Risk appetite of long-term investors shows mixed attitude towards illiquid assets

Academic research and survey results on portfolio construction and the relative merits of investing in illiquid assets such as hedge funds for long-term institutional investors show diversity is key.

As part of a recent survey of the asset liability management (ALM) practices of European pension funds1 taken from the AXA Investment Managers (AXA IM) ‘Regulation and Institutional Investment’ research chair at Edhec Risk Institute, we looked at both the academic background and survey results on the construction of a performance-seeking portfolio and the relative merits of investing in illiquid assets, such as hedge funds, for long-term institutional investors.

Alternative asset classes have diversification benefits. They also introduce risks such as uncertainty, valuation risk, liquidity risk, and possibly more significant non-financial risks.

A popular means of dealing with ambiguity risk is to use maxmin preferences, as in Gilboa and Schmeidler (1989), where investors maximise their expected utility defined in a standard way (with risk aversion as its main characterisation), but where there is a set of possible probability distributions instead of only one.

Maxmin preferences involve maximising expected utility over the worst possible distribution. An intuitive alternative, suggested by Barberis (2000), simply takes into account the higher risk of uncertainty about expected returns, a greater dispersion of possible outcomes at terminal date.

The average (individual) investor’s preferences for liquidity mean that investors must pay a premium for it. Assets that can be sold with low frictional costs – low transaction costs, for example, low bid/ ask spreads – are required. For this reason the first measures of the cost of liquidity were based on bid/ask spreads (Amihud and Mendelson 1986).

These authors introduce the notion that the liquidity cost is higher for short-term investors because the annualised impact of the trading cost, seen as a one-off cost, falls as the holding horizon lengthens. By the same token long-term investors may benefit from the liquidity risk premium by investing in assets with very high bid/ask spreads and holding them for a very long period.

Institutional investors have longer investment horizons than individual investors. Unlike retail investors, institutional investors have huge amounts of wealth to invest and the resources to analyse strategies.

Because of the nature of their liabilities, they also have more distant investment horizons. In addition, by pooling savings they diversify away the specific risk of the individual requiring liquidity in times of financial stress. Each individual is subject to the risk of unemployment after a crisis, but in all likelihood only a fraction of investors will lose their jobs at any one time, so the institutional investor can invest in less liquid securities.

Pension funds have the longest investment horizons of any institutional investors, not only because of the long-term nature of their liabilities but also because the restrictions they face in the short term are generally laxer than those of other investors. Since pension funds are not commercial entities, they cannot go bankrupt.

As academic studies point out that assets with higher bid/ask spreads have higher expected returns, long-term investors may be advised to invest in assets that have large bid/ask spreads and in general in those that have the highest premium. The fact that more than 60% of Yale University’s endowment is allocated to alternative strategies is illustrative of this pursuit of liquidity risk. The endowment’s chief investment officer notes: “Accepting illiquidity pays outsize dividends to the patient long-term investor.” (Arnsdorf 2009, p 1.)

Amihud (2009) provides the rule of thumb that the liquidity risk premium should be at least equal to the (roundtrip) trading costs times the average number of trades a year on a given security. To confirm these calculations Amihud and Mendelson (1986) estimate that a 1% increase in bid/ask spread yields a 2.5% increase in returns. These calculations were made on pre-1986 data when annual stock turnover was around 50%, much less than it is today, so they expect this excess return to have risen.

More recent estimates show the liquidity premium can be considerable. Loderer and Roth (2003) show that median-spread stocks trade at a 30% discount to zero-spread stocks (Nasdaq 1995-2001). Aragon’s (2004) analysis, more specific to hedge fund returns, shows that liquidity restrictions on hedge funds, summarised as lockup provisions and redemption periods, account for a significant share of their returns and that funds with lockup provisions have equally weighted annual returns 7%-8% higher than funds without such provisions, and value-weighted returns 4%-5% higher.

Once appropriate benchmarks for each asset class have been selected, the performance-seeking portfolio will be derived by weighting the asset classes. One-third of those surveyed invest more than 75% of their holdings in stocks and bonds. Two-thirds invest at least two-thirds of their assets in these two categories.

Mortality derivatives or reinsurance are the assets that do most to diversify away the longevity risk borne by pension funds. They are not widely used, however. Indeed, they are ignored by 46% of respondents.

Equity is the preferred asset class. On average it accounts for 32% of total allocation to the performance-seeking portfolio. Bonds seem to be relegated to hedging liabilities, as 15% of respondents have no bonds in their performance-seeking portfolios, even though bonds provide diversification benefits and can hedge against both real and nominal interest rate changes.

Outside the most liquid listed securities, one is exposed to different degrees of uncertainty and valuation risk, liquidity risk and other specific risks. Anecdotal evidence suggests the usual industry recommendation is that pension funds invest at least 30% of their holdings in alternative assets. For example, more than 60% of Yale University’s endowment is allocated to alternative strategies, an allocation illustrative of the pursuit of liquidity risk.

Most of those surveyed allocate very little to other asset classes. Average cumulative investment in hedge funds, private equity and infrastructure is 15% in continental Europe and 19% in the UK. Only 10% invest 25% of their assets or more in the following potentially less liquid securities: infrastructure, private equity, hedge funds and mortality derivatives.

Combined with real estate, however, investments in these asset classes amount to nearly 25% and only 8% of those surveyed have no real estate in their portfolios. Both statistics underscore an apparent preference for real estate as a source of the illiquidity risk premium. When real estate is accounted for, a quarter of those surveyed have more than 30% in all potentially illiquid investments.

On the whole, however, investments in alternative asset classes seem to be insufficient both to maximise diversification benefits and to gain access to the illiquidity risk premium most readily accessible to pension funds. 

Research for this article was produced as part of the research chair on “Regulation and Institutional Investment” at Edhec Risk Institute sponsored by AXA Investment Managers (AXA IM). 

Samuel Sender, Applied Research Manager, Edhec Risk Institute wrote this article.

 

Footnotes
Sender S, June 2010, “Edhec Survey of the Asset and Liability Management Practices of European Pension Funds.” EDHEC Publication. This survey was produced as part of the AXA Investment Managers (AXA IM) ‘Regulation and Institutional Investment’ research chair at EDHEC Risk Institute.

References
Amihud, Y 2009. How much is liquidity worth? (It depends when). Liquidity premium conference held in London (12 November).

Amihud, Y, and H Mendelson. 1986. Asset pricing and the bid-ask spread. Journal of Financial Economics 17 (2): 223-49.

Aragon, G 2004. Share restrictions and asset pricing: Evidence from the hedge fund industry. Working paper, Boston College.

Arnsdorf, I 2009. From coffers to cash. Yale Daily News (17 April).

Barberis, N 2000. Investing for the long run when returns are predictable. Journal of Finance 55 (1): 225-64.

Gilboa, I, and D Schmeidler. 1989. Maxmin expected utility with non-unique prior. Journal of Mathematical Economics 18:141–53.

Loderer, C, and L Roth. 2003. The pricing discount for limited liquidity: Evidence from SWX Swiss Exchange and the Nasdaq. Freiburg University conference.

 

 

 

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