Doubts raised about illiquidity premiums

Although illiquid assets can offer opportunities to enhance investment portfolios, the risk-return premiums may not be as significant as many investors may believe, according to research released by Russell Investment Group.

Speaking at a Russell roundtable event yesterday, senior research associate Geoff Warren said the risks of illiquidity were growing in importance as more institutional investors participated in new private markets and alternative assets in general.

“Liquidity is an elusive concept in investment markets. It is abundant when it is not needed, and evaporates when it is,” Warren said.

“The extreme risk here is if you find yourself being forced to sell unexpectedly in a weak market. In such a situation you can be wiped out completely.”

According to Warren, there are two reasons why investors would venture into the illiquid space. The first is the diversification opportunities, and the second reason is that illiquidity can often offer higher returns through an illiquidity premium “because illiquidity is so risky there is usually some compensation for it”.

However, Warren warned that although there is an illiquidity premium, it’s not as big as many investors believe.

“When you actually look closer, it reveals that the benefits may not be as potent as you think,” Warren said.

“For example, in terms of risk compensation, the academic literature has tried to model this and most of the time the results are measured in tens of basis points, not hundreds of basis points.

“And if there is an illiquidity premium, shouldn’t we see it in the research data? Russell’s research into private unlisted property versus publicly listed property in Australia, US and the UK found listed property has significantly outperformed. If there really is a big illiquidity premium, you would certainly expect unlisted properties to significantly underperform.”

Warren said that although illiquid assets should not be ignored, investors must remain circumspect, not only because the premiums may not be there, but also because of the risk involved in the event that investors can’t sell the asset.

“So one of the key messages is that you just can’t consider illiquid assets in their individual contexts, but you need to think more broadly about how much illiquidity risk you have in your portfolio and understand that many of those illiquid assets could all fall at once,” he said.

“And if you are in such a situation of being forced to sell in today’s markets, you could be in real trouble if you hold a lot of those assets.”