What effect typically arises during periods of financial stress, affecting the share of illiquid investments?

• A. Denominator effect
• B. Asset illiquidity
• C. Exit timing
• D. Synthetic secondaries

Answer: (A)

The denominator effect refers to a phenomenon that occurs during periods of financial stress when the value of liquid investments decreases significantly, while the value of illiquid investments may not change as rapidly or may remain stable. As the denominator in an investment ratio (such as total portfolio value) declines, the proportion of illiquid assets relative to the total portfolio value increases. This rise can lead to a distortion in how investors view their asset allocations and risk levels.

When this effect takes place, investors often reassess their portfolio and may become concerned about the increased weight of illiquid investments relative to their liquid assets. This can lead to a heightened sense of risk or a desire to adjust the portfolio to realign with investment objectives, potentially prompting discussions about rebalancing or the perceived liquidity risk of the illiquid assets.

The other options provided do not accurately describe the situation where financial stress amplifies the disproportionate share of illiquid investments in a portfolio relative to liquid investments. For example, asset illiquidity specifically refers to the lack of marketability of an asset rather than the effects of financial stress on asset allocation. Exit timing relates to the decision-making process around when to liquidate an investment, while synthetic secondaries pertain to strategies used in private equity to manage