From NAV to Impact: The Hidden Cost of Exiting Funds

When Robert Almgren and Neil Chriss published their seminal work on optimal portfolio liquidation in 2000, they formalized a trade-off every equity trader understands intuitively: liquidate too quickly and you’ll pay dearly in market impact; liquidate too slowly and you’re exposed to adverse price moves. While their framework was developed for stock trading, the fundamental tension they identified appears throughout finance—including in a domain where it’s rarely discussed: institutional fund allocation.

Allocators to hedge funds and private markets face a structurally similar problem, just in disguise. The mechanics differ, but the economic trade-offs are remarkably parallel.

The Allocator’s Dilemma

Consider an institutional investor who wants to exit a $100 million position in a hedge fund. Unlike stock positions, they face a peculiar choice architecture:

The Primary Market Path (Slow Execution): Redeem through the fund’s standard process. Pay zero transaction costs (trading at NAV), but accept:

• Notice periods (commonly 45–90 days, sometimes longer)
• Lock-ups that may still be in effect
• Gates that can limit redemption amounts (often 10–25% of AUM per quarter)
• Side pockets that may trap portions of the investment indefinitely

The Secondary Market Path (Fast Execution): Sell the position to another investor. Execute immediately, but accept:

• Discounts to NAV (5–15%, sometimes much more)
• Limited liquidity and opaque processes
• Information asymmetry working against the seller

This is the allocator’s version of the Almgren–Chriss trade-off. Primary redemption is the “slow” path—no explicit cost, but exposure to NAV drift and operational risk. The secondary market is the “fast” path—certainty of exit, but at a visible haircut.

Mapping the Framework

The parallels to Almgren–Chriss are striking:

The cost functions even align conceptually:

• For equities, cost = market impact + variance of price path.
• For allocators, cost = secondary discount + NAV drift/operational risk during notice.

The Allocator’s Execution Frontier

Just as traders choose between trading fast or slow, allocators face their own efficient frontier:

• Slow execution (NAV redemption): No discount, but uncertainty during the notice period.
• Fast execution (secondary sale): Immediate certainty, but a discount to NAV.

The plot below illustrates the trade-off. Execution risk (NAV drift) increases with longer notice periods. Execution cost (discount) rises with faster exit. Neither choice is free—allocators live on this frontier.

When to Pay the Impact Cost

Risk preferences determine where an allocator should sit on the frontier. Situations where secondary sales may be rational:

• High conviction in deterioration. If the fund’s strategy has lost its edge, expected NAV decline during notice may exceed the secondary discount.
• Regime changes. In stressed markets, volatility surges and the risk of gates rises, amplifying timing risk.
• Operational red flags. If governance, valuation, or integrity issues emerge, immediacy is insurance against deeper losses.
• Portfolio-level risks. Reducing exposure quickly to rebalance across managers can justify paying for liquidity.
• Gate anticipation. If peers are likely to redeem en masse, expected delays dwarf the secondary discount.
  

By contrast, primary redemptions remain optimal when:

• Strategies are stable and risks low.
• The redemption is for rebalancing, not urgent de-risking.
• Positions are small relative to fund AUM.

Beyond Binary Choices: A Missing Market

Here the analogy highlights inefficiency. Equity markets let traders fine-tune execution speed across a spectrum—from patient limit orders to aggressive sweeps. Allocators, by contrast, face a binary world: either wait for standard redemption terms or sell at a discount in secondary markets.

That gap suggests room for innovation:

• Redemption tranching. Explicit “fast lanes” priced at a premium but cheaper than secondary discounts.
• Contingent liquidity options. Investors could pre-purchase rights to faster redemption during stress events.
• Liquid share classes. Higher fees for shorter notice periods, formalizing the liquidity trade-off.

These structures exist in pockets but remain rare. The execution lens shows why they should be more common.

Making the Invisible Visible

The key breakthrough of Almgren–Chriss was not discovering that execution is costly, but showing how to make those trade-offs explicit and measurable. The same insight applies to hedge fund allocation.

Allocators face hidden execution costs: NAV drift during notice, exposure to gates, and discounts in secondary sales. Framing these as execution decisions rather than operational quirks transforms how investors assess liquidity risk.

In short: execution costs exist even where spreads aren’t flashing on a screen. The question isn’t whether you pay them—it’s whether you manage them deliberately or accept them by default.