By Cliff Asness
In his recent post, Cliff Asness reconsiders the conventional wisdom that investors demand a return premium for bearing illiquidity - "that illiquidity is a bad thing for which you need to be paid extra for taking it on". He considers whether many investors knowingly accept a lower return for very illliquid assets and the the privilege of not regularly being told their prices.
Conventional wisdom is that you get an expected return premium for bearing illiquidity. Illiquidity is a bad thing, and, all else equal, you need to be paid extra for taking it on. But, what if this is backwards? What if investors will actually pay a higher price and accept a lower expected return for very illiquid assets?
I have a long history of odd conversations about private investing and my thinking about it has evolved over time. When I was much younger (like 25 and working at Goldman Sachs Asset Management), I thought that PE managers believed that their investments were “uncorrelated” to traditional markets and I thought that this was dumb. In my defense there was some evidence for this idea. I recall many presentations back then that explicitly claimed this silly lack of correlation. And, there certainly were some who actually believed it to be true. But, even back then, and increasingly over time, I think that many, and perhaps nearly all investors in PE today, would say that over long horizons PE is very correlated to public equity. If we have a ten-year bear market for stocks, which many have forgotten can occur but I promise is at least possible though rarely the expected case, I think most of our forecasts for private equity would be for some fairly extreme pain and for it not to act as a big portfolio diversifier. I used to think that was a vital point that was not understood. I haven’t changed my view that PE is actually quite correlated to traditional markets (particularly a portfolio of PE investments which will, like all portfolios, diversify away much of the idiosyncratic risk). But, I now think that this really isn’t the vital point at all. That means that in the past I wasn’t so bright, and others so benighted.
If people get that PE is truly volatile but you just don’t see it, what’s all the excitement about? Well, big time multi-year illiquidity and its oft-accompanying pricing opacity may actually be a feature not a bug! Liquid, accurately priced investments let you know precisely how volatile they are and they smack you in the face with it.
What if many investors actually realize that this accurate and timely information will make them worse investors as they’ll use that liquidity to panic and redeem at the worst times? What if illiquid, very infrequently and inaccurately priced investments made them better investors as essentially it allows them to ignore such investments given low measured volatility and very modest paper drawdowns? “Ignore” in this case equals “stick with through harrowing times when you might sell if you had to face up to the full losses.” What if investors are simply smart enough to know that they can take on a lot more risk (true long-term risk) if it’s simply not shoved in their face every day (or multi-year period!)? Could the same investor who finds private equity easy to stick with also find a levered publicly traded small-cap portfolio impossible to stick with even if they’re economically very similar investments?
Sounds pretty plausible to me. Of course, the question is whether this stick-to-itiveness comes at a price (lower expected returns than the comparable risk but liquid and marked-to-market investment) and, if so, is that price large or small, and is it generally accepted as a cost of an easier ride or hidden? For instance, are investment committees being told “we like these investments, even at a potential return discount to comparable liquid aggressive investments, because we’ll all be better off in the long term if we just have less information”?
While I phrase it somewhat sarcastically above, I’m not sure there’s anything wrong with such tricks. Investors have used simple heuristics, even ones that are silly in some ways, for as long as there’ve been investors. Someone in ancient Rome was likely a better investor because an investment that was really down L% only showed up as down XXV% in his or her quarterly report scroll. As an example, take dollar-cost-averaging. It’s dumb. To prove that, imagine you were handed two portfolios, one the final equity portfolio you really want, the other all cash. Many, even most, investors wouldn’t immediately buy the final desired equity portfolio. No, that risks massive regret. Not buying any also risks massive regret. But if you average in slowly, perhaps you minimize this regret? But it’s a silly thing to do on just the numbers. For instance, if you were handed the all-equity portfolio you actually ultimately wanted, instead of being handed cash, you would not sell it just to average back in, would you?
Of course not. So, the averaging-in strategy is silly. But silly perhaps only to a Vulcan. What if it leads to better outcomes for the non-Vulcans? What if the investor were right, they can’t take the regret, and that might lead them to do things like panicking and selling back out if they buy in immediately and markets dive? Just showing that an action isn’t rational in a narrow return/risk sense doesn’t mean that it isn’t rational in a broader sense.
The preference for illiquid, infrequently-priced assets that don’t smash you in the face with their volatility (even though it’s really there) could be rational in the same sense. Perhaps a levered small cap portfolio is a rational investment for long-term investors, but there’s little chance they’d stick with it full-cycle. However, they find PE easy to stick with?
It’s not hard for me to imagine these are both true for some (or many).
Finally, to address our main topic, what’s the next implication of extreme illiquidity and pricing opacity being a feature not a bug? Well, you pay up in price (and give up in expected return) for features you value (not bugs you can’t stand). Attractive smoothness of returns may not come for free. If illiquidity is more positive than negative to many investors, it could easily mean paying a higher price and accepting a somewhat lower return to obtain it. Sounds really counter-intuitive, I know. But it also sounds, to me, pretty plausible.
Given the fees and other features of PE, is it hard to imagine that investors are paying up a bit in price, and accepting a modestly lower net expected return (than, say, an analogous levered small-cap portfolio) to get something they know they will stick with? Opinions can vary, but I don’t think so.
So, I think it’s entirely possible that investors are accepting a discounted expected net return (though discounted from a high level as we are starting with levered small-cap not a low-risk, low-return investment) for the privilege of not being told the prices.
That may be frustrating to those of us who live in the violent world of liquid, accurate, mark-to-market pricing. But, that doesn’t mean it’s crazy. It may be stone cold rational (in that broader sense). And while my discussion has focused on PE, the idea applies to all illiquid assets with smooth returns.
There really may be an illiquidity discount (in expected returns) with the opposite sign from the illiquidity premium we’ve always assumed. Many know that in PE they’re getting some serious smoothing, and a palatable (as it’s way understated) reported volatility. But it’s likely that many still assume they’re getting a return advantage also.
It seems very plausible that only one half of that free lunch may be true. Mind blowing I know.
I mean, let’s get real, does anyone seriously doubt that at least part of the attraction of PE, and its wildly growing popularity, is an increasing acceptance among investors that they will have to get very aggressive to reach their goals (e.g., underfunded pension plans and the like), but still possess an absolute aversion to living under the true reported volatility this aggression entails? I’ll end by making the self-serving message implicit throughout this piece explicit. Liquid, truly uncorrelated alternatives actually diversify a portfolio both short- and long-term. They offer real diversification, not the diversification that comes from not reporting actual returns. But, when they have very painful periods (as you may have noticed!) you have to live through it in all its excruciating glory. This is perhaps a better portfolio than very correlated alternative assets possibly at an expected return discount. But only better if you can indeed live with it. If investors are going to move from a better portfolio to a worse one because it’s easier to live with, that may, yet again, be rational, but they should be open-eyed about what they’re doing.
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