The return premium that institutional investors can expect due to the illiquidity of some alternatives, such as private equity, may be as low as 0.5 per cent according to new research.

The research, from Russell Investment Group’s Australian office, should sound a cautionary note for super fund trustees, most of whom have been rapidly expanding their allocation to a range of alternatives in recent years. A paper, by Andrew Goddard, Russell’s director of alternative assets and strategies, and Geoff Warren, senior research associate, was distributed at a regular Russell client roundtable in Sydney and Melbourne last week. Speaking to the research, Warren said that investors tended to look at some alternatives, such as private equity, as an attractive asset class, because average returns were about 3 percentage points above listed equity. “But private equity funds are geared and the bulk of what you’re buying is manager skill,” he said. This is because of the wide dispersion of returns by private equity managers. In private equity, the top-performing managers tend to be further ahead of the pack than in listed markets. They also tend to be able to show better persistence of returns. However, the compensation for illiquidity – tying the investment up for several years, for instance – was probably about 0.5 per cent, Warren said. “So, you have to find other reasons to invest in alternatives.” He said the academic literature tended to show a differential of “tens of basis points, not hundreds” when modelling for illiquidity premia. “The academic literature on the difference between listed and private equity says that there is roughly a 30 per cent discount [for private equity]. But that is gross. You have broker costs of 3-5 per cent and total costs may be as high as 10 per cent. Plus, there’s a listing discount of another 10 per cent.” Warren said that work by Russell had shown that listed property, net of all costs, had outperformed unlisted property. The full paper can be found at: http://www.russell.com/AU/shared/Russell_Research/illiquidity.asp

Leave a comment