This article was published in the National Post on February 15, 2020. It is being republished with permission.
by Tom Bradley
You need two ingredients if you want to earn a return above a risk-free investment such as a GIC or government bond: risk and time.
There are four types of investment risk: interest rate and credit (or default) risk relate to the fixed-income market; equity (or ownership) risk is the one investors are most familiar with (i.e., stocks can go down); and the final one, liquidity, which by contrast is poorly understand and worth a deeper dive.
In simple terms, liquidity risk involves sacrificing the ability to sell an investment when you want (daily, weekly or monthly) in exchange for a higher expected return. If you have two identical securities, one that trades daily and the other that can’t be sold for five years, you’d only buy the latter if it had much higher potential.
Sacrificing liquidity is a valuable investment strategy since not all your holdings need to be easily tradeable.
I first learned this from my former partner at Phillips, Hager & North, Tony Gage, who was Canada’s dean of bonds in the 1990s. Gage loved to own “off the run” Government of Canada bonds as opposed to benchmark bonds that were actively traded by brokers. The off-the-runs still had a government guarantee, but offered a slightly higher yield because they weren’t as easy to trade in large amounts — less liquid, in other words. He wasn’t taking additional interest rate or credit risk, but instead sacrificed liquidity for extra return.
Risk versus the reward
How much extra return is required to justify an investment depends on the type of security and how illiquid it is. Small-cap stocks trade erratically so investors expect to buy at a lower price-to-earnings multiple and thus achieve a higher return. High-yield bonds are similar.
Even higher risk premiums are required when buying private companies that don’t trade on an exchange. This is generally done through professionally managed funds that have fixed terms of 10 years or more. In other words, investors have a limited ability to get out (without penalty) prior to the fund’s maturity. Funds may also hold mortgages, loans, real estate, infrastructure and more esoteric investments such as farmland, timber and catastrophe bonds.
Beware the mismatch
The growth of private equity and debt has been a defining feature of this market cycle. Institutions have steadily increased their holdings and even individual investors are getting into the act. Indeed, the proliferation of mutual fund-like products has led to concerns about a growing mismatch: liquid funds investing in illiquid assets.
Freddie Lait, managing partner of U.K.-based Latitude Investment Management LP, put it this way: “Illiquidity is a risk which has been mispriced over the past 10 years as quantitative easing programs have flooded financial systems with cash, and regulators have allowed funds to run liquidity mismatches in their portfolio.”
The potential downside of this mismatch was on full display last year in Lait’s hometown of London. The most intriguing case involved a high-profile manager, Neil Woodford, who, as a headline in The Guardian put it, went from “Bright star to black hole.”
Woodford managed a number of large funds and went through a period of poor performance. But he couldn’t accommodate the withdrawals when investors turned against him because he held too many unlisted companies. To protect existing holders, the funds were closed to redemptions, or “gated,” in hopes the funds could be wound down in an orderly manner.
Such situations are rare when the world is awash with capital and markets are strong, but we’ll see more gates close in the coming years as more mismatched products come to market.
How to benefit from illiquidity
If investors want to take advantage of the fourth risk and avoid a mismatch, they can’t go halfway. These investments need to be truly illiquid. Investing in private companies, real estate, infrastructure, loans and mortgages requires you to provide the fund manager with long-term capital that matches the task. You don’t want to invest alongside others who can leave at a moment’s notice and force the sale of assets at an inopportune time.
It’s also important to target asset types that you’re comfortable owning for a long time and pick a manager who will be around for a decade or more. That’s because the time component of the risk plus time formula is locked in. You’re going to have the investment in your portfolio for a long time.
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