Practical Applications of Rebalancing-Diversification Return: The Opportunity Cost of Illiquid Investments

Practical Applications Summary

In Rebalancing-Diversification Return: The Opportunity Cost of Illiquid Investments, published in the Summer 2018 issue of The Journal of Investing, John Linder of Ryan Labs Asset Management examines how portfolio managers can employ illiquid investments to increase returns, and quantifies the trade-offs they present in terms of illiquidity. Led by private markets (especially private equity), asset managers pursuing greater returns amid the ongoing low rate-of-return environment have increasingly turned to illiquid investments. These alternative investments are especially attractive if the investor’s time horizon is substantially longer. In contrast with a liquid portfolio, investments in illiquid assets give up three main attributes: the ability to spontaneously rebalance the holdings, reallocating back to the strategic asset allocation to maintain the intended risk posture over time, and purchasing distressed assets in times when liquidity is dear and thus prices are depressed.

Linder discusses how alternative illiquid investments introduce an opportunity cost for which investors should demand an illiquidity premium, and proposes a framework to quantify it. He also suggests strategies to increase the available returns from liquid investment through diversification and leverage.