Kitces: A Counterintuitive Approach to Liquidity
From: financial-planning.com
Liquidity may be an appealing characteristic for an investment, but a growing base of research is finding that illiquidity may be even more desirable. Ironically, demand for illiquid investments is so low, that they appear to carry persistent excess return premiums. This view has been popularized in recent years by people including David Swensen of Yale Endowment, who racked up a whopping 13.9% annual return for the past 20 years in large part by relying heavily on illiquid investments.
Of course, the first caveat to investing in illiquid assets is that it is only appropriate for the portion of a portfolio that the investor can afford to place into illiquid holdings. Yet the more significant (albeit more nuanced) danger is that the return premium is only beneficial for an otherwise sound investment. Owing a bad investment that is also illiquid just compounds the problem by locking the investor in.
And notably, a bad investment is not just one with poor economic fundamentals, but also one where the interests of the investment manager and the investor are not well aligned. That leads to situations where even an appealing investment turns sour later, as has occurred with illiquid investments from various hedge funds, to certain life insurance and annuity products, and non-traded REITs.
Yet perhaps the greatest misalignment of interests is the one that occurs when illiquid investments are sold by salespeople who benefit in the short-term, while an investor is locked into the illiquidity for the long run. In other words, illiquid investments may be one situation that is especially appropriate for the involvement of a fiduciary where long-term economic interests are aligned. That goes a long way to explaining why illiquidity has served institutional investors like the Yale Endowment so well, even as it so often goes awry for the individual investor.
THE ILLIQUIDITY PREMIUM
An investment’s liquidity is generally defined as the degree to which it can be quickly bought or sold in the market without affecting its price. For short-term investors, liquidity is crucial to ensure that cash can be generated when needed. For longer-term investors, liquidity is less important from the perspective of converting to cash, but is still important to ensure the easy ability to convert it into another more appealing investment in the future. All else being equal, any rational investor would prefer to hold liquid investments over illiquid ones.
However, as it turns out, not all else is equal. A growing base of research suggests that the prospective returns of highly liquid investments are impaired, compared to those that are illiquid. Viewed another way, illiquid investments (and whole illiquid asset classes) have a higher expected return than those which are more liquid.
Of course, some return enhancement for illiquid investments would be expected, just to accommodate the implied impact of transaction costs to buy and sell them. Yet it appears that investors may actually have such a strong desire for liquidity — even to the extent of being irrational about it — that illiquid investments offer an outsized return premium, over and above just that which would be implied by their transaction costs alone.
This phenomenon has increasingly been called the illiquidity premium. The available excess returns appear to be significant and stable enough that a recent Ibbotson paper suggested it should be a factor which itself receives a long-term allocation, similar to having tilts towards size, value, or momentum stocks. In fact, outsized returns previously attributed to the alpha generated by private equity managers are now being attributed to their illiquidity premium instead.
