
Correlations with other asset classes will be artificially high, giving the appearance of high systematic risk, which can be corrected using enlarged regressions with additional lags of the market factors and summing the coefficients across lags.
C
Volatility will be artificially low, giving the appearance of low total risk, which can be corrected by taking into account the resulting negative autocorrelation of returns.
D
Correlations with other asset classes will be artificially low, giving the appearance of low systematic risk, which can be corrected using enlarged regressions with additional lags of the market factors and summing the coefficients across lags.