The Illiquidity Risk Premium and Expected Returns

The Illiquidity Risk Premium and Expected ReturnsWe talk a lot about liquid alternatives here at DailyAlts, but many alternatives are illiquid, and they still have a role to play in investors’ portfolios. While liquidity is often an attractive feature, investors do have to pay for it. Similar assets with less liquidity have to offer the potential for higher returns in order to compensate – this is known as the “illiquidity risk premium.” Willis Towers Watson explores this phenomenon in a white paper titled Understanding and Measuring the Illiquidity Risk Premium.

What is Liquidity?

Willis Towers Watson measures an asset’s liquidity based on the degree to which it can trade in sufficient volume without negatively impacting price.

Ultimately, all assets fall somewhere on the liquidity spectrum – certain public stocks are more liquid than others, and U.S. Treasury bonds are more liquid than investment-grade corporate bonds, but all would be considered “liquid” assets. Among illiquid assets some are less liquid (or more illiquid) than others, too.

Illiquidity Risk Premium

Less-liquid assets should offer the promise of higher returns relative to similar assets of greater liquidity. If they didn’t, then there would be no sensible reason for investors to choose the less-liquid asset over the more-liquid one. The premium demanded for a less-liquid asset over its more-liquid counterpart is known as its “illiquidity risk premium” or “IRP.”

What determines how much IRP an asset commands? First and foremost, the aggregate IRP demanded by the sum of each participating investor’s “utility function” – i.e., how much they personally value liquidity. All things equal, everyone would prefer liquidity – but investors may be able to sustain some illiquidity over a portion of their portfolio, so long as they’re duly compensated.

Other factors impacting IRPs include the degree of the asset’s illiquidity and volatility. Less-liquid, more-volatile assets command higher IRPs than more-liquid, less-volatile comparables. And since illiquid assets trade infrequently, volatility of cash flows – rather than price volatility – tends to be a better measure of the volatility factor.

Estimate of average required IRP

Calculating Expected IRP

Willis Towers Watson offers the following method for calculating expected IRP:

  1. Determine expected yield
  2. Subtract the appropriate “risk free” rate (i.e., government bond yields of similar maturity)
  3. Adjust for credit risk and other risk premia

The Building Blocks of Expected Returns

IRP Drivers

Individuals have their own unique “utility functions,” so the attractiveness level of the IRPs offered by the market can vary over time. What drives the fluctuations in aggregate IRPs? Central bank intervention has been the primary culprit as of late, with quantitative easing (“QE”) explicitly and intentionally driving down all risk premia, IRPs included. And while the U.S.’s Federal Reserve is expected to begin tightening monetary policy later this year, global central banks – most notably the European Central Bank (“ECB”) and the Bank of Japan (“BOJ”) – are still implementing QE policies.

ECB and BOJ Balance Sheet Expansion is Driving Easy Global Liquidity Conditions

Given the expected continuation of these policies, IRPs may be depressed for some time to come, but does that mean there’s no place for illiquid alternatives within investors’ portfolios? No, but with the reward for holding them lower than it otherwise would be, illiquid alts are marginally less attractive for the time being.

For more information, download a pdf copy of the white paper.