If you think two-dimensionally and focus only on returns and volatility, you may miss important investment risks. This is what Peter von Lehe, Head of Investment Solutions and Strategy, and Stephen Smith, Head of Insurance Analytics, of U.S. asset manager Neuberger Berman, warn about. They show how to take liquidity risks into account in the investment strategy.
The financial press has been reporting a lot lately about the difficulties of investors who are only interested in yield and volatility, but ignore market liquidity. This was particularly problematic in the case of often illiquid non-listed investments. Their lack of liquidity can easily turn into a nasty surprise, although it could be prevented.
In the 1880s, the English teacher Edwin Abbott wrote the satirical story "Flatland", flat land. In it, they all have a maximum of two dimensions. This also applies to the narrator, or more precisely: to the square. In a dream, the square moves to the one-dimensional "Lineland" – line land – where everything is a line. The square cannot convince residents that it is more than four dashes.
Broadening the view
But even the square has a limited view. As the sphere from the three-dimensional "Spaceland – Raumland – is a guest, the square thinks it's a disc. The square can not imagine a third dimension.
Not much different might be the situation for many investors, write Peter von Lehe and Stephen Smith in the latest "Weekly Perspectives" by Neuberger Berman. If investors are used to investing in liquid markets, they would not always fully grasp illiquid assets, explain the two.
"In the world of these investors, risk is synonymous with annualized volatility in market value.", they criticize. Even with non-listed stocks – which usually take several years to divest and are valued once a quarter, but not by the market – they determine an annualized volatility to fit the pattern.
"Volatility is not the appropriate indicator"
"In most cases, they then determine a higher volatility than for comparable liquid securities. As a result, unlisted assets sometimes get short shrift in asset allocation, to the detriment of investors", continue vo Lehe and Smith.
The two financial specialists therefore also do not consider volatility to be the appropriate indicator for illiquid securities. Quarterly valuations and, above all, expected sales proceeds seem much more important to them.
In addition, the attempt to determine a calculated volatility often distracts from the true risks. "The main risks of non-listed securities are liquidity risk and repayment risk, i.e. the difficulty of selling when you need your money and the uncertainty about the return at the scheduled end of the investment period", they state.
Just as the square fails to capture the essence of the sphere, a classical risk-return optimizer fails to capture the essence of a non-listed investment.
To avoid the temptation of "Flatland to resist "asset allocation must take into account the investor's liquidity and liability profile", emphasize from Lehe and Smith: "Here's how to calculate the risk of running out of cash in the end – whether it's because the investment is valuable but illiquid, or because it's liquid but underpaid.".
Let's say an investor sets aside 100 euros today and needs 200 euros in ten years, give an example. In this case, an investment with more than 10% annual return with an average volatility of 6% annually could make sense. "And yet we consider such a two-dimensional view to be incomplete", they warn.
Add to the example the second dimension, volatility, extreme risks, risk of high losses. In the event of an unusually heavy loss, the annual average yield could fall below 10%, leaving less than 200 euros in the end. With what probability can the investor live with it? You should be able to answer this question at the beginning.
Don't miss the third dimension
Then von Lehe and Smith add a third dimension, liquidity. Diversification can reduce the risk of loss to an acceptable level, but sometimes at the expense of expected returns. While illiquid assets can be used to restore expected returns to desired levels, and without adding volatility and extreme risks. But liquidity risk must be considered, he said. How likely is it that you will need your money before the ten years are up? is the key question.
It's hard to say goodbye to the two-dimensional Flatland "but it's worth the effort", the investment experts at Neuberger Berman state that. Otherwise, they will fare like the square that the visit of the sphere leaves perplexed. "If a fund cannot meet its payment obligations", they explain "it also does not meet its investment objective. This makes a complete analysis of all risks all the more important."