Thought Leadership (Professional Only)
The illiquidity conundrum: does the illiquidity premium really exist?
Locking your money up for a longer period of time can be a risk, particularly in times of market stress. However, some believe that long-term investors should be able to stomach illiquidity and will receive higher returns as a result.
3 September 2015
In this paper we examine the illiquidity premium and its place in a UK defined benefit pension scheme portfolio. We consider:
- To what extent pension schemes can tolerate illiquidity
- Approaches to identifying, isolating and quantifying the illiquidity premium
- To what extent illiquidity is a rewarded risk
- An illiquidity premium does appear to exist for some alternative asset classes (in particular property). Furthermore, being able to tolerate a degree of illiquidity enables pension schemes to access a wider range of asset classes for return generation and diversification purposes. However:
– There are a number of difficulties with measuring illiquidity risk. A key difficulty is isolating asset specific illiquidity risks from systematic or market risk
– Returns may not fully compensate investors for the risks embedded in illiquid assets, such as tail risk
– Higher returns may be the result of other underlying risk factors which can be exploited in other ways, without locking up assets for a long period of time.
Although illiquid assets may (and arguably should) play a role in a pension scheme’s investment strategy, given the challenges above, pension funds should be wary of investing in illiquidity “for illiquidity’s sake.”
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