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Whet your appetite for illiquidity!
Whet your appetite
for illiquidity!
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Whet your appetite for illiquidity!
Contact:
Yi Sing Ang
Consultant
+44 (0)20 7086 9008
[email protected]
Summary
Many defined benefit UK pension schemes
invest the vast majority of their assets in
highly liquid investments due to concerns
over risks associated with illiquidity.
As a result, many schemes hold more liquidity
than is needed in their portfolios.
Illiquid assets can be used to improve the
scheme’s risk adjusted return by providing:
 An illiquidity premium — Returns are
expected to be higher in illiquid assets
than more liquid investments.
 Diversification — Illiquid assets tend to
have very different characteristics from
traditional assets.
Whet your appetite for illiquidity!
Adding illiquidity helps – can your
scheme benefit?
Many UK pension schemes use active management within
their growth assets in order to:
 Diversify returns away from market beta.
 Achieve a higher long term return.
Few schemes consider adding illiquidity to their portfolio
to achieve this result.
Although individual circumstances need to be considered,
there are many pension schemes with more liquidity than is
needed in their growth portfolios and these schemes could
be missing out on an opportunity to enhance returns.
Increasing trend in the UK
Over the past few years, an increasing number of schemes
invested in various illiquid alternatives.
More recently, Central Banks worldwide implemented
quantitative easing which supported post-financial crisis
equity and bond rallies to fairly excessive levels despite muted
global growth.
With limited return potential in traditional equities and bonds,
investors have progressively diversified into illiquid assets as a
means of enhancing their portfolio return.
This trend is led by larger schemes as smaller schemes tend
to view illiquid assets more cautiously due to a more onerous
governance commitment.
Can your scheme benefit from an attractive return
potential by investing in illiquid assets?
Figure 1. Percentage of UK pension schemes that
invest in illiquid alternatives
What is illiquidity?
35
30
Illiquidity is a state exhibited by assets that cannot easily
be sold or exchanged for cash without the risk of a notable
loss in value.
25
Illiquidity is a common characteristic of long-term
investment assets such as direct real estate, infrastructure,
private equity and some hedge funds.
15
In the rest of this paper, illiquid assets are referred to as
this group of assets rather than listed equities, bonds and
cash equivalent assets even though in extreme market
conditions, some of these usually liquid investments can
also become illiquid.
20
10
5
0
2007
2008
2009
2010
2011
2012
PE
Hedge Funds
Infrastructure
What produces illiquidity?
Understanding the causes of illiquidity helps investors
make decisions on whether to invest in these assets.
Figure 2. Allocation (%) of average UK pension
schemes, 2003–2012
 Lack of buyers and sellers — The lack of ready buyers
also leads to larger discrepancies between the asking
price (from the seller) and the bidding price (from a
buyer) than would be found in an orderly market with
daily trading activity.
20
10
5
Illiquid alternatives (PE/Infrastructure/Hedge Funds)
Real Estate
Figure 1 and 2 Source: UBS Pension Fund Indicators 2013
2011
2009
2008
2007
2006
2005
2004
2003
2002
0
2001
 Uncertain valuation — Uncertainty about the value
of an asset is also a common reason which can be
caused by general financial instability or issues specific
to the asset. Investors would be reluctant to buy or sell
an asset that they cannot price with confidence. For
example, Apple shares are more liquid (tradable) than a
factory in a small rural village partly because it is easier
to value the Apple shares than to value the factory.
15
2012
2
3
Whet your appetite for illiquidity!
Diversification — Illiquid assets possess different
characteristics compared to traditional equities and bonds
so they inherently provide diversification.
The Global Trend
There has been a steady increase in allocations to illiquid
assets made by pension schemes across the world.
Although the trend is similar in the UK, it remains behind a
number of other major pension markets.
Figure 3. Allocation percentage in alternatives in
key pension markets
Gl Eq
30
16
d
er
lan
da
Sw
et
Ca
ra
na
lia
s
n
ed
e
UK
Sw
2012
Source: UBS Pension Fund Indicators 2013
Benefits of illiquid investments
Compared to traditional liquid investments, illiquid
assets can often provide a number of benefits to pension
schemes and other long-term investors.
Illiquidity Premium — Most investors would prefer to
hold liquid assets which can be sold quickly with low
transaction costs. Banks and insurers in particular are
required to hold a certain portion of liquid assets for
regulatory reasons. This means that by holding illiquid
assets, investors should expect to receive superior
risk-adjusted returns just because these assets lock
up invested funds for longer periods. Note that many
hedge funds typically require 1–6 months notice for
disinvestments so are classified as illiquid. However when
the underlying assets are not illiquid, investors do not
benefit from the illiquidity premium.
Figure 4. 10yr Expected Return/Risk characteristics
of various asset classes
10%
Private Equity
Return (p.a.)
9%
Infra
8%
Hedge Fund of Funds
5%
3%
2%
0%
UK Corps
US Corps
UK Gilts
5%
10%
Infra
HFoF
PE
1
-0.1
0.1
0.4
0.4
0.6
0.7
1
0.7
-0
-0
0
-0.1
1
0.1
0.1
-0.2
-0.1
1
0.2
0.2
0.3
1
0.4
0.3
1
0.5
UK RE
US T-Bills
15%
20%
Risk (p.a.)
25%
1
Source: 31 March 2014 Aon Hewitt Capital Market Assumptions
In liquid markets, investors react quickly to market movements
whereas illiquid assets are valued less frequently due to
fewer transactions within a limited supply. Also, investors in
illiquid assets have a long-term horizon so are unlikely to be
forced sellers in a liquidity crisis. Therefore, there appears to
be a level of protection by providing relatively more financial
market stability in times of short-term market falls.
Consideration factors
“How long has your pension scheme held a daily
trading fund without transacting?”
If your answer is “a long period of time”, it is worth
considering these key factors to determine your scheme’s
scope to add illiquidity:
Cashflow position — Pension contributions inject liquidity
and offset benefit payments, allowing greater allocation to
illiquid assets.
Future liability settlement — If a pension scheme has
at least a 5-8 year investment horizon, consider increasing
the illiquid allocation to complement its target (i.e.
self-sufficiency or buyout) end date.
Risks — A scheme may be forced to liquidate illiquid
investments in extreme market conditions. It is advisable that
stress tests are carried out for various economic scenarios.
Conclusion
US RE
6%
4%
Global Equity
UK RE
7%
UK RE
PE
N
2001
US
Jap
an
5
UK
Corps
HFoF
7
5
itz
6
st
7
nd
8
3
UK
Gilts
Infra
11
Au
10
15
12
rla
12
16
he
15
UK
Gilts
Gl Eq
UK
Corps
19
20
0
28
25
25
25
Figure 5. 10yr correlations between asset classes
30%
Source: 31 March 2014 Aon Hewitt Capital Market Assumptions
Illiquid investments are an alternative for pension schemes
to achieve long-term asset growth and diversification.
Pension schemes with a long time horizon should consider
taking advantage of such opportunities. By reducing
unnecessary liquidity and investing in appropriate longterm illiquid assets, a pension scheme can improve its
expected return and/or reduce risk.
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Whet your appetite for illiquidity!
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