The Illiquidity Premium

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 |  Includes: TTFS
by: Sameer Jain

As retail investors increase their allocations to real assets and other illiquid sources of durable income, their portfolios often accumulate infrequently traded assets such as private real estate and non-traded REITs, which involve substantial "lock-up" periods. When constructing portfolios of traditional assets, investors normally just consider the trade-off between risk and return. This approach is sensible when the assets under consideration are comparable in their level of liquidity. However, when investors mix non-traded, or illiquid, assets with traded assets, it may not be sufficient to classify portfolio construction choices simply in terms of market risk and return.

In these cases it would be helpful to isolate an illiquidity premium for investments in non-traded assets that may justify investors locking up their money for longer periods of time. However, not all illiquid assets offer similar illiquidity premiums. The difference in premium is on account of differences in their volatility, their ability to diversify portfolios as well as their length of lockup.

Market Volatility. By investing in an asset that restricts trading, an investor gives up (or "sells") an option to trade the asset. Such investors deserve to be compensated for giving up this option. Option pricing theory suggests, the value of an option increases as the risk of the underlying position increases.

  • Ipso Facto, assets with higher volatility such as opportunistic real estate should earn a higher premium than durable incomeassets which typically have lower volatility (such as in net lease or core real estate investing programs).

Portfolio Diversification. Illiquid assets that act as broad diversifiers against other assets in a portfolio ostensibly need not earn as high a "reward" for non-tradability as illiquid assets that act simply as proxies for traditional assets.

  • Ipso Facto, durable income assets such with their relatively low correlation to stocks and bonds, are likely to carry a lower premium than assets (such as leveraged buyouts), which are highly correlated with public equities.

Length of lockup and redemption frequency. An asset with a longer lockup is more restrictive than an asset with a shorter lockup. It should therefore "pay" the investor a higher illiquidity premium.

  • Ipso Facto, medium term durable income programs such as those typically found in 5 to 7 year investing in net lease 'should' pay a lower illiquidity premium than say opportunistic real estate funds with a 10 to 12 year fund life.

Conclusion

The tradability premium that illiquid assets appear to earn suggests that they can be attractive additions to a portfolio, as well as often serve as a source of durable income. But how attractive they are will depend in part on how each investor values liquidity. Investors will need to determine their own allocations to illiquid assets based on considerations such as their tolerance for risk, cash flow requirements (and time horizons), reinvestment opportunities as well as portfolio rebalancing frequency. Because there is a premium for non-tradability, in addition to the premium for risk, investors may benefit from portfolio construction choices that incorporate less liquid sources of durable income.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.