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The Price to Pay for Ibbotson’s Illiquidity Premium

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Regular readers of this column frequently inquire as to which alternative asset classes or investment strategies may have risk-return characteristics that are similar to direct investments in startups and early-stage private ventures.

These pings often come from wealth managers who recognize direct private venture investments (PVI) not only as a compelling asset class, but also as a business practice differentiator and game-changing value proposition for their advisory firm. However, despite their interest in PVI, they lack the access to deal flow, due diligence skills, regulatory latitude, HNW client base, or, simply the compulsory cojones to actually allocate their client capital to private ventures.

Other advisors have embraced the progressive precepts of Hybrid Portfolio Theory yet require more accessible investment products than direct investments in private ventures to populate Portfolio B—the 15% to 30% of the alpha-producing portion of the portfolio that seeks positive asymmetric investment outcomes.

I have always maintained that specialized managed futures, distressed, deep-value securities and out-of-the-money option strategies have the asymmetric return profiles that are required to fulfill Portfolio B’s mandate. But for many investors and advisors, these aforementioned strategies are as arcane, elusive and illiquid as investing in PVI. Many investors simply do not have the investment horizon required to successfully harvest venture investments. They require liquidity—not lockups.

The Illiquidity Premium
Fortunately, there remains a compelling asset class for the more pedestrian advisor seeking leptokurtosis in exchange-traded investments—specifically, among less liquid publicly-traded stocks.

Relevant research and return data indicate that there is a seemingly-significant semblance between the returns of venture capital and less liquid, publicly-traded small company stocks.

In 2004, John Cochrane, finance professor at the University of Chicago’s Booth School of Business, published “The Risk and Return of Venture Capital” which examined whether individual investments in venture capital projects “behave the same way as publicly-traded securities” and which kind of securities they resemble.

Compiling data from the 16,613 financing rounds of 7,765 private companies over a 13-year period, Cochrane observed similar volatilities and alphas between venture capital returns and the smallest Nasdaq stocks and concluded that “thinly-traded Nasdaq…small stock portfolios are natural candidates for a performance attribution of venture capital investments.”

More recently, the pioneering investment industry academic Roger Ibbotson got a little more granular when he re-introduced his working paper Liquidity As An Investment Style which he initially co-authored with Zhiwu Chen in 2007. The work is important to adopters of Hybrid Portfolio Theory as it more narrowly defines a potential substitute for private venture investments by articulating the phenomenon of the “Illiquidity Premium.”

From 1972 to 2009, Ibbotson studied the returns of 3,500 publicly traded U.S. stocks in the context of their relative liquidity (defined by annual trading volume divided by total shares outstanding). The surprising results were that liquidity (as an investment style) was a far more effective predictor of returns than the conventional Fama-French factors. Specifically, the equities that produced the best returns during the period were less liquid small-caps that attract distinctively less trading interest. These companies generated a remarkable 17.87% annual return over four decades.

In contrast, the most liquid (and most widely held) growth stocks performed miserably at 3.3%—below the risk-free rate. The apparent performance attribution is due to the premium that most market participants are willing to pay for the most liquid securities—which, in turn, has the unintended but discernable consequences of reducing their returns.

Quanitification Illumination
Venture investors have always acknowledged the existence of an illiquidity premium and that they are swapping liquidity for upside. The historical returns of the venture capital asset class prove this out. But this quantification of the role of illiquidity as a risk factor, with a risk premium, is most illuminating.

“There is a clear pattern of decreasing returns as the liquidity of stocks increase,” writes Ibbotson. There is indeed an excess return attributable to less liquid stocks and “the less liquid stocks are not necessarily more risky. Measured by standard deviation, risk seems to increase with liquidity.”


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