The illiquidity premium puzzle
One of the sales pitches you’re sure to hear associated with prestige investments is that your inability to get at your cash quickly is a feature, not a bug. You want the illiquidity, they’ll tell you, because then you get to earn what the academic finance guys call an illiquidity premium. And because you may not need this money during your lifetime, or at least any time soon, you’re crazy not to take on the illiquidity in order to earn the extra return.
In plain English, because illiquidity is an undesirable trait in an investment, those who are willing to take it on should be compensated for doing so. In practice, this means that illiquid investments are priced somewhat cheaper than they should be, meaning that investors will get higher returns by investing in them. So, for example, the theory says that if two investments pay off $100 in two years, the liquid one might be priced at $95, while the illiquid one (which you will be unable to sell) might be priced at $90. That incremental return you get paid for accepting this sale restriction is the illiquidity premium.
The academic finance world has done a lot of serious work over the years trying to figure out how much investors are typically paid for accepting illiquidity, with estimates I’ve seen ranging from zero to as high as 10 percent per year.
And then, in 2019, fund manager and researcher Cliff Asness dropped a bomb on the whole charade with a paper he titled “The Illiquidity Discount?” In this paper, Asness asks, “What if investors will actually pay a higher price and accept a lower expected return for very illiquid assets?”
Asness made the case that because illiquid assets are not being constantly valued by market participants, owning them may actually help long-term investors behave. That is, they hide the volatility you would otherwise see if your investments were publicly traded. As he says in the paper: “Many know that in private equity they’re getting some serious smoothing, and a palatable (as it’s way understated) reported volatility.”
And so maybe one should expect a lower return in exchange for taking on illiquidity. In other words… maybe investors aren’t buying illiquid investments at a discounted price. Maybe—just maybe—they’re actually paying more for the “privilege” of not being able to panic sell their investments.
It’s an intriguing thought experiment. I don’t always agree with the conclusions Asness arrives at in his research, but he always makes me question my assumptions. This idea should force anyone chasing the illiquidity premium to question their assumptions.
Volatility lies
John Maynard Keynes is famous for the branch of economics that carries his name. But few people know that he is also respected as a very successful investor.
In the paper “Keynes the Stock Market Investor: A Quantitative Analysis,” Chambers, Dimson, and Foo deconstruct his investment track record as the bursar of King’s College at Cambridge.
The short version of the story is that once he stopped trying to time the market and transitioned his style to a more bottom-up value approach in the early 1930s, he kicked ass. His post-1932 record is one of consistent outperformance versus the benchmark.
Until Keynes came along, endowments had been invested almost entirely in real estate. He moved the King’s College portfolio into public market equities, making the case that property investments were riskier than they looked.
One must not allow one’s attitude to securities that have a daily market quotation to be disturbed by this fact or lose one’s sense of proportion. Some Bursars will buy without a tremor unquoted and unmarketable investments in real estate which, if they had a selling quotation for immediate cash available at each Audit, would turn their hair gray. The fact that you do not [know] how much its ready money quotation fluctuates does not, as is commonly supposed, make an investment a safe one.
So yes, private investments hide volatility. But just because volatility is hidden doesn’t mean that it doesn’t exist.
And seeing it doesn’t mean you should succumb to irrational fear. Keynes’s experience tells us that those who can manage their emotions and see through to what’s really happening underneath the price action can position themselves for investment success… and it doesn’t take a portfolio full of prestige investments to do so. Quite the opposite—he proved that by being able to see through the obfuscation of private markets and withstand the volatility visible in public markets, one can assemble a legendary investment track record.