When institutional investors allocate to private equity assets—and the data suggest that many are seeking to do more and more of this in the years ahead—they face a range of complexities that are absent in public markets. High on the list is the liquidity of the asset class, or more precisely, its lack thereof. Liquidity is among those financial concepts—like “risk”—that have multiple correct definitions. So when you have a conversation about it, it’s helpful to define it first so everyone is aligned. In this case we are talking about what is sometimes called funding liquidity: the impact that illiquid assets have on the broader multi-asset portfolio.
For most investors, the starting point in defining their asset allocation is mean-variance analysis. Introduced by Nobel laureate Harry Markowitz in his legendary 1952 article, this framework enables investors to identify a portfolio allocation that maximizes return for a given level of risk. Though it is sometimes criticized, we believe much of this criticism is misplaced. Nearly 70 years after its introduction, the construct is remarkably robust. Having said that, there are occasions where it can benefit from some enhancements. And liquidity is one such occasion.
We have discussed liquidity challenges with some of the world’s biggest and most sophisticated investors. Before we discuss how investors should approach it, it can be helpful to discuss some of the most important and persistent misconceptions.
Misconception #1: We have positive cash flows, so we don't need to worry about liquidity risk.
This one is widespread. For organizations in the enviable position of having more than enough cash coming in each month to meet their demands, it's tempting to just write off liquidity risk altogether. Here’s the problem with that. The ability to meet cash demands isn’t the only benefit that liquidity imparts to an investor. Consider rebalancing. Research—and common sense—suggest that investors can benefit by periodically rebalancing their portfolios back to target weights. But when a large fraction of the portfolio is immobile, rebalancing gets harder. Also, think about tactical asset allocation. Some investors have skill in forecasting returns and reallocate their portfolios dynamically to enhance returns. But if a chunk of your portfolio is locked up, your ability to deploy this skill is hampered. It is impossible to deploy a monthly trading strategy for private equity, no matter how good your forecasts are. The point is that investors bear an opportunity cost to the extent that any portion of the portfolio is immobile. And they need to take this into account.
Misconception #2: Assets that are less liquid should offer an illiquidity premium that should be priced in, so we don’t need to account for it.
This one is also tempting because it’s theoretically clean. And it is likely even true in many cases. Unfortunately, the illiquidity premium that is priced in reflects the liquidity profile of the AVERAGE investor. To the extent that a given investor has more near-term liabilities and therefore needs a more liquid portfolio—or, on the opposite end of the spectrum, has cash inflows and a long horizon and therefore needs less liquidity—a given illiquid asset may be more or less attractive. Assets have a price but there are an infinite number of liquidity profiles. Liquidity is personal. And investors need to account for their own situation when evaluating assets.
Misconception #3: Liquidity is a separate feature of a portfolio that is distinct from its risk and return.
The most common approaches to addressing liquidity risk take this view. For example, they might constrain liquidity not to fall below a certain level. Or they might assign arbitrary liquidity scores to assets and ensure that the score is greater than or equal to a particular threshold. The problem with this approach is that it is ad hoc. You can’t make informed tradeoffs between return, risk and liquidity decisions. In fact, liquidity can be translated into risk and return units. Imagine opening two brokerage accounts. One is prohibited from trading and the other allows trading. Both start with the same portfolio allocation. After a few years, all else equal, we’d expect the liquid account to have a higher return. The investor was able to rebalance it and deploy tactical skill. The bottom line is that liquidity has direct implications for risk and return, and if we translate it into this language, we can make better decisions.
Bearing these misconceptions in mind, what is an investor to do?
Thankfully, the remedy is straightforward: we need to recognize that liquid assets bring additional benefits to a portfolio, while illiquid assets impose additional costs.
There are many ways to benefit from trading. One is to tilt portfolio weights to capitalize on predictive skill. Another is to take advantage of new investment opportunities that arise over time. In these ways and others, investors ‘play offense’ by striving to make their portfolios better. Tradeable assets like listed stocks, bonds, and commodities, facilitate all of this. In other words, the value of an asset is more than what it does as it sits in your portfolio. The value to you includes the potential that an asset permits you over time. These benefits to trading are called ‘shadow assets,’ and they should be attached to all the tradable assets you own.
On the other hand, some assets like direct property or private equity cannot be sold. Or, it would be so costly that it simply doesn’t make sense. These illiquid assets prevent investors from exercising good portfolio hygiene. You may want to ‘play defense’ by rebalancing your portfolio’s weights, or by exiting unproductive investments, but you can’t. In other words, these assets reduce your opportunity as they sit immobile inside the portfolio. These costs are called ‘shadow liabilities,’ and they should be attached to all the non-tradeable assets you own.
Shadow assets and liabilities are unique to each investor. They represent the value that specific investor derives from trading, or foregoes by not trading. So how large are these shadow values? To find out, we can simulate thousands of hypothetical futures for an investor and his or her portfolio. In each trial run, we generate unbridled paths for asset returns, plus demands for cash that mimic the investor’s real-world situation. And we record how much better off, or worse off, the investor is when we account for liquidity than if we ignore it. These values become the shadow assets and liabilities.
The beauty of simulations is that they can be as simple or complex as we need. For instance, the liquid assets confer benefits, but they are not free to trade. So we deduct transaction costs from each trade, thereby lowering the net benefit of each shadow asset. We can even model distress scenarios like the 2008 financial crisis, where extreme levels of illiquidity might have forced investors to borrow money at punitive rates in a pinch. All of these realities accrue to the shadow assets and liabilities.
This entire approach is quite convenient because it works with any existing portfolio construction method. Once the shadow allocations are in place, they are just additional inputs to the process. Mean-variance optimization makes it easy to attach shadow assets, and by the benefits or costs they afford you may find dramatically different portfolios. Those who favor a more intuitive approach to portfolio formation can do the same, weighing the pros and cons at the portfolio level.
In summary, liquidity is a concept that takes many forms. It differs across assets, and its usefulness differs across investors. But at the end of the day, liquidity matters because it affects the two most fundamental aspects of investing: return and risk. We need to consider assets that cost money to trade alongside those that can’t be traded at all. We need to consider opportunity costs alongside crisis survival. We need to consider unique investor profiles alongside aggregate market prices. What we want is a non-arbitrary, unified approach. Shadow allocations provide it.
This is a part of a broader series by State Street:
William Kinlaw is a Senior Managing Director and Global Head of State Street’s academic affiliate, State Street Associates, a unique partnership that bridges the worlds of financial theory and practice.
David Turkington is a Senior Managing Director and Head of Portfolio and Risk Research at State Street Associates.
The views presented in this article are solely those of the authors and do not necessarily reflect the views of State Street Corporation or its affiliates.