Funds investing in illiquid assets report returns with spurious autocorrelation. Consequently, investors need to unsmooth these funds’ returns when evaluating their risk exposures. We show that funds with similar investments share a common source of spurious autocorrelation not fully resolved by traditional unsmoothing methods and thereby leading to underestimation of systematic risk. Thus, we propose a generalized unsmoothing technique and apply it to hedge funds and private commercial real estate funds. Our method significantly improves the measurement of funds’ risk exposures and risk-adjusted performance, especially for highly illiquid funds. Overall, the average illiquid fund alpha is lower than previously thought.

We show that demand effects generated by institutional frictions can influence systematic return predictability patterns in stocks and mutual funds. Identification relies on a reform to the Morningstar rating system, which we show caused a structural break in style-level positive feedback trading by mutual funds. As a result, momentum-related factors in stocks, as well as performance persistence and the “dumb money effect” in mutual funds, experienced a sharp decline. Consistent with the proposed channel, return predictability declined right after the reform, was limited to the U.S. market, and was concentrated in factors and mutual funds most exposed to the mechanism.