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IT’S time to start transitioning from illiquid alternative investments to liquid alternatives, argues Pendal multi-asset portfolio manager Alan Polley.
“Illiquid assets have had a fantastic secular tailwind for the last two decades because interest rates have been falling and they have been chased by a wall of effectively free money bidding up prices, says Polley.
“These illiquid assets have had cash-flow benefits in terms of lower financing costs, and the lowering of the discount rate has led to positive valuation effects.
But the good times for illiquid assets are over, thanks to the accelerated rate tightening cycle, which in the US has been 500 basis points in a little over a year, Polley says.
Illiquid alternative assets are dominated by property and infrastructure and are private, or unlisted, assets. The economic environment for these assets has changed, he says.
“It’s certainly not free money anymore. This has been a step change.
“These assets tend to be very sensitive to interest rates in terms of financing costs and also the discount rate applied to future earnings.”
“There certainly isn’t a tailwind anymore and … given how sensitive to interest rates these assets are, there is potential downside.”
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Illiquid assets, by definition, don’t trade regularly in normal circumstances.
With even fewer sales over the last year, there are very few benchmarks to revalue assets.
Large investors need to revalue assets twice a year and, without the benefit of recent and relevant sales, tend to use dated sales prices or long-term averages for discount rates which are skewed towards lower rates.
But the interest rate environment in coming years will be very different to recent years, Polley says.
“No-one wants to sell the assets right now because they know they will take a haircut. There’s no transactions going on,” Polley says.
An indication of how much value has potentially been lost can be garnered from public assets that trade regularly.
“If you look at the REITs (real estate investment trusts) market, they’ve dropped about 25 per cent,” Polley says.
“The public markets tend to lead the private markets and are a clear indication that the private markets haven’t been priced to reflect the new reality. There is a lot more risk for private, or illiquid assets.”
The valuation question has triggered regulators, in recent months, to take an interest in the dearth of revaluations for illiquid assets. They are questioning valuations provided by some large managers.
“Regulators want to make sure that unlisted assets are being held at fair value in the new market environment,” Polley says.
Illiquid assets promise a “liquidity risk premium”. Because they are illiquid, there’s extra risk involved and that should attract a premium over time.
That risk will eventually be felt — the question is when?
“Illiquidity risk is a risk-on factor, so when the market environment is poor, that liquidity risk tends to underperform.” Polley says.
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“Often the hope is that an investor can ride through a poor market environment and not feel the effects of liquidity risk.
“But if the investor’s situation unexpectedly changes, then the true risk of illiquidity could be felt.
“Regardless, because these assets are priced infrequently, the true economic reduction in valuation can accumulate through time, and then an investor can get hit in one go.
“Plus, all illiquid assets will likely be affected at the same time. This leads to illiquidity risk having very fat tails.”
“A final disadvantage of illiquid assets is they introduce potential concentration risks and can reduce returns associated with being unable to effectively rebalance portfolios.
“Rebalancing can generate positive returns because it forces you to sell high and buy low. Having illiquid assets means you can’t always do that.
“Inability to rebalance means the portfolio could become overly exposed to illiquids, and potentially at the worst time.
It’s a whole-of-portfolio consideration that people often ignore or don’t think about when investing in illiquids.”
Shifting to liquid alternative investments will be a theme for this year, Polley says.
“Look for those that offer true diversification benefits and other forms of returns besides traditional equities and bonds.
“Look for assets that have a secular tailwind, such as sustainable investment companies, and investments with inflation linkage.”
Alan is a portfolio manager with Pendal’s multi-asset team.
He has extensive investment management and consulting experience. Prior to joining Pendal in 2017, Alan was a senior manager at TCorp with responsibility for developing TCorp’s strategic and dynamic asset allocation processes covering $80 billion in assets.
Alan holds a Masters of Quantitative Finance, Bachelor of Business (Finance) and Bachelor of Science (Applied Physics) from the University of Technology, Sydney and is a CFA Charterholder.
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
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