LO 65.5: Compare illiquidity risk premiums across and within asset categories.
Illiquidity Risk Premiums Across Asset Classes
As part of the analysis in Antti Ilmanens 2011 book Expected Returns, we can relate liquidity to expected returns as shown in Figure 1. Note, however, that we cannot completely pigeonhole asset classes based on illiquidity (e.g., some private equity funds are more liquid than some hedge funds or infrastructure investments). Also note that, in this analysis, returns are computed over the period 1990 to 2009 and the illiquidity estimates are just estimates (i.e., they represent Ilmanens opinions). Ilmanens work does imply a positive relationship between the illiquidity of an asset class and its expected return. Venture capital is considered the least liquid and has the highest expected return, between 16% and 17%. Buyout funds and timber are also illiquid but command lower expected returns, approximately 13% and close to 12%, respectively. Hedge funds are more liquid and are expected to earn a little more than 12%. Real estate is on par with hedge funds in terms of liquidity but commands a lower return of nearly 8%. Equities are much more liquid and earned a bit more than 4% over the period. Cash is the most liquid and it too earned a little over 4% during the period. 1
1.
Ilmanen, A. (2011). Expected Returns: An Investors Guide to Harvesting Market Rewards. Chichester, West Sussex, U.K.: Wiley.
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It is the conventional view that there is a premium for illiquidity However, this may not be true. First, there are illiquidity biases. As discussed previously reported returns of illiquid assets are too high (i.e., overstated if using raw, unsmoothed data) and risk and correlation estimates are too low.
Second, illiquid asset classes such as private equity buyout funds, and physical assets like timber contain significant risks beyond liquidity risk. After adjusting for these risks, illiquid asset classes are much less attractive. According to one study after adjusting for risk, most investors are better off investing in the S&P 500 than in a portfolio of private equity.
Third, there is no market index for illiquid assets. Private equity hedge fund, and real estate indices are not investable, so no investor is actually earning the index return. For example, the NCREIF includes thousands of properties. Because individuals do not typically own thousands of properties, they are much more subject to idiosyncratic risks and are less diversified within the asset class.
Fourth, you must rely on manager skill in illiquid asset classes. There is no way as there is with tradeable, cheap bond and equity index funds, to separate factor risk (i.e., systematic risk) from the talents of fund managers. As noted, there is no way to earn index returns. If an investor cannot earn index returns in illiquid asset class markets, he has no way of separating passive returns from alpha generated by active managers.
These factors imply that it may not be possible to generate substantial illiquidity risk premiums across illiquid asset classes. However, there is evidence of large illiquidity risk premiums within asset classes.
Illiquidity Risk Premiums Within Asset Classes
Less liquid assets generally have higher returns than more liquid assets, within asset classes. Currently there is no formal theory about why illiquidity risk premiums exist within asset
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Topic 65 Cross Reference to GARP Assigned Reading – Ang, Chapter 13
Figure 1: Liquidity vs. Expected Returns
Topic 65 Cross Reference to GARP Assigned Reading – Ang, Chapter 13
classes but not between. It might be that investors simply overpay for illiquid asset classes, chasing the illusion of higher returns. It may also be that firms do not manage portfolios as a cohesive whole, but instead put asset classes in different silos. Mispricing (i.e., the lack of a premium across classes) may be due to slow-moving capital across classes, limits to arbitrage, and institutional constraints (e.g., the fixed-income desk doesnt talk to the equity traders, and so on).
Illiquidity Effects in U.S. Treasury Markets
On-the-run (i.e., newly issued) Treasury bills (T-bills) are more liquid and have lower yields than ofiF-the-run (seasoned) T-bills. The difference is called the on-the-run/off-the-run bond spread. During the 20072009 financial crisis, same maturity T-bonds andT-notes traded with different yields. While prices should have been the same, T-bond prices were more than 5% lower than T-note prices. Given that the U.S. Treasury market is one of the largest and most liquid in the world, it is surprising to observe large illiquidity effects.
Illiquidity Effects in Corporate Bond Markets
Larger bid-ask spreads and infrequent trading led to higher yields in corporate bond markets. Studies indicate that illiquidity risk explains 7% of the variation in investment grade bond yields and 22% of the variation in junk bond yields. Also, as bid-ask spreads increase, yield spreads increase by more than double the amount (e.g., a one-basis point increase in the bid-ask spread results in a more than two-basis point increase in the yield spread).
Illiquidity Effects in Equity Markets
Price impact of large trades. Informed trading measures (i.e., adverse selection). There are several variables related to illiquidity that are shown to impact equity returns. Studies indicate that less liquid stocks earn higher returns than more liquid stocks. Illiquidity factors that impact equity returns are: Bid-ask spreads. Volume. Turnover. Volume measured by whether the trade was initiated by buyers or sellers. Ratio of absolute returns to dollar volume, called the Amihud measure.
Quote size. Quote depth.
Number of zero returns (in liquid markets returns are usually not zero). Return autocorrelations (which are a measure of stale prices). All of these factors are characteristics of illiquidity that are unique to each stock. There are also illiquidity risk betas that are covariances of stock returns with illiquidity factors. Researchers estimate illiquidity risk premiums at 1% to 8% depending on the illiquidity measure used. Research also indicates that risk premiums have declined, although studies find a 1% risk premium for listed equities compared to a 20% risk premium for OTC stocks.
Frequency of trades.
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Topic 65 Cross Reference to GARP Assigned Reading – Ang, Chapter 13
Secondary Markets for Private Equity and Hedge Funds
Private equity funds trade companies with each other, providing needed liquidity. In 2005, these secondary buyouts represented about 15% of all private-equity buyout deals. This does allow funds to get out of specific deals, may give limited partners (LPs) some cash in the process, and may allow LPs to better understand the values of portfolio companies. However, secondary buyouts do not allow limited partners to get out of the private equity fund itself.
LPs can exit private equity funds in secondary markets. However, these markets are immature, small, and more opaque. Firms participating in these markets on the buy side were called vultures in the 1990s. Buyers took advantage of distressed sellers, getting discounts of 30% to 50%. Discounts fell below 20% in the early 2000s, but shot up again during the 2007-2009 financial crisis.
Harvard University saw its endowment fall by more than $8 billion, or 22%, between July 1, 2008, and October 31, 2008. Harvard relies on the endowment for some of its operating funds. Endowment fund managers attempted to sell stakes in private equity to free up cash for operations and faced discounts of 50%.
Because hedge fund investors can typically redeem their investments at predetermined dates, discounts on secondary market transactions are much smaller than in private equity investments. During the recent financial crisis, hedge fund discounts were 6% to 8% on average. Some funds traded at a premium, even during the crisis, due to strong demand (i.e., the funds were closed to new investors). Large asset owners like sovereign funds and pension funds can supply liquidity in hedge fund and private equity markets, buying stakes at reduced prices and harvesting illiquidity risk premiums.
In sum, there are four ways that investors can harvest illiquidity premiums: 1. Allocating a portion of the portfolio to illiquid asset classes like real estate. This is
passive allocation to illiquid asset classes.
2 . Choosing more illiquid assets within an asset class. This means engaging in liquidity
security selection.
3. Acting as a market maker for individual securities. For example, Dimensional Funds
Advisors (DFA) is a liquidity provider that buys stock at a discount from those wanting to sell quickly and sells small-cap stocks at a premium to investors demanding shares. The firm avoids adverse selection problems by choosing counterparties who fully disclose information about stocks. The firm is trustworthy in its dealings and does not manipulate prices or engage in front running. Sovereign wealth funds, large pension funds, and other large asset owners can also act as market makers, providing liquidity while buying at discounts and selling at premiums.
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Topic 65 Cross Reference to GARP Assigned Reading – Ang, Chapter 13
4. Engaging in dynamic factor strategies at the aggregate portfolio level. This means taking long positions in illiquid assets and short positions in liquid assets to harvest the illiquidity risk premium. Investors rebalance to take advantage of the liquidity differences as less liquid assets become more liquid. Rebalancing the portfolio is the simplest way to provide liquidity. As long as buyers buy when others want to sell and sell when others want to buy, rebalancing is countercyclical. Of the four ways investors can harvest the illiquidity premium, this is the easiest to implement and can have the greatest effect on portfolio returns.
Po r t f o l io Al l o c a t io n t o Il l iq u id As s e t s