Illiquidity Raises Investment Risk

"If [investors] evaluate illiquid assets based on their average risk..., failing to note that they can become considerably riskier during volatile times, then investment strategies could appear better than they actually are."

One of the principal tenets of today's professional fund managers is that their portfolio of holdings should adhere to a strategy dictated by the Capital Asset Price Model (CAPM). The CAPM is an analytical tool -- a formula of sorts -- widely utilized by professional investors seeking assurances that purchasing a risky asset is justified because its rate of return is expected to compensate for the asset's risk. For example, investors would not buy into a tech stock unless they expect it to outperform the S&P500 index by an amount commensurate to the difference in risk between the two investments.

In Flight to Quality, Flight to Liquidity, and the Pricing of Risk (NBER Working Paper No. 10327), author Dimitri Vayanos asserts that the analysis as is currently performed may significantly understate the risk of holding assets that cannot readily be sold at face value, that is "illiquid assets." More to the point, Vayanos finds that fund managers may not sufficiently appreciate how a confluence of factors -- chiefly, a jittery market that in turn prompts individual investors to withdraw their money en masse -- so skews demand toward assets that can quickly be converted into cash (liquid assets) that illiquid assets head for the financial market equivalent of the remainder bin.

For example, fund managers purchasing a 30-year U.S. Treasury bond generally take into account the risk that if they sell it before it matures, they won't get face value for the asset and they will incur what is known as a "transaction cost." But they may not consider how the value of that illiquid holding could plummet when troubled times prompt a "sudden and strong preference for holding liquid assets" (the so-called "flight to liquidity") which in turn makes that bond, even one just a few months old, something that can be sold only at a heavy loss.

Vayanos notes that during the financial crisis in 1998, a flight to liquidity prompted the value of a three-month-old 30-year Treasury bond to drop. It was a clear example, he observes, of how "illiquid assets become very risky in volatile times," as the preference for liquid assets creates an environment in which "the negative effect of volatility is reflected more strongly on (the suddenly shunned) illiquid assets."

Meanwhile, liquid assets -- which could include "near cash" instruments such as Treasury bills or money market funds -- can experience the opposite effect, becoming "more valuable" during troubled times "because they give their owner the option to convert them easily into cash if needed." This phenomenon, Vayanos writes, is tied to a world in which fund managers generally are under pressure to sell their holdings when performance drops below a certain threshold. In other words, if one were to remove the "performance-based" pressure to sell, then the risks associated with the illiquid assets would remain constant, and the value of illiquid assets would not escalate so sharply, if at all, relative to liquid assets when markets take a dive.

But that is not the reality in which the vast majority of fund managers operate. Instead, when the going gets especially tough, the individuals who have invested in their fund are likely to bail out. Moreover, these investors assume that fund managers are purchasing assets after thoroughly considering the risks they present, especially when it comes to "worst case" scenarios.

Vayanos believes that his study "has implications" for how investors in general and fund managers in particular go about assessing the risks associated with purchases of illiquid assets. He warns that if they evaluate illiquid assets based on their average risk (average "beta" in the CAPM analysis), failing to note that they can become considerably riskier during volatile times, then investment strategies could appear better than they actually are.

-- Matthew Davis

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