Illiquid investors risk bad hair day

Investors need to recognise and actively manage distinct risk issues associated with illiquid alternative assets in order to avoid “taking a haircut” on returns, according to investment consultant Russell Investment Group.

The research paper, entitled “Illiquidity: A Story of Haircuts and Perms”, looks at how investors can better deal with the risks associated with illiquid assets such as private equity, unlisted property, unlisted infrastructure and hedge funds.

It also provides investors with a framework for deciding on an appropriate allocation to unlisted assets, using the novel classifications of having a “haircut” or a “perm”.

Written by capital markets research head Geoff Warren and senior research associate Andrew Leung, the paper warns that investing in “higher returning illiquid securities” present a distinct set of challenges and risks.

It suggests illiquid assets typically cost more to transact, illiquidity can result in a failure to transact, the true asset value is often unknown and historical performance can often be misleading.

“Investors pursuing higher returns from illiquid asset sectors must develop a more intimate appreciation of the associated risks to avoid taking a haircut on returns,” Warren said.

“While investing in unlisted assets can bring benefits, we sense that some investors are over-optimistic.”

Historical data is sometimes interpreted as “providing evidence that unlisted assets are a pathway to diversification that offers low volatility and high returns”, he said.

“This particularly applies to private equity and hedge funds, and so it is worthwhile delving a bit deeper before investing in these assets.”