Imagine an investor at a cocktail party: one guest is holding a glass of water $($cash$)$, another has a freshly squeezed orange juice $($stocks$)$, and then there’s the third — clutching a rare bottle of aged scotch locked in a vault $($private equity$)$. Welcome to the world of illiquidity premiums — where holding on longer may mean higher returns… or just warmer beer.
Let’s uncork the truth about illiquidity and figure out when (and how) investors get paid for being patient.
🧠 Illiquidity Risk Premiums – Across and Within Asset Classes
💹 Illiquidity Risk Premiums Across Asset Classes
It’s long been believed that illiquidity = more return. Why? Because if you’re locking up your money like Rapunzel in a tower, you’d expect a princely return to come save it.
Antti Ilmanen’s legendary book Expected Returns gives us a snapshot of this idea. Between 1990 and 2009:
- Venture Capital $($super illiquid$)$ earned the highest expected return: ~17%.
- Buyouts and Timber were also illiquid, with expected returns around 12–13%.
- Hedge Funds: slightly more liquid, expected returns ~12%.
- Real Estate: more liquid than hedge funds, lower returns $($~8%$)$.
- Equities and Cash: very liquid, lower returns $($~4–5%$)$.
🧭 Key Term: Illiquidity Risk Premium is the extra return an investor demands for holding an asset that can’t be easily sold.
But wait — don’t sip the Kool-Aid just yet.
If illiquid assets yield more, shouldn’t we all go buy art, timber, and abandoned castles?
🚨 Caution: The Illiquidity Mirage
Here’s where it gets interesting. That extra return — the so-called illiquidity premium — may be overstated. Why?
- Reporting Biases: Returns are smoothed, risks are understated. (Think: airbrushed selfies of portfolios.)
- Hidden Risks: Private equity and real assets carry risks beyond just illiquidity (like operational and leverage risk).
- No Index Investing: You can’t just buy “the S&P 500 of Timber.” Indices in private markets are not investable.
- Manager Dependence: Your returns depend heavily on manager skill — not market performance.
So, if the “premium” across asset classes is possibly a myth, where is the premium real?
🧬 Illiquidity Premiums Within Asset Classes
Ah-ha! Within the same asset class — say, corporate bonds — less liquid securities tend to offer higher returns.
🧪 Why? Well, the jury’s still out, but theories include:
- Investors overpay for illiquid asset classes in general.
- Institutions manage portfolios in silos — the fixed income team doesn’t chat with the real estate team at lunch.
- Capital moves slowly across markets, making arbitrage difficult.
If this applies even in liquid markets, what does it say about supposedly ultra-liquid instruments like $U.S.$ Treasuries?
💵 Illiquidity Effects in U.S. Treasury Markets
Believe it or not, even the mighty Treasury market isn’t immune.
- On-the-run Treasuries $($just issued$)$ are more liquid and trade at lower yields.
- Off-the-run Treasuries $($older issues$)$ are less liquid, so they offer slightly higher yields.
During the 2007–2009 crisis, some $T$-bonds traded at prices 5% lower than comparable $T$-notes. In the most liquid market in the world, illiquidity showed up like a magician’s rabbit — unexpectedly, but undeniably.
If Treasuries have liquidity problems, what’s happening in riskier bond markets?
🏢 Illiquidity in Corporate and Equity Markets
📈 Corporate Bonds
- Illiquidity explains 7% of investment-grade yield variation.
- For junk bonds: a whopping 22% is explained by illiquidity.
- Example: A 1 basis point increase in bid-ask spread can cause a 2+ basis point jump in yield spread. (That’s leverage, baby!)
📊 Equities
Less liquid stocks tend to earn higher returns. Factors impacting this include:
- Bid-ask spreads
- Turnover
- Volume
- Quote depth
- Trade frequency
- Price impacts
- Return autocorrelation $($aka “stale prices”$)$
🧪 One famous metric: Amihud measure — price movement per dollar of trading volume.
Studies suggest illiquidity risk premiums range from 1%–8%, and can be much higher in OTC stocks $($up to 20%$)$.
So we see the premium exists. But how can investors actually access it?
🔄 Secondary Markets: Private Equity & Hedge Funds
Secondary markets offer escape hatches… kind of.
🏗 Private Equity
- Secondary buyouts $($funds trading companies$)$: ~15% of buyout deals in 2005.
- Selling fund stakes: Discounts ranged from 30–50% in 2008–09.
🧨 Example: Harvard had to sell private equity at 50% discounts in the 2008 crisis. Imagine a fire sale at the Ivy League!
🧳 Hedge Funds
- More flexible — you can redeem at predetermined dates.
- Discounts during 2008–09 were 6–8%, sometimes even premiums if the fund was high-demand and closed to new investors.
Clearly, there’s potential to profit — so what’s the best way to harvest this premium?
🌾 4 Ways to Harvest Illiquidity Premiums
- Passive Allocation: Invest a chunk of your portfolio in illiquid assets like real estate or private equity. Long-term, hands-off.
- Liquidity Security Selection: Pick less liquid assets within an asset class $($e.g., small-cap stocks over large-cap$)$.
- Be a Market Maker: Act like DFA or a sovereign fund. Provide liquidity to others by buying low and selling high, responsibly.
- Dynamic Factor Strategies: Go long illiquid assets, short liquid ones. Rebalance frequently. This counter-cyclical approach helps harvest the premium when others panic.
These are powerful. But how should you allocate illiquid assets in a real portfolio?
🧮 Portfolio Allocation to Illiquid Assets
🤔 What to Consider:
- Investment horizon
- Cash needs
- Manager monitoring
- Transaction costs
- Rebalancing constraints
🔄 Problem with Models
Most asset allocation models assume: “Just pay the transaction cost and you’re good.”
But that’s not reality. If no one’s buying your office building in mid-crisis, you’re stuck. Even due diligence can take months. There are no free lunches in private markets.
🍞 And You Can’t Eat Real Estate
Liquidity = the ability to convert an asset to cash to fund consumption. Hence, even if private equity returns 6% more than public stocks, it doesn’t help if you need cash for payroll tomorrow.
💡 Portfolio Allocation Impacts:
- Reduces optimal holdings: The longer you wait to sell, the less you should hold.
- Rebalancing is tricky: You can’t always shift weights to stay on target.
- Consumption is limited: If you can’t trade it, you better spend less.
- No arbitrage: You need trading opportunities for true arbitrage.
So, is it all worth it? Should you dive into illiquids or keep it simple?
🎯 Final Thoughts: Should You Bet on the Illiquidity Premium?
Let’s recap:
✅ Illiquid assets can deliver extra returns.
❌ But those returns are not guaranteed, and often overstated.
🧠 Success requires skill, scale, and patience.
💼 Endowments like Yale and Harvard?
Yes — they have the team and tools to pull this off.
🤹♀️ DIY investor with a brokerage account?
Maybe not so fast.
💡 Conclusion: Illiquidity offers opportunity — but only for those who can survive the ride and understand the risks. And remember, when liquidity vanishes, even the strongest portfolios can become paper tigers.