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Harvesting the illiquidity premium and portfolio construction

The most widely known examples of illiquid investments are probably hedge funds, real estate, private equity and infrastructure. However, examples can also be found within more liquid markets. For instance, on-the-run (newly issued) bonds are found to be more liquid than off-the-run (older) bonds with similar characteristics and the same remaining maturity. Also, stocks of certain companies are much more liquid than stocks of other companies for different reasons.

Investments in illiquid asset classes have become more popular in recent decades. There are a number of reasons for this increasing popularity including the perception that expected returns are higher as well as that they offer greater diversification potential. It is however not always clear what the required extra return or diversification benefits for the illiquidity should be. Besides, investing in illiquid assets introduces additional risks, which are not present while investing in the traditional asset classes.

Probably the best known example of such a risk is the Harvard University endowment case (see Ang 2014). After a prolonged period of good performance, during the turmoil in 2008 the endowment’s illiquid asset investments suffered heavy losses. The liquid part of the portfolio had become too small to meet the running expenses. In need of cash, the Harvard endowment tried to sell some private equity investments. Although this was possible they faced having to sell at 50% discounts in the secondary market. All in all, the Harvard case showed the world the dark side of having a large part of a portfolio invested in very illiquid assets.

In this internship we will investigate the added value of investing in illiquid assets. This could be further divided in two main sub questions:

  1. Which investments deliver an illiquidity premium? (De Jong and Driessen, 2013; Markwat and Molenaar, 2016)
  2. How should these investments be incorporated into a portfolio? (Ang, Papanikolaou and Westerfield, 2014; Kinlaw, Kritzman and Turkington, 2013)
  3. Can we use market timing to exploit time-variation in liquidity premium?

An answer to the questions above should add to the academic literature on portfolio choice and illiquid assets. Furthermore, it will give practitioners guidelines for investing in these asset classes. Something which is high on the agenda, given today’s search for yield and the need for more investments in for example infrastructure.

References
Ang, A., 2014, “Asset Management: A Systematic Approach to Factor Investing”, Oxford University Press
Ang, A., Papanikolaou and D., Westerfield, M.M., 2014, “Portfolio Choice with Illiquid Assets”, Management Science, 60(11):2737-2761

De Jong, F.C.J.M. and Driessen, J.J.A.G., 2013, “The Norwegian Government Pension Fund’s Potential for Capturing Illiquidity Premiums”, Tilburg University research for the Norwegian Ministry of Finance

Markwat, T.D. and Molenaar, R., 2016, “The Ins and Outs of Investing in Illiquid Assets”, CAIA, Volume 5(1), 23-33

Kinlaw, W., Kritzman, M. and Turkington, D., 2013, “Liquidity and Portfolio Choice: A Unified Approach” Journal of Portfolio Management, 39(2): 19-27

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Let us know your motivation and send it together with your CV and list of grades to SQ@robeco.nl.