Wednesday, 2 November 2016

Generally speaking for an asset or investment to be considered liquid, you expect to be able to liquidate the asset rapidly without negatively impacting the price or value of the underlying asset or investment. Conversely, for something to be considered illiquid, it is not possible to access your money quickly without affecting the price of that investment.

This foregone flexibility is also known as “opportunity cost” as the investment cannot be readily liquidated to take advantage of other emerging opportunities. The cost of illiquidity can also be inflated depending on the uncertainty of the cash flows associated with investing in a particular illiquid asset. The longer the money is tied up, the longer the period of unknown outcomes. A premium (known as the “illiquidity risk premium”) is therefore required to compensate investors for these possible outcomes as well as the opportunity cost.

When we invest in illiquid assets to access the illiquidity risk premium, we don’t do so blindly. We need to make sure that the premium available adequately compensates for the above two costs. So just how much is this premium worth?

In practice for most illiquid assets, quantifying the risks and associated risk premium involves a reasonably large amount of subjectivity and it can be difficult to estimate what this is worth. It also varies with each individual asset – especially those that have a higher uncertainty around cash flows.

A simple, real life example of the illiquidity premium in action is in the interest rates offered by your bank on the various dated term deposits. Below is an example of term deposit products that might be offered by a bank:

  At call 3 months 4 months 6 months 12 months 24 months
Deposit Rates 
(p.a.) 
2.30%  2.35%  2.50%  2.55% 2.65% 2.70%

Source: This information is provided for illustrative purposes only. It is a hypothetical case study.

You can see that the longer the time period the money is locked away in a term deposit, the greater the amount of interest earned1. Among other things, this would be in recognition of the longer period of time the investor (or depositor in this case) is willing to forego the flexibility of having these funds available for other uses.

You can also see the increase in the interest rate as the term of the deposit gets longer is only marginal. This could be explained by the fact that with term deposits from a highly rated Australian bank, there is a very high level of certainty that underlying payments will be made and the investment will perform as expected. As such the illiquidity risk premium is priced fairly modestly.

If the example was for a different investment with less certainty around underlying cash flows (a private equity investment for instance), you would expect to see a much higher illiquidity premium over the different time periods to compensate. For private equity, we expect a premium of over 3% per annum above the return of listed share markets given degree of illiquidity and uncertainty of outcomes for a portfolio of private companies.

So where is the illiquidity premium available and how does QSuper access it?

The chart below shows the asset allocation of QSuper’s Balanced Investment Option as at 30 June 2016. We generally seek an illiquidity risk premium from our investments in real estate, infrastructure and private equity assets.

QSuper Balanced Investment Option – Asset Allocation as at 30 June 2016 

Balanced investment option graph_asset allocation 300616

Source: QSuper Website Balanced Option (https://qsuper.qld.gov.au/our-products/investment-options/readymadeyourchoice/balanced/)

As the next chart shows, together these asset classes make up approximately 26 per cent of the Balanced Option. We recently wrote about the illiquidity premium when investing in real estate and it is similarly an important consideration when investing in any of the privately traded asset classes.

QSuper Balanced Investment Option – Asset Allocation as at 30 June 2016

Balanced investment option graph_asset allocation 300616 26percent

Source: QSuper Website Balanced Option (https://qsuper.qld.gov.au/our-products/investment-options/readymadeyourchoice/balanced/)

But while it’s great we can expect to be compensated through the illiquidity risk premium for holding these assets, what are the challenges?

Liquidity risks require careful management and this is something that QSuper is acutely aware of. We’ve spoken before about how we carefully monitor and manage the Fund’s liquidity in order to carry out day-to-day activities such as making member payments and purchasing assets as required. In addition, there are a few features of illiquid assets which make them a natural fit for QSuper.

For example, real estate, infrastructure and private equity are assets we expect to generally hold over a medium to long term time frame. This aligns nicely with the liquidity or drawdown profile of super funds and our QSuper members – where there is a very long period over which super is accumulated and income payments are drawn.

It’s generally easier for large institutional investors like QSuper to access these illiquid assets than retail investors. In fact super funds have an advantage in accessing the illiquidity premium due to their mandated nature and the scale that results from the large pool of funds that we manage on behalf of hundreds of thousands of members.

The expected extra return from the Illiquidity Premium is one reason to invest in illiquid assets but it isn’t the only consideration. As with all our investment decisions, the overall risk / return profile is regularly reviewed to ensure adequate compensation is being received for the risks that we are taking. The illiquidity risk premium is however an important consideration when we are looking to invest in these asset classes and given the long-dated drawdown profile of our membership, provides an attractive avenue for accessing returns over a long time horizon.


1. This is generally the case where interest rates are higher for the longer the term of the deposit however it is not always the case.  There are times when there are expectations of future interest rate falls larger than the illiquidity premium.  For illustrative purposes, I have not considered this scenario.

The views of the author are not necessarily the views of the QSuper Board. We’ve put this information together as general information only and as such it doesn’t take into account your personal financial objectives, situation or needs. You should get professional advice before relying on this information.

Past performance is not a reliable indicator of future performance. Each of our investment options has a different objective, risk profile, and asset allocation.

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