Inside the 'Liquidity Premium' and How it Benefits Investors

The liquidity premium (also known as the “illiquidity premium”) is a term used to describe the enhanced return that is expected for investing in illiquid assets. Put simply, if you invest in something that isn’t easy to get your money out of, you can expect a greater return on that investment due to the inconvenience.

Assets are considered to be “illiquid” if they cannot readily be sold for cash without a significant loss in value. Examples include hedge funds, venture capital, private equity, and real estate.

A rational investor would expect a liquidity premium in the form of a higher yield on investments that are less liquid because such investments are generally considered to be riskier than investments with more liquidity.

Conversely, an investor who highly values liquidity in their investments may demand lower yields in exchange for the ability to cash out at will. Illiquid assets generally have longer investment horizons than liquid assets such as stocks, bonds, and mutual funds. Investing in illiquid assets also comes with unique risks and opportunity costs. As such, investors demand additional compensation for having their assets locked-up in this illiquid form.

For the patient and prudent investor, a liquidity premium can serve as an attractive bonus for seeing an investment through.

What is the Yale Model?

An example of the liquidity premium in action can be found in the now-famous “Yale Model.”

When David Swenson was hired as Chief Investment Officer for Yale University in 1985, the Yale endowment was worth approximately $1 billion. As of 2019, the endowment is worth approximately $29 billion.

How? Over the course of his 30+ year tenure, Swensen completely changed how Yale managed its endowment. Leveraging his background on Wall Street and Yale’s impressive alumni connections, Swensen shifted funds away from domestic equity and fixed income and moved instead into real estate, private equity, and hedge funds. Essentially, Swensen shifted the endowment from being invested in liquid assets to illiquid assets.

And the results have been spectacular.

A multi-billion dollar university endowment may not be analogous to an individual investor’s portfolio, but the lesson from Swensen’s tenure at Yale is undeniable: there is a premium placed on locking up investments for the long-term. By allocating more of the endowment to illiquid assets, Swensen was able to take advantage of the illiquidity premium while diversifying and expanding the fund’s portfolio.

The Liquidity Premium and Investment Returns

The potential presented by capitalizing on liquidity premiums has not escaped the notice of innovative investment companies and fund managers. In a 2018 study of liquidity premiums across different market capitalization layers of 3,000 U.S. stocks, Vanguard found the liquidity premium of the large-cap stocks to be 2.40%, 2.00% for the mid-cap stocks, and 5.00% for the small-cap stocks.

The study concluded that: “For investors able to cope with the cyclicality associated with any active strategy, a fund that systematically captures the premium generated by the liquidity factor may offer investors the opportunity to tilt their portfolios in a manner that is at once controlled and meaningful. It can significantly reduce costs, as investors pay only for the returns they want, while offering a powerful addition to a well-balanced, focused investment portfolio.”

In February 2018, Vanguard even launched an ETF to track this liquidity premium called the U.S. Liquidity Factor ETF. As of November 2019, the fund is up 13.90% since its inception.

How to Profit with the Liquidity Premium

For individual investors with a long-term investment horizon, it is worth considering the potential value of liquidity premiums in contemplating the balance of liquid vs. illiquid assets. Liquidity premiums are an “added bonus” for investors who are more risk-tolerant and have longer investment horizons.

For instance, an investor planning for retirement 30 years down the road who is financially secure enough to set aside a portion of their portfolio in illiquid assets is likely to benefit from the excess yield such investments produce. This investor is exchanging a heightened level of risk in the form of temporary illiquidity for an enhanced return on the initial investment.

The liquidity premium is a factor that exists in varying degrees across asset classes, so it is possible to balance a portfolio in a way that takes advantage of the premium while keeping undue risk in check.

One does not need to have all their investments in illiquid assets for the entirety of an investing career in order to sensibly utilize the liquidity premium. By shifting one’s asset allocation from less liquid to more liquid as the investment horizon approaches, it is possible to maximize the premium while risk tolerance is high and minimize exposure as risk tolerance shrinks.