The liquidity of an asset is the extent to which it can be bought or sold without affecting its price. In extreme market conditions especially, investors trying to sell illiquid assets may be forced to accept drastically reduced prices to find a buyer quickly (or at all). A lesson learned by many during 2008/9.
Investment wisdom (and common sense!) therefore holds that liquidity is a desirable property and we should demand additional compensation to hold less liquid assets. The acute aversion to volatility demonstrated by the investment industry at present may be causing investors to lose sight of this principle.
Eric wrote last year on the industry’s obsession with volatility and some of the associated issues. An intense focus on metrics like volatility and value at risk (VAR), neither of which are an appropriate measure of genuine risk, is misleading and potentially very costly.
With risk viewed through this narrow prism, less liquid assets suddenly seem more compelling. Investors effectively observe a smoothed price for assets that are only revalued periodically and/or with an element of discretion. This lowers measured volatility and correlation with other assets, lowering measured risk and making measured return profiles seem more palatable. It can make illiquidity a desirable quality.
If the management (avoidance) of volatility is your foremost concern, illiquidity could actually become a desirable quality. It might therefore be tempting to add illiquid assets to a portfolio, and investors are doing just this. BlackRock’s 2019 Global Institutional Rebalancing survey shows a clear shift towards illiquidity. The asset classes that funds were most likely looking to add exposure to in 2019 are real assets, private equity and real estate; with listed equity the most anticipated reduction (all of this for the 2nd year in a row).
The Role of illiquid assets
I do believe that there can be a role for such investments in a multi-asset portfolio. To the extent that they have different fundamental drivers or experience meaningful mispricing they can provide a useful, diversified source of risk and return.
However, the benefits can also be overstated though and are somewhat illusory. Stated prices won’t accurately represent the underlying market value of the assets and portfolio risk properties may not actually be altered in a meaningful, economic sense. Illiquidity also tends not to be an issue until investors try to sell positions, at which point (especially if this occurs across market participants) low volatility/uncorrelated assets can prove to be just the opposite. Investors may therefore fail to appreciate the true risks being run.
The popularity of and flows in to illiquid strategies risks pushing pricing to the extent that expected returns no longer compensate adequately for the liquidity risks that they entail. Expensive valuations have been flagged over the last year in areas like private equity, US commercial real estate and indeed private markets more generally. The growing desire to avoid volatility could ultimately actually cause people to pay up for illiquidity and remove the illiquidity premium that is an important element of delivered returns.
The liquidity discount
We would argue that the desire to avoid volatility impacted liquid assets as well. The key valuation disconnect that we would observe on today is the attractiveness of (listed) global equities vs perceived safe-haven assets like bonds and cash (chiefly outside the USA). The equity risk premium (ERP) measures the additional compensation that investors demand to own equities instead of typically less volatile (and less growth-exposed) government bonds. In the volatility averse regime induced by the financial crisis, investors have demanded a larger ERP to tolerate this risk.
The emotional challenge of watching asset prices gyrate around on an hourly, daily or weekly basis can make assets like equities challenging to own, while adding to the pull of illiquids.
There is also an innate human desire to look back and wish you had had more of the assets that had done well and create rationales to hold them even as their valuations deteriorate. Several studies have suggested that the tendency for return-chasing, pro-cyclical behaviour is a vice for both institutional and retail investors (see for example the summary here or here from the IMF). The apparent benefits of illiquid assets look particularly attractive after a volatile phase of such as we have experienced.
It can also be a temptation when the mood is bearish to think that illiquid assets may provide some protection against broader market trends. However, as Tony has discussed in the past all assets will have some exposure to growth and interest rates in some form; if the major fear today is that these forces are headwinds for many assets today, then it is not clear that seeking illiquidity for its own sake will do anything but delay losses or make it harder respond to a changing environment.