Paths to illiquidity November 1, 2018 A healthy mix of liquid and illiquid investments offers institutional investors returns and the necessary security. Ensuring that a portfolio has some degree of liquidity is sensible and necessary for institutional investors such as pension funds. However, they tend to pay too much for it and underestimate the additional returns that can be generated with illiquid investments. Optimum allocations with a long investment horizon Institutional investors such as pension funds or foundations generally have a long investment horizon. Preferably, optimal allocations for a long time horizon include a higher proportion of less liquid asset classes. These typically include directly held real estate, but also alternative investments such as private equity, infrastructure investments or insurance-linked strategies. Illiquidity premium improves portfolio returns Higher illiquidity involves risks for which investors want to be rewarded by a premium. This liquidity premium, or rather illiquidity premium, is therefore, an additional source of return that investors demand for holding investment instruments that are rarely traded. Such illiquid asset classes thus offer institutional investors the opportunity to improve their portfolio returns while at the same time increasing planning certainty due to their often fixed investment horizon. Less market volatility with illiquid investments With illiquid investments, investors are much less exposed to daily market volatility. Moreover, short holding periods for illiquid asset classes are not efficient because buying and selling illiquid assets reduces the illiquidity premium or even leads to negative returns due to inefficient market access. Practical indicator: bid-ask spread Liquidity refers to the ability to sell (liquidate) an investment quickly. For many asset classes, the bid-ask spread is a well-known and practical indicator. It represents the costs incurred when an investment is sold on the market and immediately bought back. The size of the bid-ask spread depends primarily on the liquidity of the trade. Differentiated view is necessary However, the liquidity of asset classes must be viewed in a differentiated and multidimensional way. For real estate, for example, the bid-ask spread is not easy to determine. Other investments vary in the course of the cycle and are, for example, highly liquid in an upswing or at their peak and not in a crisis. And the type of investment also plays an important role, as closed-end funds can deviate from the value of the underlying investments. Illiquidity over alternative asset classes Real estate and alternative asset classes such as private equity, infrastructure, insurance-linked strategies or alternative alpha/beta strategies are distinguished from traditional asset classes such as listed equities or bonds by specific features such as risk premia and varying degrees of illiquidity. Reasons for alternative asset classes There are essentially three reasons that count in favor of alternative/illiquid asset classes: First, due to their long-term illiquidity, alternative investments offer a high return potential. It delivers the premium that investors demand. Second, alternative investments typically have little or no correlation with traditional asset classes, resulting in a lower overall portfolio risk. Third, the volume is relevant. The market volume of alternative investments is larger than that of traditional investments. USA: Real estate market bigger than the stock market The real estate market in the US, for example, is bigger than the US equity market. In the US as well as in Europe, there are significantly more companies with sales over USD 100 million that are not listed on the stock exchange than those that are. How liquid are individual asset classes? A study by the National Bureau of Economic Research looked at the time it took to complete a transaction and the annual turnover of various investment funds with the result that most asset classes are rather illiquid (see box). Illiquid assets typically include directly held real estate, private equity and infrastructure investments. Exceptions are asset classes like equities and bonds, which can generally be described as liquid. Liquidability of collective investment schemes In the case of long-term and illiquid investments, such as private equity investments, investors usually make their capital commitment to the target fund. This means that the capital is normally blocked for around 8 to 10 years. As there is no public market, the underlying assets are not readily tradable. No public market prices for private equity investments While there is a secondary market for existing private equity investments, there are no public market prices. What is more, the sale process can take several weeks. Typically, such illiquid vehicles are closed after the subscription period. As private equity investments are subject to a predefined term, they are particularly suitable for investors with a long-term investment strategy. Expert knowledge is essential With increasing illiquidity, the main source of return is different. It shifts from the broad market movement towards expert knowledge. Vehicles such as private market investments require solid know-how and many years of experience. Investors do not only need knowledge of various investment segments such as venture capital, buyouts and special situations, but also have to be versed in regulatory and tax frameworks. In such areas, it is recommended to choose an experienced manager who has the expertise to navigate a investment to exit. Preference should be given to managers who above all pursue an active strategy and an innovative, transparent and cost-efficient structure. The more illiquid an investment, the higher the returns To conclude, we can say the following about the various asset classes: The more illiquid an investment, the higher the returns (see chart). Sources: Based on Antti Ilmanen (in his book "Expected Returns", 2011). Subjective illiquidity estimate according to Antti Ilmanen. Average annual returns from January 2009 to December 2017, Bloomberg, GAM, Cantab, Zurich Invest AG. Past performance is not an indicator of future performance. Source: Schweizer Personalvorsorge 07/18 Liquidity of different asset classes Asset class Transaction time Turnover p.a. Public equities Within seconds more than 100% OTC (1) equities Possible within one day, many within one week 35% US government bonds Within seconds more than 80% Corporate bonds minutes to within one day 25-35% Private equity 12 to 14 years; secondary transactions exist, but illiquid less than 10% Real estate Direct: Sale up to 6 months Open-End funds: up to 1 year 4-7% Infrastructure 12 to 14 years; secondary transactions exist, but illiquid less than 10% (1) OTC stands for "Over-the-Counter" and stands for a share that is not traded on a stock exchange but in a separate market via a broker. Sources: Ang, Papanikolaou and Westerfield (Working Paper of the National Bureau of Economic Research (NBER), 2013), Research Paper 2 / 2018 by PPCmetrics, Zurich Invest Ltd.