LIQUIDITY is one of the most overlooked characteristics of assets.
It can have a key impact on investment strategies, ranging from the cost to trade, the ability to get out and the predictability of price.
Illiquid investments can provide a range of interesting features for investors, including the premium to hold these assets, the often higher yield, the scope for added value, and the diversification benefits.
But it all depends on your investment horizon and your patience.
When most of us think about investing we frame it in terms of predicting how a certain asset or security is going to behave in the future.
One of the more overlooked factors is the asset’s liquidity – its ability to be bought or sold without causing a drastic change in its price.
Liquidity can vary widely among different asset classes - some assets like public equity can be traded within seconds, while municipal bonds may trade as little as twice a year, and the holding period for private real estate can stretch across years.
Of the different asset classes out there, the most illiquid ones are deemed to be hedge funds, real estate, private equity and infrastructure.
When a certain asset is illiquid, it is usually more difficult to find counterparties to trade with at a reasonable price. Therefore, transaction costs associated with trading within illiquid assets can become large, even definitive.
However, despite illiquidity being seen as a negative characteristic of an asset, we argue that long-term investors can potentially improve portfolio returns by tapping directly into the asset’s illiquidity itself.
Intuitively, illiquidity is an additional source of risk for an investor. When investors accept illiquidity, they accept an increase in the uncertainty of the ultimate outcome.
Even if the asset can be liquidated, its illiquidity manifests in lower certainty over the price available. A real-life example of illiquidity risk is Harvard University’s endowment fund – currently the world’s largest university endowment.
Given the risks of illiquidity, illiquid assets should, in theory, provide a greater level of return to compensate investors for these risks. This extra return is often referred to as the illiquidity premium.
In effect, investors who can afford to tie up their investments for long periods of time can harvest the illiquidity premium by being invested in illiquid assets.
But does the illiquidity premium exist? While the textbooks may argue for the existence of an illiquidity premium, quantifying its true size is much more difficult.
Within the academic literature, multiple studies have purported to show the existence of an illiquidity premium within asset classes.
Nevertheless, disentangling cause and effect can be difficult. After all, all asset classes are a collection of differing risk premia in varying amounts.
For example, many illiquid stocks belong to small-cap companies and the higher return from these stocks can be contaminated by the size premium.
The illiquidity premium is therefore often intertwined with a host of other risk premia such as value, volatility, and size. Disentangling the contribution from each premium is difficult.
Besides which, property and hedge fund returns can be distorted by survivorship bias and selection bias.
The fact that liquidity is not a constant, but multi-dimensional and variable over time, obviously adds further complexity.
Today, yield-hungry investors are increasingly forced into alternative asset classes, where there remain pockets of returns that are less correlated to traditional risk assets.
For the long-term investor, we argue that the illiquidity premium, portfolio diversification, and potential added value from good active manager selection are compelling reasons to maintain some allocation towards illiquid assets.
Craig Jamieson is regional director at Barclays Wealth.
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