Download The value of illiquidity

UBS Asset Management
The value of
illiquidity
The case for alternative investments
Liquidity: does less equal more?
The advent of unorthodox monetary policy has led to asset price inflation in all the
traditional asset classes. This in turn has created yield compression across all sectors
of the bond and equity markets. Yield-hungry investors have been forced further
out along the risk spectrum as their return requirements have not changed. With
one third of developed market sovereign bonds offering subzero yields, investors
have turned to more complex and less liquid assets. Besides the higher potential
returns generated, we would argue that diversification and (in some cases) inflation
protection characteristics, are compelling reasons for investors to have a significant
allocation to illiquid assets.
The quest for higher income and risk-adjusted returns has lured investors towards a broad range of illiquid or
alternative assets, such as, hedge funds, real estate, private equity and infrastructure. In return for accepting the
risk of less easily tradable assets, investors have been rewarded with the so-called ”illiquidity premium”.
Cash is king or is it not?
Most investors place a higher value on liquid assets compared to those which are illiquid. As a result, they
demand a higher rate of return for assets which cannot be easily converted to cash at any time. In our view, this
explains the illiquidity premium.
The illiquidity premium is justified if we consider the opportunity costs borne by an investor. By investing in an
illiquid asset, investors are restricted in their ability to adjust their portfolio’s asset allocation to changes in market
environment or liquidity requirements. In particular, when markets start to fall, illiquidity becomes a concern as
investors may not be able to sell their assets quickly, and thus have to suffer prolonged losses. Under such a
scenario, illiquidity tends to intensify as more investors try to sell while buyers remain thin on the ground.
Furthermore, given the lack of transparency and complete data points, illiquidity also makes it challenging for
investors to assess the potential risk-return profile of assets, and make an efficient asset allocation.
Information asymmetry
Digging a little deeper we can look into the drivers of differences in liquidity between markets to understand how
this is likely to impact on an investment strategy. One of the key drivers of liquidity, we believe, is the degree of
information asymmetry between market participants; in layperson’s terms, the degree to which price sensitive
information is available to a privileged few or even one market participant versus markets where price sensitive
information is available to all on an equal basis.
Regulated developed world equity markets offer, at least in theory, an even playing field which encourages
investor participation and supports liquidity. By contrast there is significant information asymmetry in private
markets. For example, in the case of private equity, corporate fundamental data are just as relevant as they are in
valuing and analyzing companies in public equity markets. But due to the lack of market regulations, some
market participants may have access to a much greater depth of information about the fundamentals, corporate
strategy and economic performance on a given company or security than others. In turn, this information
asymmetry may lead to market participants to be less likely to trade and provide liquidity.
Fig.1
Expected asset class returns vs liquidity
19
Venture Capital
15
Private Equity
Compound annual returns (%)
Hedge Funds
Small Equity
Timber
11
Global Government Bonds
High Yield
Real Estate
7
US Fixed Income
Global REITs
Deposits
3
1
Higher
2
3
4
5
Liquidity estimates
6
Lower
Source: ”Expected Returns”, by Antti llmanen, 2011. Scatterplotting average asset returns 1990-2009 on (subjective) illiquidity estimates. Sources: Bloomberg, MSCI
Barra, Ken French’s website, Citigroup, Barclays Capital, J.P. Morgan, Bank of America Merrill Lynch, S&P GSCI, MIT-CRE, FTSE, Global Property Research, UBS, NCREIF,
Hedge Fund Research, Cambridge Associates. For illustrative purposes only. Actual future results may differ materially from expectations.
During periods of market stress, the impact of asymmetric information as a key driver of liquidity becomes
obvious. An example is the widening bid/ask spread in the interbank credit market in 2007, which dried up
almost entirely in 2008. This was mostly because lenders believed that other market participants had non-public
information about the credit rating of the borrower, and questioned the credibility of the market information.
Alpha not beta the key driver in illiquid markets Liquidity and transparency allows investors to safely follow
passive approaches and gain cheap access to market performance, or beta. Conditions in illiquid markets are
very different and require investors to rely on specialist investment expertise and fund manager skill, also known
as alpha. Besides superior stock selection, alpha may also include, for instance, the ability to source favorable
opportunities based on superior information and relationships.
On a side note, there has recently been a lot of bad press on the topics of fees charged by hedge funds.
There have also been some prominent institutional investors who have terminated a number of alternative
managers, mainly due to high fees. In our view, it’s not about whether fees are high or low, but instead are
they fair? Are they justified? Alpha (excess returns) needs to justify the fees and there needs to be transparency
with regards to where the fees are going to, i.e. a team of two people or expensive infrastructure and
technology.
During periods of market stress, the impact of
asymmetric information as a key driver of liquidity
becomes obvious.
5
Whether or not the illiquidity premium can be precisely
measured, the fact is illiquidity can be harvested.
Quantifying the illiquidity premium
UBS Hedge Fund Solutions (HFS) conducted a study of 234 hedge funds on the HFS platform to determine if there
was a relationship between hedge fund performance and liquidity of the underlying investments. Using
redemption frequency as a proxy for the liquidity of underlying holdings, the study concluded that each month of
illiquidity on average translates to approximately 20 bps of additional return.
These findings are broadly consistent with a separate analysis1 of the investment histories of nearly 1,400 private
equity funds over a 24-year period derived from the holdings of over 200 institutional investors. The resulting
analysis showed private equity funds‘ median return net of fees outperforming its public equity market counterpart
(S&P 500) by over 3% per year.
Isolating the illiquidity premium
There may, of course, be other factors at work here other than a straightforward reward for embracing illiquidity.
Indeed, even if we are able to say unequivocally that illiquid assets have outperformed over the long-term, and
provide at least some empirical evidence of the scale of outperformance, attributing that outperformance
precisely to illiquidity is not straightforward. After all, all asset classes are a collection of differing risk premia in
varying amounts. Illiquidity is therefore intertwined with a host of other risk premia such as volatility and size.
Further complicating accurate measurement is the fact that liquidity is not a constant, but multi-dimensional and
variable over time.
Illiquidity: a rewarded risk
In our view, we believe that there is sufficient evidence that illiquid assets generate higher returns to justify
consideration. We see the key focus for investors as the total potential return for all the potential risks – including
illiquidity – within the context of each investor‘s broader investment objectives and constraints. It has been
suggested that illiquidity is “in essence a transfer of economic rents from illiquid risk avoiders to risk takers“. But
for ‘risk takers’ who understand and can tolerate those risks, illiquid assets may offer attractive returns for the risks
assumed. In our opinion, that should be a powerful catalyst for those investors who are able to take a longer term
view to explore further what illiquid assets have to offer.
Fig. 2
Hedge fund liquidity (redemption frequency) vs annualized returns
20
17.1
Annualised return (%)
14.2
12.8
11.1
10
8.3
8.1
7.0
7.8
4.5
3.0
2.4
0.7
0
<1Q
~4,700 Funds
<1Q–1 yr
~2,000 Funds
25th Percentile
1 yr–2 yr
~200 Funds
Median
2 yr–3 yr
~100 Funds
75th Percentile
Source: Blackstone: Barclays Strategic Consulting analysis based on data from HFR, BarclayHedge and HedgeFund.net. Lockup period is aggregate of hard lock, redemption notice
and redemption frequency.
1
Source: Harris R, Jenkinson T and Kaplan S (2013) “Private Equity Performance: What Do We Know?” Journal of Finance.
Alternative investments: industry trends
Many pension funds (and endowments) have increased their allocation to alternatives given the low returns from
fixed income investments and an ultra-loose global monetary policy. In 2014, the Government Pension
Investment Fund (GPIF) of Japan announced the adoption of a new policy asset mix that allows for a maximum of
5% allocation to alternatives. Besides public pension funds, some university endowments have been investing in
alternatives to enhance return since many years. A recent survey done by Preqin2 showed an overall positive
trend in institutional investors’ plans for alternative investments in the long term.
Demand for alternatives has surged over the years and PWC estimates that total alternatives assets will grow
to USD 13.6 trillion by 2020 (from USD 7.9 trillion in 2013) in their base case scenario3. Ultra high net worth
individuals are also showing more interest for alternatives and are likely to become a more important source of
capital in the future.
Institutional investors’ plans for allocations in the longer term2
Reduce Allocation
Increase Allocation
6%
48%
PRIVATE EQUITY
15%
31%
HEDGE FUNDS
10%
36%
REAL ESTATE
11%
53%
INFRASTRUCTURE
8%
62%
PRIVATE DEBT
23%
19%
NATURAL RESOURCES
2
3
Source: UBS Asset Management; Preqin Investor Interviews, December 2016; Preqin Investor Oultook: Alternative Assets H1 2017.
Source: PWC report ”Alternative asset management 2020 Fast forward to center stage”, 16 June 2015.
7
References
• Jain, S (2016) “Investment Considerations in Illiquid Assets” Alternative Investment Analyst Review
• Ilmanen, A. (2011). ”Liquidity Factor and illiquidity premium” from Expected returns: An investor’s guide to
harvesting market rewards. pp. 359–374. John Wiley & Sons
• Preqin Private Debt Database 2015, Bank of America Merrill Lynch.
• Rajan, Amin (2015) ”The rise of Private Debt as an Institutional Asset Class” for ICG
• UBS Hedge Fund Solutions (2015) ”The Hedge Fund Illiquidity Premium”
• Harris R, Jenkinson T and Kaplan S (2013) ”Private Equity Performance: What Do We Know?” Journal of Finance
• Jensen, Michael C (1989) ”Eclipse of the Public Corporation” Harvard Business Review
• Harris R, Jenkinson T, Kaplan S, Stucke R (2014) “Has Persistence Persisted in Private Equity? Evidence from
Buyout and Venture Capital Funds”
• Blackstone: ”Patient Capital, Private Opportunity. The benefits and challenges of illiquid alternatives”
• UBS Asset Management, Investment Insights (April 2017), Liquidity: does less equal more?
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