Explicit policies for handling cash requirements are a crucial tool for investors in illiquid assets

Today Ortec Finance, a market-leading provider of technology and solutions for risk and return management, in collaboration with Netspar, releases a report summarizing pension funds’ views on investment and management decisions towards illiquid assets. The key best practice emerging from their study is that investors in illiquid assets should have explicit policies in place to be able to fulfill immediate cash requirements at all times.

Over the past decades, the average illiquid asset allocation of the largest pension markets in the world has increased significantly, from on average 4% in 1997 to 25% in 2017. There exists a large body of research that studies the benefits and challenges of investing in illiquid assets. Yet, the attitudes of investors in illiquid assets themselves have not been studied before. The growing trend of pension fund investments in illiquid assets shows the importance of understanding how investors view illiquid assets and how they deal with the illiquid nature of these assets.

As a first step towards achieving this understanding, Kristy Jansen (Tilburg University) and Patrick Tuijp (Ortec Finance) have interviewed nine Dutch (342 billion, or approximately 26 percent of total pension assets in the Netherlands) and five Canadian pension funds (203 billion, or approximately 9 percent of total pension assets in Canada) on the investment and management decisions towards illiquid assets.

“We interviewed the Dutch and Canadian pension funds and fiduciary managers on the investment and management decisions towards illiquid assets. The most important reasons for these investors to invest in illiquid assets are their attractive risk-return trade-off, diversification benefits, and, in some instances, they provide a hedge against liabilities”, explains Kristy.

The long investment horizon makes pension funds well-suited investors in illiquid assets. Yet, despite the long investment horizons, pension funds do have liquidity needs. While expected payments to retirees can be managed easily, this is not the case for margin calls on derivatives. These margin calls are unpredictable and even tend to be higher during periods of financial market stress.

“We think it is crucial for investors in illiquid assets to understand how their portfolios are affected during times of stress. Under such conditions, illiquid assets may prove difficult to sell. Alternatively, selling liquid assets may lead to a deviation from the intended asset allocation. One of the best practices emerging from our study is that investors in illiquid assets should have an explicit policy that specifies in advance what to sell, in which order and in which quantities in case there is insufficient cash at hand to cover immediate requirements,” says Patrick.

The set-up of these policies is relatively easy and quick to implement and can help investors in illiquid assets to be well-prepared for handling sudden market liquidity dry-ups.

Want to know more?
The complete research has been published as a Netspar Industry paper “A survey of investment and Management Decisions on Illiquid Assets” by Kristy Jansen and Patrick Tuijp.