Book 4. Liquidity and Treasury Risk

FRM Part 2

LTR 19. Illiquid Assets

Presented by: Sudhanshu

Module 1. Illiquid Markets, Market Imperfections, Biases and Unsmoothing

Module 2. Illiquidity Risk Premiums and Portfolio Allocation to Illiquid Assets

Module 1. Illiquid Markets, Market Imperfections, Biases and Unsmoothing

Topic 1. Illiquid Asset Markets

Topic 2. Market Imperfections

Topic 3. Illiquid Asset Return Biases

Topic 1. Illiquid Asset Markets

• Illiquid assets form a critical, yet complex, component of global finance and investor portfolios.

• Key Characteristics:

1. Widespread Illiquidity: Most asset classes are illiquid to some degree; even highly liquid markets can seize up.

2. Market Size: Markets for illiquid assets are vast, often exceeding the total wealth held in traditional, liquid stock and bond markets.

3. Investor Holdings: Illiquid assets comprise the bulk of most investors' portfolios (e.g., a home is often an individual's largest asset).

4. Liquidity Drought: Liquidity can rapidly dry up, even in highly liquid asset markets, particularly during stressed economic periods.

• ​Illiquidity is measured by low turnover, infrequent trading, and small transaction sizes.

​

• Market Size and Investor Allocations

• Illiquid assets represent a significant portion of global wealth and institutional mandates.

• Market Size (2012 Examples):

  • U.S. Residential Mortgage Market: $16 Trillion

  • Institutional Real Estate Market: $9 Trillion

  • Contrast: NYSE and Nasdaq Market Cap: $17 Trillion

• Individual Holdings: Illiquid assets (primarily housing) represent approximately 90% of an individual’s total wealth (excluding human capital).

• Institutional Allocations (Increases since 1990s):

  • University Endowments: Increased allocation to            (up from 5%).

  • Pension Funds: Increased allocation to            (up from 5%).

• ​Liquidity Freezes (Drying Up)
  • During financial distress, even traditionally liquid markets can become completely illiquid.

• The 2007-2009 Financial Crisis:

• • Money Markets froze: Repurchase agreement and commercial paper markets saw investors unwilling to trade at any price.

  • Structured Markets froze: Residential and commercial mortgage-backed securities (MBS) markets seized.

  • Auction Rate Securities (floating rate municipal bonds) froze and remained illiquid for years.

• Pattern: Major liquidity crises have historically occurred at least once every 10 years, coinciding with downturns and financial distress globally.

Practice Questions: Q1

Q1. Global liquidity crises generally occur because:
A. governments choose not to engage in monetary policy actions to stimulate economies.
B. financial distress causes markets to freeze.
C. markets for illiquid assets shrink, causing liquidity issues to infect traditional asset classes.
D. transaction costs increase as developing economies get stronger.

Practice Questions: Q1 Answer

Explanation: B is correct.

In stressed economic periods, such as during the 2007–2009 financial crisis,
liquidity can dry up. Major liquidity crises have occurred at least once every ten
years across the globe, in conjunction with downturns and financial distress.

Topic 2. Market Imperfections

• The Relationship Between Imperfections and Illiquidity: Traditional economic theory assumes "perfect markets" (rational utility maximization, no transaction costs, perfect information).

  • Reality: Markets are imperfect, and these imperfections are the root cause of illiquidity.

  • Imperfections that Encourage Illiquidity:

    • Market Participation Costs

    • Transaction Costs

    • Search Frictions

    • Asymmetric Information

    • Price Impacts

    • Funding Constraints

• ​Key Imperfections - Costs and Barriers

1. Market Participation Costs

• Costs associated with entering a market (time, money, energy, expertise).

• Clientele Effect: Only certain investors have the required expertise, capital, and experience to participate (e.g., private equity).

• Impact: Barriers to entry limit the number of participants, reducing overall market.

2. Transaction Costs

• Includes commissions, taxes, and for illiquid assets, additional costs like performing due diligence (attorneys, accountants, investment bankers).
• Challenge to Theory: While some theory suggests an asset is liquid if transaction costs can be paid, this fails to account for other impediments.​

3. Search Frictions (Difficulty Finding a Counterparty)

• The time and effort required to find a willing and capable buyer/seller.

• Example: Finding a buyer with sufficient capital to purchase a major office tower, or someone to understand and purchase a complicated structured credit product. Can take weeks, months, or years to transact.

4. Asymmetric Information

• When one party has more information than the other.

• Impact: Fear of being taken advantage of (i.e., buying a "lemon") makes investors less willing to trade, increasing illiquidity. Extreme asymmetry leads to market breakdowns (liquidity freezes).​

5. Price Impacts and Funding Constraints

• Price Impacts: Large trades can move the market price, resulting in liquidity issues for the asset or class.

• Funding Constraints: Many illiquid assets (like real estate) are highly leveraged; if access to credit is compromised, investors cannot transact.

Topic 3. Illiquid Asset Return Biases

• The Problem of Reported Returns: Investors should be skeptical of reported returns in illiquid asset markets because they are generally overstated due to reporting biases.

• Three Main Biases that Inflate Returns:

1. Survivorship Bias: Only successful funds/assets are included in databases.
2. Sample Selection Bias: Assets are reported/transacted when prices are high.
3. Infrequent Trading Bias: Infrequent pricing leads to artificially smoothed returns.​

• ​Survivorship Bias: This bias results from only analyzing the performance of funds or assets that successfully operate throughout the analysis period.

• Mechanism:

  • Poorly performing funds tend to stop reporting returns to database providers.

  • Failing funds are excluded from performance studies because they do not "survive" the entire period.

• Impact: Non-surviving funds have below-average returns, but only the above-average returns of surviving funds are included.

• Quantified Effect: Studies suggest reported mutual fund returns are 1%-2% lower than reported; for illiquid assets, returns may be as much as 4% lower than reported.

• Sample Selection Bias: This bias occurs when asset values and returns are reported only when they are high or transacted under favorable conditions.

• Mechanism in Real Estate: Sellers often wait until property values recover before selling, leading to higher recorded sale prices used for return calculation.

• Mechanism in Private Equity: Buyout funds take companies public (IPOs) and Venture Capitalists sell companies when stock prices/values are high.

• Impact on Metrics:

  • Expected Returns (Alpha): Overestimated (only high prices recorded).

  • Risk (Beta and Volatility): Underestimated (fewer data points flatten the security market line, lowering reported variance).

• ​Infrequent Trading Bias and Smoothing: By definition, illiquid assets trade infrequently, meaning reported prices are often stale.

• Smoothing Effect: The use of stale prices results in artificially smoothed returns.

  • Prices appear less volatile than they actually are.

  • Return volatility, Betas, and correlations with other asset classes are all reported as too low.

  • Example: Quarterly returns appear less volatile than daily returns for the same asset.

• ​Unsmoothing (De-smoothing): A process using filtering algorithms to add noise back into reported returns to uncover the true, noisier returns.

  • Effect of Unsmoothing: Dramatically increases estimated risk and reveals higher correlation with liquid markets.

Practice Questions: Q2

Q2. When an investor has difficulty ending a counterparty for a complicated credit product like a structured debt instrument, this is known as:
A. market participation costs.
B. agency costs.
C. search frictions.
D. selection bias.

Practice Questions: Q2 Answer

Explanation: C is correct.

Difficulties finding a counterparty are called search frictions. For example, it may be difficult to find someone to understand/purchase a complicated structured credit product. It may also be difficult to find buyers with sufficient capital to purchase multimillion dollar office towers in major metropolitan areas. No matter how high the transaction costs, it may take weeks, months, or years to transact in some situations. Asymmetric information can also be a type of search friction as investors search for non-predatory counterparties with which to transact.

Practice Questions: Q3

Q3. Blue Sky Funds, a private equity fund, has suffered low returns for the last five years. As a result, the find has decided to quit reporting returns. The fund did report returns each year for the last 10 years when performance was strong. This problem of reporting leads to:
A. survivorship bias.
B. sample selection bias.
C. infrequent trading bias.

D. attrition bias.

Practice Questions: Q3 Answer

Explanation: A is correct.

There are no requirements for certain types of funds, like private equity funds, to report returns. As such, poorly performing funds have a tendency to stop reporting. Additionally, many poorly performing funds ultimately fail.
Performance studies generally include only those funds that were successful enough to survive over the entire period of analysis, leaving out the returns of funds that no longer exist. Both of these factors result in reported returns that are too high. This is called survivorship bias.

Module 2. Illiquidity Risk Premiums and Portfolio Allocation to Illiquid Assets

Topic 1. Illiquidity Risk Premiums

Topic 2. Portfolio Allocation to Illiquid Assets

Topic 1. Illiquidity Risk Premiums

• Illiquidity Risk Premiums Across Asset Classes

  • The Conventional View: The traditional finance theory suggests a positive relationship between illiquidity and expected returns. Illiquid assets like venture capital and buyouts are often shown to have higher expected returns (16-17% and 13%, respectively) compared to more liquid assets like cash and developed market equities (around 4%).

  • The Flawed Assumption: This conventional view can be misleading. The apparent outperformance of illiquid assets may be largely due to biases that overstate returns and understate risk. It's difficult to separate the genuine liquidity premium from other inherent risks, such as the unique operational and execution risks of a private equity deal. Furthermore, because there is no widely investable "market index" for many illiquid assets, investors are exposed to high idiosyncratic risk that is not easily diversified away.

• Illiquidity Risk Premiums Within Asset Classes

  • There is much stronger and more robust evidence for illiquidity premiums within asset classes. This premium is the additional return demanded by investors for holding a less liquid asset over a more liquid one within the same asset class.

• Illiquidity Effects in U.S. Treasury Markets: The illiquidity premium is clearly visible in the U.S. Treasury market. More liquid "on-the-run" T-bills (the most recently issued) have a lower yield compared to less liquid "off-the-run" T-bills of the same maturity. This yield difference, often called the "liquidity spread," compensates investors for the lower liquidity of the off-the-run securities.

• Illiquidity Effects in Corporate Bond Markets: In the corporate bond market, the bid-ask spread serves as a key indicator of illiquidity. Less liquid bonds have larger bid-ask spreads, which leads to higher yields to compensate investors for the difficulty in trading. Studies have shown that illiquidity risk can explain a significant portion of the variation in corporate bond yields—7% for investment-grade bonds and 22% for junk bonds.

• Illiquidity Effects in Equity Markets: Within the equity market, less liquid stocks tend to have higher returns. The Amihud measure, a widely used proxy for illiquidity, is the ratio of absolute returns to dollar volume. A higher Amihud measure indicates lower liquidity, and researchers estimate that the illiquidity risk premiums in equities can range from 1% to 8%, demonstrating that even in a highly liquid market, illiquidity can still command a premium.

• Secondary Markets for Illiquid Assets

  • Nature of Secondary Markets: Secondary markets for illiquid assets like private equity and hedge funds exist to provide a potential exit for investors. However, they are often characterized as immature, small, and opaque, lacking the transparency and volume of public markets.

  • Significant Discounts for Sellers: Buyers in these secondary markets, often referred to as "vultures," frequently take advantage of sellers who need to exit their positions quickly. This leads to sellers accepting significant discounts. The document mentions that these discounts can be as high as 30% to 50% during times of crisis when liquidity is scarce.

  • Hedge Funds vs. Private Equity: The discounts for hedge fund secondary market transactions are typically much smaller (e.g., 6% to 8% during the 2007-2009 crisis) compared to private equity. This is because hedge funds generally offer more frequent redemption opportunities, reducing the urgency for a secondary market sale.

Practice Questions: Q1

Q1. Which of the following variables is not an illiquidity factor that affects equity returns?
A. Measures of adverse selection.
B. The number of recorded positive returns.
C. Turnover.
D. Volume.

Practice Questions: Q1 Answer

Explanation: B is correct.

There are several variables related to illiquidity that are shown to impact equity returns. They are bid-ask spreads, volume, turnover, volume measured by whether the trade was initiated by buyers or sellers, the ratio of absolute returns to dollar volume, the price impact of large trades, informed trading measures (i.e., adverse selection), quote size and depth, the frequency of trades, the number of zero returns, and return autocorrelations. It is not the number of recorded positive returns, but the number of recorded zero returns, that are relevant.

Topic 2. Portfolio Allocation to Illiquid Assets

• Key Considerations for Allocation: The decision to include illiquid assets in a portfolio is not as simple as it might seem. Investors must consider several factors, including:

  • Investor circumstances: The investor's personal wealth, financial goals, and specific constraints.

  • Time horizon: Illiquid assets are only suitable for investors with a long time horizon who can afford to tie up capital for many years.

  • Managerial Talent: Investors must rely heavily on the skills and talents of the external manager, introducing significant agency problems.

• The Challenge of Rebalancing: Infrequent trading in illiquid assets makes portfolio rebalancing extremely difficult. This means that a portfolio's allocation to illiquid assets can vary from being too high or too low relative to the optimal target, potentially increasing the portfolio's overall risk.

• Real-World Transaction Costs: Academic models often assume that a transaction can be completed if the investor is willing to pay the transaction costs. In reality, with illiquid assets, it is possible that a counterparty cannot be found at any price in a reasonable timeframe, making a timely sale impossible.

• Ways to Harvest Illiquidity Premiums:

  • Passive Allocation: A straightforward approach is to simply allocate a portion of the portfolio to illiquid asset classes, such as real estate.

  • Liquidity Security Selection: A more nuanced approach is to select more illiquid assets within a class, such as choosing off-the-run U.S. Treasury bills over more liquid on-the-run issues to capture the liquidity spread.

  • Acting as a Market Maker: Large investors, like sovereign wealth funds, can act as liquidity providers. They buy from distressed sellers at a discount and sell to buyers at a premium when the market recovers.

  • Dynamic Factor Strategies: This involves taking long positions in illiquid assets and short positions in liquid assets, and then actively rebalancing to take advantage of changes in liquidity. The rebalancing process is itself considered a way to provide liquidity and earn a premium.

Practice Questions: Q2

Q2. Rick Faircloth, a general partner and portfolio manager with Faircloth Funds, is considering ways in which his company can profit from illiquidity risk premiums. He has studied several alternative methods for harvesting illiquidity risk premiums. Which of the following strategies might Faircloth implement that will likely have the greatest effect on portfolio returns?
A. Acting as a market maker for individual securities.
B. Choosing the most illiquid assets within an asset class, even if the asset class is generally considered to be liquid.
C. Allocating a portion of a portfolio to illiquid asset classes.
D. Using dynamic factor strategies at the aggregate portfolio level.

Practice Questions: Q2 Answer

Explanation: D is correct.

There are four primary ways that investors can harvest illiquidity premiums:

1. Allocating a portion of the portfolio to illiquid asset classes like real estate (i.e., passive allocation to illiquid asset classes).
2. Choosing more illiquid assets within an asset class (i.e., liquidity security selection).
3. Acting as a market maker for individual securities.
4. Engaging in dynamic factor strategies at the aggregate portfolio level. This means taking long positions in illiquid assets and short positions in liquid assets to harvest the illiquidity risk premium. Of the four ways investors can harvest illiquidity risk premiums, this is the easiest to implement and can have the greatest effect on portfolio returns.