Illiquid assets

GLOBAL INVESTOR 1.15 — 11 >
Liquidity premium
Psychology
and (il)liquidity
Maintaining a certain amount of liquidity in a portfolio is fully justified, but investors tend
to pay up too much for it while underestimating the extra returns from holding illiquid assets.
The overpricing of liquidity seems to be greater in equities than in bonds, in part because
in equities the price is strongly influenced by “stories,” whereas in bonds it is dry mathematics.
INTERVIEW BY OLIVER ADLER Head of Economic Research, JOSÉ ANTONIO BLANCO Head Global MACS,
SID BROWNE CIO and Head of Research Liquid Alternatives
Sid Browne: Economic theory states that
there should be a premium available for
accepting illiquidity. You’ve studied premiums
– and associated risks – attached to
both illiquid and liquid assets. What can you
tell us about your findings in general within
a portfolio context? How should institutional
and private investors invest?
Roger Ibbotson: Let me start off by
saying that the stocks that I study are actually
publicly traded stocks. They may be less
liquid than the most liquid stocks, but they’re
all liquid stocks. There’s a strong theoretical
reason why you’d expect less liquid stocks,
in fact less liquid assets of any type, to be
lower valued. People want liquidity, and
they’re willing to pay for it. They pay a higher
price for the most liquid assets, and therefore
the less liquid assets sell at a discount.
That discount means that, for the same
cash flows, you pay a lower price and
sub sequently you get higher returns. Now,
what’s especially interesting in liquid markets
is that giving up a little bit of liquid -
ity actually can have a surprisingly big
impact – by buying stocks that trade every
hour, say, as opposed to every minute.
José Antonio Blanco: From an investor’s
perspective, could you call the effect you’ve
just described a risk premium, or is it
instead the result of market inefficiency in
the sense that investors focus on certain
companies and disregard the rest?
Roger Ibbotson: It could be both.
You can create a risk factor from a liquidity
premium. But I am rather thinking of
something I call a “popularity” premium,
which I’ve expanded on in recent papers.
The stocks that trade the most are the
most popular. And those are the ones
where there is mispricing because they get
to be “too” popular, as measured for example
by their heavy trading. Interestingly, our
measures of stocks that trade less show
lower volatility. So these stocks don’t really
seem more risky. Therefore I don’t really
like calling the extra return a risk premium.
Sid Browne: What about in the event of a
squeeze, when all of a sudden you want
liquidity and rush to sell your illiquid stocks?
Isn’t there that flight-to-quality risk?
Roger Ibbotson: There could be the risk
of having to sell quickly. In actual experience,
though, for example in 2008 when you had
a kind of a liquidity crisis, it was the most
liquid stocks that were sold and dropped the
most. So even in a financial crisis, the less
liquid stocks do relatively well compared to
the more liquid stocks. Now it is true that it
is more difficult to sell the less liquid, and