Alternative investments, such as private equity and private debt, generally require investors to commit funds for a specified lockup period. The lack of liquidity is usually compensated for with the illiquidity premium, which provides compensation for the associated loss of investment flexibility.
But is this premium worth the added risk?
Is the illiquidity premium worth its extra returns?
A recent report from Morgan Stanley suggests not. Indeed, according to the report, compiled by analysts Martin Leibowitz and Anthony Bova, over the period 1990 to 2016 funds with a large percentage invested in private equity have consistently produced return advantages of 1.5% to 2% relative to a standard 60/40 portfolio.
However, thanks to the strong equity market performance since the financial crisis, the return advantage has deteriorated to 0.5% over the most recent 2010-2016 period.
As shown in the chart below, over time this extra performance can have a dramatic impact on a portfolio’s performance. That being said, the report also finds that for funds that are “highly sensitive to liquidity constraints” then these returns may have to be adjusted by implementing liquidity charges on the illiquid asset values.
Thanks to these costs “illiquid return advantage may then be eroded to the point where the net returns are roughly similar to a more liquid portfolio with comparable volatility.”
The costs associated with illiquidity is the main reason why these assets never form a significant part of portfolios. Even though higher returns are possible costs, such as fees and the effort of ensuring the rest of your portfolio is liquid enough, can erase all of the extra gains.
Unfortunately, trying to gauge the exact cost/reward ratio accurately is never going to be possible because these assets are illiquid. There’s often no price discovery mechanism for analysts to use to base assumptions on (pretty much anything can be sold if there is complete flexibility over price) something Morgan’s report also notes. Instead, Wills Towers Watson has come up with a table based on “the academic literature to determine” and “our experience of investing in illiquid assets” to determine what premium investors have demanded when investing in illiquid assets. The findings are shown in the table below:
If like most investors, private equity and private debt is out of your range, research shows that illiquid publicly traded stocks also outperform over the long-term.
The best 2013 article in the Financial Analysts Journal went to Yale School of Management’s Roger Ibbotson, who looked at the performance of stocks with various liquidity profiles from 1972 to 2011. Of the 3,500 US stocks considered, the least liquid quartile, from 1972 to 2011, returned an average of 16.38%, compared to 11.04%. Interestingly, this suggests outperformance of 5.4% 340 bps more than Morgan’s estimate of private equity outperformance.
One of the main reasons why illiquid stocks tend to outperform is, that in a drawdown investors can’t sell them. As the Financial Times explained:
As illiquid stocks should be harder and more expensive to trade, it becomes harder for share prices to readjust smoothly, creating volatility. But in practice, the experience of the 2008 crisis was exactly the opposite. Daniel Kim, one of the co-authors and research director for Zebra Capital Management in Connecticut, reports that illiquid stocks suffered far lower drawdowns during the most dramatic days of heavy selling. That was because, in an emergency, people sold whatever they could, so liquid stocks were sold first.