Asset Class Liquidity Considerations

The problem of illiquid assets complicates traditional asset allocation. Some of the most prominent investments in this category include direct real estate, infrastructure, private equity, and hedge funds.

Illiquidity and Lack of Investable Index

Illiquid assets represent those for which a ready and available market may not be available. Due to the unique nature of these investments, investors who invest in illiquid assets may have to take a price reduction on the sale of the assets or may have to wait longer than wanted to complete a sale at a satisfactory price.

In addition to not having a ready market comes the complication of not always having a relevant and applicable index for passive investment purposes. For some relatively illiquid asset classes, a satisfactory proxy may not be available; including such asset classes in the optimization may, therefore, be problematic. For finance professionals, be open to clients who wish to invest in this asset category.

Illiquid asset classes also tend to be much more heterogeneous. While an index for a stock or bond may contain thousands of similar investments with similar risk and return characteristics, illiquid assets tend to carry more idiosyncratic risk. This idiosyncratic risk could be the specific company risk in a venture capital fund or the regional risk inherent in an infrastructure investment.

Collecting data upon which to model the investment risks of illiquid assets becomes much more challenging. More room for professional judgment and experience is required on the investor’s part.

Institutional Investors

Large institutional investors can invest in less liquid asset classes, such as direct real estate, infrastructure, and private equity. These investors often earn an illiquidity premium for their increased risk. Other considerations include large investment minimums and long lock-up periods, which institutional investors are uniquely positioned to deal with.

Potential Solutions

In addressing asset allocation involving less liquid asset classes, practical options include the following:

1. Exclude less liquid asset classes (direct real estate, infrastructure, and private equity) from the asset allocation, and then consider pooled investment vehicles as a replacement (real estate, infrastructure, and private equity funds).
2. Include less liquid asset classes in asset allocation and attempt to model their specific risk characteristics.
3. Include less liquid asset classes in the asset allocation decision and attempt to model the inputs to represent the highly diversified characteristics of the true asset classes.

Question

Which of the following risk premiums is least likely to present an investment in private equity?

1. Systemic risk.
2. Illiquidity risk.
3. Idiosyncratic risk.

Solution

The correct answer is A:

Systemic risk factors are common to an entire market, such as interest rates or changes in GDP. These risks are prevalent in passive index investments such as replicating the FTSE or S&P 500.

B is incorrect. Illiquidity risk refers to the fact that a large, robust, and efficient market is not present, a common characteristic of alternative investments.

C is incorrect. Idiosyncratic risk refers to company-specific risk. This is much more prevalent for illiquid assets than for assets with large public markets.

Asset Allocation: Learning Modul 4: Principles of Asset Allocation; Los 4(f) Discuss asset class liquidity considerations in asset allocation