Many people would place ‘capturing the illiquidity premium’ at the top of their list of benefits from long-term investing. However, extracting additional returns from illiquidity is not as simple as just buying and holding any illiquid asset. Returns to illiquidity vary across investors, markets and time. In this article, I sketch out the traits of illiquid assets. Investors should ask two questions before seeking the illiquidity premium. First: Am I suited to investing in illiquid assets? Second: Am I being adequately rewarded?
Trait 1: Illiquid assets involve additional costs and risks
Exposure to illiquidity brings with it additional costs and risks:
- Illiquid assets cost more to transact. The additional transaction costs often appear as greater ‘market impact’, i.e. the need to pay a price premium to get set, or accept a price discount to exit. Costs of locating, analysing and accessing illiquid assets can also be higher, especially in unlisted markets, including advisory fees and agent commissions.
- Illiquid assets cost more to hold. Many illiquid assets involve higher ongoing expenses, related to management, monitoring, and capital commitment. For instance, investment managers charge considerably more in unlisted markets.
- Illiquidity = loss of flexibility. Illiquid assets take longer to transact, and in some circumstances, trading may be prohibitively costly or even impossible. The inability to trade quickly, or at an acceptable price, can result in being stuck with a portfolio.
- Risk of being a forced seller at the wrong time. Liquidity is like finding a taxi: plentiful when not required, hard to find when really needed. When markets come under pressure, not only does illiquidity tend to worsen, but the chance of some investors losing funding and becoming forced sellers rises. Market crises can go hand-in-hand with redemptions, margin calls, withdrawal of trading capital, and so on. Becoming a forced seller at the wrong time can be very, very costly.
Trait 2: Impact of illiquidity varies across investors
The impact of illiquidity will be typically lowest for those with high discretion over trading, which was nominated in my first article as characteristic of long-term investors. Being able to choose when to trade facilitates waiting patiently for a high return premium before buying. Once invested, it provides the scope to continue holding. Longer holding periods dilute the influence of transaction costs on returns. In rough terms, transaction costs of 10% reduce returns by ~10% over a 1-year holding period; by ~2% over 5 years; by ~1% over 10 years, and so on. Further, an investor with discretion over trading is never a forced seller, while short-term investors are more exposed because they may not always have a choice.
Trait 3: Pricing depends on how illiquidity impacts the marginal investor
The identity of this ‘marginal investor’ is pivotal to who sets the price, as it dictates the magnitude of the opportunity. An important question to ask is: “who is setting prices in this market?” Before expecting an excess return, an investor should be facing off against a marginal investor who is more affected by illiquidity, and places a high value on liquidity.
Trait 4: The marginal investor varies
The identity of the marginal investor varies with market context and the extent to which illiquidity is reflected in prices. At times, a high illiquidity premium can be on offer. At other times, it may be non-existent. It is during liquidity crises that investing in illiquid assets can be most lucrative, as the marginal investor is more likely to be a desperate seller who pays handsome rewards for providing liquidity. For example, a large illiquidity premium seemed evident in bond markets during the GFC, when US Baa corporate bond spreads over treasuries exceeded 7% amidst a near-complete drying-up of liquidity. These spreads subsequently fell back to well below 2%. In contrast, no illiquidity premium currently appears on offer in unlisted infrastructure, notwithstanding being a clearly illiquid asset. Infrastructure prices are being set by funds with long horizons and a flood of capital to invest. Thus the marginal investor is not only highly tolerant of illiquidity, but is willing to pay a price premium (accept a return discount) to get set.
Trait 5: Yields are a key indicator
A good indicator of the compensation for illiquidity is the level of prices relative to income, e.g. the yield. The logic is as follows. The costs associated with illiquidity might be thought of as additional cash outflows; while the additional risks might be viewed as requiring a higher discount rate. Recognition of these features means a lower price per unit of income. If a large illiquidity premium is on offer, illiquid assets should trade on noticeably high yields either relative to their more liquid counterparts, and/or relative to that seen during more liquid times.
Summing up
The answer to the first question of ‘Am I suited to investing in illiquid assets?’ depends on the degree of discretion over trading held by an investor, as well as how costly it is for them to access illiquid assets relative to the marginal investor. Investors who may be poorly suited to investing in illiquid assets might include institutions with limited control over their funding; or smaller investors who lack the capacity to access illiquid assets at a reasonable cost. The answer to the second question of ‘Am I being adequately rewarded?’ hinges on the nature of the marginal investor in a particular market and is evidenced by a sizeable yield premium. The answers are likely to lead to a more dynamic approach, whereby illiquid assets are purchased in times of markets stress when large premiums are on offer, and exited when liquidity is plentiful and the illiquidity premium is skinny.
Geoff Warren is Research Director at the Centre for International Finance and Regulation (CIFR). This article is for general information purposes and readers should seek independent advice about their personal circumstances.
This series of Cuffelinks articles brings out the key messages from a research project examining long-term investing, conducted by CIFR in collaboration with the Future Fund. The full report, which comprises three papers, can be found at: http://www.cifr.edu.au/project/T003.aspx