As institutional investors search for higher returns and better opportunities for diversification, they often opt for illiquid investments. But do these asset classes really offer the right return characteristics? Robeco’s conclusion is that effective manager selection is crucial.
Together with portfolio strategist Jaap Hoek, Robeco researchers Thijs Markwat and Roderick Molenaar have written a white paper called “The ins and outs of investing in illiquid assets”, based on an extensive literature study. Markwat and Molenaar explain the key findings of their research in an interview.
“There are four factors that limit the liquidity of investments,” says Molenaar. “The first is the external costs incurred through transactions. Those are generally higher for hedge funds, real estate, private equity, and infrastructure than they are for quoted stocks and bonds, for instance because legal specialists are involved in the transactions. A second factor is that market makers are needed to make the trade possible and they have to maintain supply. The market makers must be compensated for the risk that they may temporarily be unable to find a counterparty.
Illiquidity also arises when the buyers and sellers don’t have the same information. The less well-informed party will want compensation for the risk of potentially not trading at the right price. That makes it more complex and reduces the liquidity. The fourth factor is ‘search friction’, when it’s difficult to match up supply and demand. That happens when there’s no centralized market, for instance. A small market with few parties can result in wide spreads between bid and offer prices. These various sources of illiquidity overlap too and thus reinforce each other.”
“Their long investment horizons mean that pension funds are in a good position to invest in illiquid assets,” says Molenaar. “They are less likely to experience reduced tradability as a drawback than investors with a short-term horizon. But they are can benefit from the compensation that the market demands. They’re also less affected by the high transaction costs.”
’There’s little or no empirical evidence for a yield differential between liquid and illiquid asset classes’
“On theoretical grounds, you might expect there to be some kind of liquidity premium,” says Markwat. “But the results of academic research are mixed. Within some asset classes, illiquid investments offer better yields than liquid investments do. So a liquidity premium exists in such cases. But there’s little or no empirical evidence for a yield differential between liquid and illiquid asset classes. You can’t say that there’s no liquidity premium between asset classes, but it is certainly very difficult to demonstrate that it exists.”
“For many illiquid investments, there often isn’t a market value available,” says Molenaar, “so you have to work with book values that are intrinsically of a lower quality. For some people, it’s an investment belief that you should receive a premium for investing in illiquid assets.”
You should invest in illiquid asset classes for the alpha, rather than for the risk premium’
“Whatever the illiquid asset class, it’s important that you pick good fund managers,” says Molenaar. “The managers and their funds must always be in the top quartile. David Swensen, Chief Investment Officer of Yale University and the architect of the endowment investment strategy, agrees. In his study called ‘Pioneering Portfolio Management’, he says that you shouldn’t invest in illiquid asset classes for the risk premium, but for the alpha you can generate. It’s not always possible to establish whether good returns are the result of a manager’s added value or perhaps because there’s a premium for illiquidity. But you do get an additional return, and that’s a combination of factors that you can’t put your finger on.”
“Swensen argues that there are more opportunities to generate alpha because it’s more difficult to gather and process the correct information about investments in illiquid markets. That’s in contrast to public markets, where the investors have all the information.”
“A study by Tilburg professors, Frank de Jong and Joost Driessen, shows that investors with a longer-term investment horizon are able to ask - and get - a higher liquidity premium,” says Markwat. “Because they can hold investments for longer and therefore have to trade less often, long-term investors have lower transaction costs. But because they won’t be satisfied with a lower gross return, the premium they receive has to be higher.”
‘Liquidity premiums are higher in times of crisis’
“Predicting a crisis is pretty much impossible,” says Markwat, “so anticipating one isn’t an option. It’s true that you can buy illiquid assets at low prices during a crisis, but the timing’s still awkward. You never know if the crisis is going to deepen. On top of that, your own situation is important. If you have a solid position, you’ll be more capable of benefiting from the discounts than if you’re affected by the crisis too.”
“There are examples of parties who got into trouble by investing too heavily in illiquid investments,” adds Molenaar. “Think of the Harvard University endowment case. The university fund got into big trouble during the crisis in 2008.”
“These investments can offer exposure to specific characteristics,” says Molenaar. “Take inflation, for instance. By investing in infrastructure, you can acquire inflation exposure (in the Netherlands, at least). Or, if we’re talking real estate, investments in rental housing offer different characteristics - more defensive ones, perhaps - to quoted commercial real estate.”
“A second benefit of diversification comes from the fact that the prices of liquid and illiquid investments don’t respond at the same time to market developments. That’s because the prices of illiquid investments are based on valuations. There’s a delay in their response to developments on the stock market, for example. Because of that timing difference, the value of the portfolio as a whole is less volatile. In itself, this is just an exercise on paper applying accounting rules, but it can still be a benefit from the portfolio management point of view.”
“That the returns on illiquid investments are largely determined by the managers you select,” says Molenaar. “If you’re an investor who wants to invest in illiquid asset categories, you should always ensure you have the necessary skills to select the right managers.”