Scott Donald has some advice on how should investors incorporate illiquidity into their thinking and outlines five strategies which could be applied
Most institutional investors are familiar with the notion of an efficient frontier. Risk, though, is too elusive a concept to be tamed by the simple mathematics underlying Markowitz’s model. As events in the US subprime market have shown, apparently distant tremors can impact in unexpected places, opening up fault-lines in portfolios a world away from the US housing market. Investors who included alternative investments in their portfolios to exploit the perceived diversification benefits or an ‘illiquidity’ premium (or both) were given an important wake-up call.
One reason why investors were caught out by the aftershocks of the US subprime quake is that traditional investment models do not effectively incorporate the potential impact of illiquidity. This is not surprising, as modelling illiquidity is particularly difficult. Yet with the growing participation of institutional investors in new private markets and alternative assets in general, the impact of illiquidity is assuming much greater importance.
There are two main reasons why illiquidity is hard to model. First, the cost of realising an investment is often related to economic and market conditions. Academics call this type of time-varying risk ‘conditional’ and it introduces an important dimension into the correlation between different asset classes. Assets whose returns appear in good times to have low or negative correlation can suddenly become highly correlated.
Second, the impact of illiquidity is highly dependent on the position of the investor. Clearly, an investor with a short time horizon will have less time to amortise the expected costs of sale than one with a longer horizon. Perhaps more importantly, a forced seller will likely incur greater costs than one who can either undertake a staged sell-down or choose not to trade if the costs are expected to be too great. And if that forced sale coincides with general market weakness, as will often be the case, the ‘haircut’ could be savage indeed.
These factors also make it dangerous to talk about an ‘illiquidity’ premium in markets. Evidence in equity markets suggests some return premium for smaller, less liquid stocks. But such findings are of only limited value when looking at assets where no public secondary market exists, such as private equity or unlisted property. Indeed in areas such as private equity there is increasing evidence that the average money-weighted holding period return is close to that of the liquid market, when all costs are taken into account. This unpalatable fact is obscured by the good performance of the most successful private equity managers, the equal prominence given to poor and propitious vintages in the historical record, and difficulties in capturing the true post-sale value realised by investors in the sector.
Given these challenges, how should investors incorporate illiquidity into their thinking? The risk management cycle familiar to many trustees can provide a framework.
Many investors underestimate the importance of this first step. “Know thyself,” counselled Sun Tzu. The temptation to mimic the successful strategies of others, or else to ensure minimal difference from one’s peers, is strong. But as Yale endowment manager David Swensen and others have demonstrated, it is worthwhile investing time to analyse one’s circumstances thoroughly and dispassionately. Trustees should understand the potential links between illiquidity and the operational details of their fund. Key factors therefore include the expected cash flow profile, probability of unexpected redemptions or benefit payments, the liability structure and the relative magnitude of the investment in illiquid assets.
The illiquidity risks associated with individual securities, sectors or markets are often easy to identify. Historical experience provides examples - not only in unlisted markets, but also in listed markets. The redemption and valuation terms of commingled vehicles such as trusts, syndicates, partnerships and OTC derivatives are usually detailed clearly in advance.
Illiquidity risk is often crystallised by an unexpected need to sell assets. For defined contribution funds, this usually arises from unexpected cash outflows, a situation exacerbated in Australia by both choice of fund and by member investment choice. For defined benefit funds, the potential for changes from the liability side or the sponsor’s objectives or situation are key considerations. Exogenous factors such as regulatory change can also play a role. Importantly, illiquidity risk can be highly correlated across assets, reflecting the macro dimension to illiquidity.
There are five classes of strategies that can potentially be applied to liquidity risk:
1. Avoid those risks that pose too great a threat to the well-being of the fund to be acceptable.
2. Accept those where it comes with an adequate return premium attached.
3. Reduce the frequency of problems. Conduct careful due diligence on the redemption and valuation conditions of all unlisted portfolio holdings to ensure there are no unexpected risks. It is also important to place limits on exposure to illiquid assets, both individually and collectively.
4. Reduce the impact of problems, especially through careful diversification, allowing for the fact that liquidity squeezes can be contagious.
5. Transfer the risks. This may be difficult at a security level, but some investors may be able to maintain a line of credit to assist when short term liquidity is required.
Trustees should review continuously the circumstances of the portfolio. This includes all holdings; markets in which it is invested; the counterparties on which it relies; cash flows through and within the portfolio; the regulatory and taxation environment; and behaviour of the underlying investors or members.
Scott Donald, is director of capital markets, Russell Investment Group, based in Sydney