By Credit Suisse From The Financialist

Maintaining a certain amount of liquidity in a portfolio is perfectly justified, but investors tend to pay too much for it, while underestimating the extra returns from holding illiquid assets. The overpricing of liquidity seems to be greater in equities than in bonds, in part because equity prices are more strongly influenced by “stories” circulating about particular companies, whereas in bonds it is dry mathematics.

Recently, three executives from Credit Suisse’s Private Banking and Wealth Management Division – Oliver Adler, Head of Economic Research; José Antonio Blanco, Head of Global Multi-Asset Class Solutions; and Sid Browne, Chief Investment Officer and Head of Research, Liquid Alternatives – interviewed Roger Ibbotson, a professor at the Yale University School of Management and founder of Zebra Capital Management, about the effect liquidity premiums can have on a portfolio.

Sid Browne: You’ve studied the premiums and risks of both illiquid and liquid assets. What can you tell us about your findings?

Roger Ibbotson: Let me start off by saying that the stocks I study are publicly traded. There’s a strong theoretical reason why you’d expect less liquid stocks – in fact, less liquid assets of any type – to be lower valued. People want liquidity, and they’re willing to pay a higher price for the most liquid assets. So less liquid assets sell at a discount. For the same cash flows, you pay a lower price and expect higher returns. Giving up a little bit of liquidity – buying stocks that trade every hour, say, as opposed to every minute – can have a surprisingly big impact.

José Antonio Blanco: Is the effect you’ve just described a risk premium or the result of market inefficiency, in the sense that investors tend to focus on certain companies and disregard the rest?

RI: I call it a “popularity” premium. The stocks that trade the most are both the most popular ones and they are also the ones that tend to be mispriced – in effect, they get to be “too” popular. Interestingly, stocks that trade less have lower volatility, so they don’t really seem more risky. Therefore, I don’t really like calling the extra return a risk premium.

SB: What about in the event of a liquidity squeeze?

RI: There could be a the risk of having to sell quickly. That said, in 2008, when you had a kind of a liquidity crisis, the most liquid stocks were both sold most frequently and saw prices drop the most. Less liquid stocks did relatively well compared to more liquid stocks.

SB: So would it make sense to have a very large exposure to less liquid stocks in one’s portfolio?

RI: If you’re a day trader, you don’t want to buy less liquid stocks because they have higher trading costs. But if you have a longer horizon, buying less liquid stocks can make sense.

Oliver Adler: What about liquidity in the bond market?

RI: Bond markets are in the fortunate position of having yields to maturity that you can actually see. You know that if the bond doesn’t default, you’re going to get a specific return.

In the equity market, you can’t see the forward returns in the same way. You only see the result. And since returns themselves are very volatile, it’s hard to discern what the result really is. Moreover, the return measures differ strongly over different periods. This is quite different in bond markets, where maturities are normally fixed.

OA: Would you say that the stock market gives rise to more irrational behavior than the bond market?

RI: I’m sure there is irrational behavior in the bond market, too. But in the equity market, people are attracted to stocks that trade a lot, and they’ll pay more for them, just as you would do with brands in the consumer market. Consequently, the return structure of less popular stocks differs from that of more popular stocks, which leads to mispricing. Of course, you’ll also see mispricings in the bond market, but they are smaller and more visible – and thus, easier to take advantage of.

SB: You’re saying that assets from the same company could be more popular in the equity market than in the bond market. Apple stock, for example, could become “hot” and very liquid, but the debt, because it’s traded less and is a discounted flow of more certain cash payments, would not be impacted by this popularity phenomenon.

RI: It could be affected, but not as much because you see the exact pricing in the yield spread. You know exactly what you’re paying for.

In the equity markets, you can tell stories about a stock – and people will pay a lot for good stories. That’s why value tends to have higher returns than growth. Growth companies have much more interesting stories than value companies.

OA: How should investors deal with liquidity in their portfolios?

RI: There’s a danger in owning too many illiquid assets like real estate, infrastructure and private equity. Some universities, for example, got into a bit of a squeeze in the financial crisis because they could not get very good prices for their private equity investments. Less liquid publicly traded stocks, on the other hand, can easily be sold in any crisis without paying much of a discount.

This interview originally appeared in Credit Suisse’s Global Investor publication. It has been edited for length.

For more on this story go to: http://www.thefinancialist.com/the-price-of-liquidity/#sthash.DgJMo8JB.dpuf