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Categories
Asset Allocation
Liquidity, Illiquidity, Private Assets and Capital Allocation
Wesley Phoa
Solutions Portfolio Manager

 


Key takeaways:

  • Liquidity is a complex, cross-market phenomenon that cannot be fully captured by any single metric

  • Liquidity is not a magic bullet for risk management, and illiquidity is not a free lunch for return enhancement.

  • The interplay between liquidity, illiquidity, and control drives capital allocation in the economy and different sources of added value from active investment management.

What is liquidity? The idea behind market capitalism is that economic value, once created out of factors of production, can be made fungible, stored and transferred for use by other value creators. Liquidity refers to what is transferred and how easily it is transferred.

 

This article discusses liquidity and illiquidity, how liquidity functions in both public and private markets, how it interacts with information and risk and what this means for the economy. It then goes on to address the role that active asset managers play in the economy. As an investor, it is easy to get tunnel vision, focusing on one’s own habitat. But it is the diversity of markets, and their mutual interactions, that facilitates capital allocation in the system as a whole.

 

The article is intended to help investment managers address several different problems:
 

  • Managing portfolios: Efficient portfolio management—and effective risk management—require an understanding of the relationship between liquidity, information and risk, within and across different markets.

  • Designing portfolio solutions: Solutions design involves understanding different investment strategies, how they behave in various market conditions and how they interact with each other. Liquidity/illiquidity is the glue that links markets together.

  • Evaluating investment products: As different kinds of liquidity guarantees appear in various new investment products, especially those that hold private assets, it’s helpful to have a framework to assess their true cost and reliability, which are not always obvious.
     

It also touches on some broader issues that concern investment managers:
 

  • Understanding active returns: It’s important to understand where the added value from active management—and the returns from owning illiquid assets—really come from. The macroeconomic function of active management is capital allocation, but the mechanisms by which it influences capital allocation are varied and often complex.

  • Understanding financial markets: That is, how markets function and interact with each other, the effects of market regulation and the role that different market structures play in corporate decision making and in the macro economy.

  • Modeling financial crises: Liquidity and illiquidity play a key role in every financial crisis, so understanding their dynamics is important in assessing crisis risk and in navigating crises when they occur.
  • Mean–variance optimization is a continuing source of new approaches and new tools for investing.

  • One new example is retirement glide-path design, traditionally seen as a multiperiod problem.

  • Another new example analyzes the return premium on illiquid assets in a portfolio context.

 


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Wesley Phoa is a solutions portfolio manager with 31 years of industry experience (as of 12/31/2024). He holds a PhD in pure mathematics from Trinity College at the University of Cambridge and a bachelor’s degree with honors from the Australian National University.

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Asset Allocation
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