Investing in illiquid assets: Why illiquidity can be advantageous

1. Fortis Investments
Paradigm Shift
Investing in illiquid assets
Why illiquidity can be advantageous November 2008
Abstract
The illiquidity premium is currently exceptionally high due to the ongoing credit crisis. Investors with investable assets have the opportunity to lock in this
premium, which should boost the returns of their portfolios during the lengthy period in which they are invested in illiquid holdings.
Long-term investors do not necessarily need 100% liquidity for all their assets. Liquidity comes at a heavy price in the shape of lower returns, so each
investor should determine how much he can afford to invest in assets with limited liquidity and with no liquidity at all.
The illiquidity premium changes over time, tending to increase significantly in crisis situations. Ad-hoc structures or strategies are the best way of
optimising the expected risk-return trade-off: by their very nature, such structures have limited or no liquidity but their expected returns are such that
they can outweigh the inconvenience of illiquidity.
Illiquidity is often a necessary evil in order to limit risk and / or generate superior returns. Guaranteed return products, for instance, typically involve
restricted liquidity. The use of leverage in hedge funds, infrastructure, non-listed real estate and other private equity funds is one of the main reasons
why illiquidity is an absolute necessity. In other words, the chance of high returns and the significant diversification benefits offered by such asset classes
are intrinsically linked to some form of illiquidity.
Institutional investors also look to illiquid alternative investments as a means of steering away from the volatility that regulatory mark-to-market
requirements bring. These advantages cannot be ignored just because of the illiquid nature of the asset classes in question.
The only valid reason for concern about liquidity is when solvency is an issue. If there is no concern over a fund’s solvency, then the liquidity of its
investments becomes less relevant. Long-term investors such as pension funds should assess alternative investments’ risks with regard to their target
rate of return and their long investment horizon.
Assessing each investor’s liquidity requirements is vital for risk management and determining an appropriate asset allocation. Portfolio managers should
not think in terms of allocating assets, but rather in terms of the allocation between different risks bearing in mind the differing levels of liquidity of each
asset class.
What is most dangerous is the illusion of liquidity: unforeseen changes in liquidity and underestimated or misunderstood liquidity risks can have
irreparable consequences.
Xavier Timmermans
Head of Alternatives Investment Specialists
Tel: +32 22 74 84 26
xavier.timmermans@fortisinvestments.com

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Investing in illiquid assets
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Why illiquidity can be advantageous
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Introduction for the higher transaction costs investors incur in a relatively illiquid mar-
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ket. A recent study1 showed a strong positive relationship between equity
What is illiquidity? returns and the aggregate commission rate for NYSE trading, which it-
A liquid asset is one that can be sold rapidly, with minimal loss of value, self exhibits a strong correlation with illiquidity indicators such as bid-ask
at any time within market hours. The essential characteristic of a liquid spreads, order imbalance, and small-trade ratio.
market is that there are ready and willing buyers and sellers at all times.
Illiquidity, its opposite, comes in different forms. 2. Restricted liquidity can protect investors against losses and
n Markets that are normally liquid may suddenly become illiquid if there guarantee returns
are too many sellers for the number of buyers and market makers Excessive liquidity can be detrimental to a fund’s performance. In prin-
withdraw from the market. ciple, the fund redemption period should not be shorter than the average
n Restricted liquidity, as for hedge funds where subscriptions and re- time required for the liquidation of its assets. Furthermore, fund redemp-
demptions can typically only be made once a quarter with a notice tions should not be allowed if the liquidation prices are lower than the
period of at least a month. net prices used to compute the fund’s net asset value. This may sound
n Illiquidity due to the absence of a secondary market. Private equity obvious, but many corporate bond funds and credit spread products lost
funds, for example, typically have ten-year duration with no exit pos- value during the recent credit crisis when bid-ask spreads and market
sibilities other than via coupons and regular reimbursement in the volatility were much higher than usual. Richelieu Finance, a well-known
final years of the lock-up period. French mid cap manager, had to be rescued by another company earlier
this year because it was unable to guarantee the liquidity of its funds
This paper examines these different forms of illiquidity from a risk-return when liquidity disappeared in the small and mid cap market.
perspective and attempts to draw some conclusions concerning the al-
location to illiquid strategies. Therefore restricted liquidity, a minimum holding period and high early exit
fees to the benefit of the fund should be seen as protection for investors
Reasons for accepting low liquidity not looking to exit the fund. Products aiming specifically at capturing the
in traditional asset classes illiquidity premium should be conceived with these kinds of provisions.
Meanwhile, investors tend to have few problems with the illiquidity of
1. The illiquidity premium
The difference in the yield of two assets that are similar in all aspects apart guaranteed products. The real question is whether liquidity limitations
from their liquidity is called the illiquidity premium. This is the compensa- are justifiable and if investors are well compensated for the temporary
tion an investor receives for accepting lower liquidity. If this compensation immobilisation of their capital.
were not positive, an obvious arbitrage opportunity would exist.
Reasons to invest in illiquid strategies in a crisis
In the government bond market, for example, for the same issuer, matu-
Illiquidity premia tend to increase in crisis situations. The current liquidity
rity and coupon, a large, recent issue has a lower yield to maturity than an
crisis is in many respects exceptional, but so are the opportunities that
older or smaller issue. However, the transaction costs (bid-ask spreads)
have arisen as a result of it.
are smaller for liquid instruments, so a bond manager must find a bal-
ance between his need for mobility and his quest for high yield to matu-
Today, the illiquidity premium is extremely high as we are in the middle of
rity. Transaction costs in illiquid instruments may completely negate the
a credit crunch. Investors with deep pockets who can tolerate high tem-
benefit of their higher yields. On the other hand, arbitrage between liquid
porary mark-to-market volatility are well placed to harvest this premium
instruments can only be justified if on average it brings better returns than
and generate what could be attractive returns for years to come.
a buy-and-hold strategy for higher-yielding illiquid securities.
The chart overleaf demonstrates how credit spreads are now well above
Such liquidity premia exist in every market and their magnitude changes
the levels reached during the previous recession.
over time. In the example above the cost of liquidity tends to decrease
when yields are low and investors’ risk appetite is high. Conversely, the
Default risk has also increased, of course, because of the economic
illiquidity risk premium increases during sell-offs when investors are look-
slowdown – the higher spreads are there to compensate for it. It is only if
ing for safety.
implied default risks are clearly exaggerated that medium-term – say five
to ten year – expected returns for corporate bonds really increase. This
Different studies show that expected returns are positively correlated with
would justify a higher strategic allocation to the asset class, even if from a
illiquidity. Illiquidity commands a higher expected return to compensate
“Is Illiquidity A Risk Factor? A Critical Look at Commission Costs” Jinliang Li, Robert M. Mooradian and Wei David Zhang, Financial Analysts Journal: Jul/Aug 2007
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Paradigm Shift I November 2008 I 3 I
Illiquid alternative investments
tactical viewpoint there are reasons to remain cautious in the short term.
So for long-term investors, the credit crisis can be seen as an opportunity
to increase their exposure to credit risk so long as they are convinced 1. Hedge funds
that implied default rates are higher than what the actual level of defaults The diversifying effect that hedge funds can bring to a multi-asset port-
is likely to be. This reasoning is valid for liquid credit instruments if one folio can be huge: if a mean-variance Markowitz optimiser were used to
believes that markets are pricing credit risk inefficiently, something that is allocate weights freely, hedge fund indices could constitute as much as
not easy to ascertain. 50% of an optimal balanced portfolio.
The problem is that at this degree of exposure, a balanced portfolio
Credit spreads
would start to be affected by other types of risks. Hedge funds are highly
subject to operational risks, for example: some 50% of new hedge funds
Bp
close within three years of launch. Meanwhile, risks linked to excessive
500
leverage cannot be measured just by looking at past standard deviations
AAA AA A BBB
of performance and correlations.
400
300
One solution is to diversify idiosyncratic risk via funds of hedge funds,
although studies have demonstrated that, on average, these vehicles
200
tend to have a positive correlation with equities and bonds. However, this
specific problem can be mitigated by choosing funds of hedge funds that
100
systematically hedge their net equity and credit biases.
-
07/99 07/00 07/01 07/02 07/03 07/04 07/05 07/06 07/07 07/08
Is hedge funds’ illiquidity worth it?
Hedge fund redemptions can typically only take place quarterly, or at best
Bp
monthly, and on top of that with a notice period of several weeks. However,
500
a new trend is becoming apparent with the emergence of managers who
Source: JP Morgan Bloomberg, funds
Illiquid hedge JP Morgan Credit Spread indices (Euro Government
40.00% AAA AA A BBB
are using strategies that are similar to those used in private equity funds,
Liquid hedge funds
bond spreads) 400
meaning that their investments need to be held over extended periods.
30.00%
300
The picture is different if investors can accept some illiquidity: on top of Some other managers have restricted the liquidity of their funds in order to
credit risk is the illiquidity premium, which has increased tremendous- exploit longer-term strategies and protect themselves against the arrival of
20.00% 200
ly. Wounded by their exposure to US sub-prime mortgages, banks are a client base that is quick to punish poor short-term performance.
now in the process of deleveraging. This means that they are no longer 100
10.00%
prepared to take new credit exposure. In other words, market makers Dr Fabrice Dusonchet, a Quantitative Analyst with E.I.M. S.A., demon-
– mostly banks – are extremely reluctant to take positions in illiquid in- strated in a recent article2 that between January 1997 and September
-
07/99 07/00 07/01 07/02 07/03 07/04 07/05 07/06 07/07 07/08
0.00%
struments, explaining why there has been a major dislocation in some 2006, hedge funds with annual liquidity outperformed hedge funds with
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
segments of the credit market. monthly liquidity by about two percentage points per year.
-10.00%
The true opportunities lie in the less liquid segments of the credit market, The performance premium
40.00% Illiquid hedge funds
in bank loans, in small-size issues, and even in convertible bonds, which Liquid hedge funds of illiquidity is 2% per year
have suffered abnormally. on average
30.00%
In most of these cases, the opportunities need to be structured in a fund
20.00%
or special mandate in order to optimise the risk-return trade-off, for ex-
ample by hedging duration and currency risk or to get the right aver-
10.00%
age maturity. Such funds tend to have a fixed maturity to reinforce the
“lock-in” feature. The lock-in feature and other restrictions to liquidity also
aim to protect investors from difficulties determining accurate valuations 0.00%
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
(mark-to-market prices may be out of line with realistic acquisition prices,
for example). -10.00%
Source: EIM
See “Hedge Funds, Is their illiquidity worth it?” Dr Fabrice Dusonchet, November 2006. EIM website http://www.eimgroup.com/jahia/page86.html
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This may be partly due to factors other than liquidity but these results are
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hardly surprising when we consider the nature of hedge fund strategies, In October 2008, shares in Volkswagen rose 348% in two days
many of which aim to exploit market anomalies that take time to disap- after it emerged that Porsche owned 74% of the company’s
pear. Distressed debt, for example, can take a couple of years before stock and that only about 5% of its shares were available for
delivering the returns it targets. As hedge funds become more popular sale. Hedge funds that had bet on the shares falling desperately
among investors, we cannot see their liquidity improving. On the con- needed to buy the remaining ones to close their positions.
trary, massive recent redemptions due to short-term underperformance
will probably lead the best of them to add further restrictions to liquidity. The scramble that followed is a classic illustration of liquidity
risk. Each individual hedge fund was aware of the possibility that
Hedge funds’ vulnerability in a liquidity crisis Porsche could increase its stake, but either did not see it com-
In theory, hedge fund strategies should perform well whatever the mar- ing, or thought they could close their position easily. But with
ket conditions: they do not have systematic exposure to bond or equity everyone trying to close at once, Volkswagen became illiquid.
markets, and may even have a net negative exposure via short positions.
Yet in the past few quarters, many hedge funds have failed to meet their It was John Maynard Keynes who famously argued in 1936,
performance targets. “There is no such thing as liquidity for the investment community
as a whole”. Seventy-two years later, it seems we are still learn-
In order to understand why this has happened and why we believe it ing the same lesson.
does not discredit hedge funds it is important to look at the ways in which
hedge fund managers aim to generate performance. They can exploit
two types of opportunity – directional and relative value – by taking long
or short positions in different instruments.
n Directional: here the manager takes a view on a market trend. Nega- liquid assets. In a liquidity crisis, investors try to move their funds into liq-
tive views can be expressed by selling, or going short, futures or uid assets and offload less liquid instruments, creating the risk of further
other derivatives on an asset class. losses on both the long and the short sides of a relative value trade and
increasing correlations across asset classes.
n Relative value: here the manager assesses the expected returns of
one asset versus another. Typically he buys, or goes long, the under- In October 2008, hedge funds faced an additional problem: following the
valued asset and sells the overvalued asset. demise of Lehman Brothers, one of the six biggest prime brokers in the
world, other prime brokers became concerned about counterparty risk
These techniques can be successful in both rising and falling markets. and reduced, if not entirely stopped, their financing of hedge fund op-
They are vulnerable, however, when there is a sudden withdrawal of li- erations. They increased the amount of collateral required, forcing many
quidity, such as that we saw recently when many market participants hedge funds to reduce their positions in the process.
tried to reduce their risk (their leverage) at the same time.
Events such as these are hard to predict, can be extremely violent, and
This is dangerous for hedge fund strategies because it means a lot of in- may do considerable damage, especially to highly-leveraged funds.
vestors are trying to close their long and short positions at the same time However, they are short lived. Prices do adjust sufficiently to attract new
– by buying back the instruments they have sold and selling those they buyers and sellers. This can create opportunities for hedge funds that
have bought. In other words they buy back the instruments they thought are able to increase their positions and so generate better future perfor-
were overvalued, pushing up their price further, and sell the instruments mance.
they thought were cheap, making them even cheaper, in order to reduce
their overall exposure to the markets. The first conclusion we can draw is that investors should not just care
about their net market exposure – they should also consider leverage.
A hedge fund manager who has made a correct initial assessment of the The second is that hedge funds are not immune to liquidity crises, al-
relative value of two instruments will lose money when this happens. The though over the longer term they can exploit the anomalies which these
situation is even worse when the markets are highly leveraged, as this lead to. In other words, short-term underperformance may be followed by
heightens the selling pressure. much more significant medium-term outperformance. From an investor’s
perspective, hedge funds’ restricted liquidity, which prevents outflows at
On top of this, long-short hedge fund managers tend to be short in liquid the first sign of underperformance, should be seen as an advantage, not
assets – since they must be able to buy back the instrument in the future an inconvenience.
to close the position – while they may take more long positions in less

5. Fortis Investments
Paradigm Shift I November 2008 I 5 I
Non-listed property private equity funds
2. Private equity
Private equity funds are the most illiquid of all alternative investments. Real estate securities have demonstrated their ability to diversify a bal-
Once invested in limited partnership interests (which are the dominant le- anced portfolio, their advantages in terms of yield, and their usefulness
gal form of private equity investments), it is very difficult to achieve liquidity as a long-term hedge against inflation. Some studies show that Real Es-
before the manager starts to sell the investments in his portfolio as capital tate Investment Trusts (REITS) have not only been a good hedge against
is locked up for as long as 12 years. Distributions are only made as and expected and unexpected increases in inflation, but that they also limit
when investments are converted to cash; limited partners typically have downside risk when inflation is falling.
no right to demand that sales be made.
Listed real estate securities offer an efficient way to allocate money to the
There is a wide range of types and styles of private equity, such as lever- real estate sector. Funds of listed real estate securities are liquid, efficient,
aged buy-outs (LBO), venture capital, capital growth, infrastructure, real transparent, diversified and easy to value.
estate and distressed situations.
However, listed real estate has a weaker diversifying effect than an invest-
Institutional investors are increasingly interested by private equity as they ment in direct real estate. Real estate securities tend to follow the fluc-
seek: tuations of stocks, whereas building valuations tend to be more stable
due to annual valuations (no mark-to-market). Naturally, direct real es-
n higher returns than can be achieved on public stock markets tate is not a practical proposition for many investors because of its lack
n diversification from traditional listed securities of liquidity, concentrated risk and the difficulties inherent in managing a
n lower volatility, as private equity is a means of avoiding the volatility portfolio of properties.
that new regulatory mark-to-market requirements bring.
Funds of private equity funds investing in non-listed real estate present
Private equity is also perceived as a better way of achieving absolute all the advantages of an investment in direct property, but without the
returns than investing in the stock markets. This is because the private disadvantages of direct investment in buildings.
equity business model has a straightforward goal: to increase the value of
a business as much as possible within a defined timeframe, typically 8-12 Funds of non-listed real estate securities offer the following advantages:
years. In contrast to public companies, private equity firms seek to sell all
of the businesses they own. This influences every stage of a private equity n similar diversifying power to direct real estate
investment’s lifespan. n low volatility: absence of stock market volatility
n high expected returns: on top of the current yield from rents and
Throughout the ownership period, private equity stewardship is relentlessly expected capital gains after a few years, there is also the additional
focused on improving aspects of the business in order to increase its at- return from the leverage generally used at the level of the private
tractiveness to new owners. Private equity investors’ use of leverage helps equity funds
drive this focus and discipline. Furthermore, investors’ and managers’ in- n low correlation with other asset classes
centives are fully aligned through performance-related fee schedules. n a higher correlation with inflation
Infrastructure private equity funds Non-listed real estate is less liquid than listed real estate: usually, funds
Infrastructure funds typically invest in public projects, such as bridges, of real estate private equity funds have a maturity of around 7-10 years.
tunnels, toll roads, airports and public transport, which are often part of a Building a portfolio of different private equity funds at different stages of
privatisation initiative. their life cycles allows some flexibility, but this type of investment is nev-
ertheless restricted to long-term investors.
Infrastructure funds present a number of specific advantages:
Is private equity illiquidity worth it?
n long-term, stable and predictable cash flow It could be expected that on average, private equity would generate
n a link to inflation as revenues are often directly or indirectly linked to higher returns than public capital markets because it involves higher risk.
inflation trackers such as the Consumer Price Index However, the reality is much more complex. The performance of private
n an improving risk profile over time: after a few years, uncertainty linked equity funds over the past few years has differed depending on the type
to the building and set-up of the facilities disappears and makes way of funds and their vintages. Even within a specific type of private eq-
for a long stream of predictable revenues. In other words, equity risk uity fund of the same vintage, the performance of the top- and bottom-
is progressively replaced by a fixed-income-type of risk. quartile managers has varied dramatically.

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Why European investors do not invest like US university
A number of recent studies3 have demonstrated that on a risk-adjusted
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endowments
basis, private equity does not outperform the public capital markets on
average. The adjustments for risk in question take into account that pri-
vate equity portfolios are typically far more highly leveraged than public In Europe, private equity and hedge funds combined make up only a few
companies and also their lack of liquidity, which adds a further element of percent of pension plan assets, whereas in North America some pension
risk and should justify an illiquidity discount. plans have allocations to private equity alone of anything up to 25%.
A particular problem is that these asset classes – including leveraged Regulatory restrictions differ by country, but in Europe the allocations to
buy-outs, venture capital and real estate – are not valued on the same private equity and hedge funds that pension funds make are typically well
basis as traditional, more liquid asset classes such as cash, bonds, and below what they are actually allowed to invest.
public equities. Illiquid asset classes have artificially-smoothed return se-
ries, making them look both less volatile than, and less correlated with, One of the main reasons or excuses given for not using the US model is
other asset classes. However, when methods are used to make the re- that it leads to a significant loss of liquidity.
turns of publicly-traded assets with those of illiquid assets more compa-
rable by removing serial autocorrelation in the data and treating errors in Liquidity has always been a preoccupation for professional investors.
measurement, the results4 lead to a dramatic revaluation of both the risk- Many of the financial innovations of the two last decades were designed
adjusted returns and the diversification benefits of the asset classes. to improve the liquidity of the markets. Derivative products have allowed
market participants to move huge sums of money from one market to
This note is not intended to add to the debate, but we believe the conclu- another, meaning that they can alter their exposure to various assets
sion of The Boston Consulting Group in the study referred to above3 is and risks rapidly and at low cost. Liquidity therefore ranks very highly in
very important: institutional investors’ priority list. In periods of low market visibility, this
phenomenon becomes even more pronounced.
“On a risk-adjusted basis, private equity does not outperform the pub-
However, given the long-term nature of their businesses, do institutional
lic capital markets; nevertheless, it remains an attractive asset class for
investors such as pension funds, insurance companies and endow-
investors. The reason: there are indications that the best private-equity
ments, really need full liquidity?
firms consistently “beat the fade” – that is, they avoid the reversion to
average returns, which, over time, afflicts the vast majority of investment
David Swensen, the highly successful manager of the Yale University
opportunities. In other words, some private-equity firms do have a strong
Endowment (which has produced an average annual return of 16.1%
likelihood of outperforming the market over time – something rarely wit-
over the last 22 years compared to an average annual gain of 12.3% for
nessed in other asset classes, such as mutual funds or individual public
the S&P 500) points out that liquidity comes at a very heavy price in the
companies.”
shape of lower returns.5
Because the risks are higher and only top-quartile private equity funds are
worth investing in, institutional investors should conduct extensive due “Managers willing to accept illiquidity achieve a significant edge in seek-
diligence before committing their capital to a new private equity fund. ing high-adjusted returns. Because market players routinely overpay for
liquidity, serious investors benefit by avoiding overpriced liquid securi-
Leverage, meanwhile, is not necessarily a bad thing, as it contributes to ties and locating bargains in less widely followed, less liquid market seg-
the excess return of the asset class. Using leverage is not compatible ments.”
with liquidity, however. This is one of the reasons why private equity il-
Guy Fraser-Sampson6 gives an additional explanation: after liquidity con-
liquidity is worth it.
cerns, “risk” is the reason most often cited as an excuse for not investing
in so-called alternative assets. The problem stems from a fundamental
See “The Advantage of Persistence, How the Best Private-Equity Firms ‘Beat the Fade’” The Boston Consulting Group & University of Navara, February 2008
3
See also “Private Equity Performance: Returns, Persistence and Capital Flows” Steve Kaplan and Antoinette Schoar (Kaplan is at the University of Chicago Graduate School of Busi-
ness and at the NBER; Schoar is at the Sloan School of Management at MIT, and at the NBER, and the CEPR).
See “How Risky are Illiquid Investments? A practical approach to estimating volatilities and correlations for non-traded assets” Vineet Budhraja and Rui J. P. de Figueiredo, Jr. The
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Journal of Portfolio Management, Winter 2005
Swensen, David (2000) “Pioneering Portfolio Management”, The Free Press, New York
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Guy Fraser-Sampson “Eppur si muove – Risk and alternative asset classes for pension funds” Pensions Vol 12.2 82-87 Palgrave Macmillan.
6

7. 0
Fortis Investments1997
1985 1990 1995 1996 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Paradigm Shift I November 2008 I 7 I
100% 1.9% 2.30%
4.0%
12.70%
11.0%
75% 14.1%
26.30%
18.7%
50% 22.10%
23.3%
7%
25%
19.50%
27.1%
10.10%
0%
Yale University Educational Institution Mean
How to prosper from illiquid assets: the Yale Endowment Fund and CalPERS
Real Assets Absolute Return Private Equity Foreign Equity 300
Domestic Equity Fixed Income Cash
US university endowments and state pension funds have several things Illiquid alternative investments are the reason
250
in common. One is that they have both been reaping the benefits of in- for this strong performance
vesting in illiquid assets for several years. Over the past two decades, Yale has dramatically reduced its Endow-
200
ment’s dependence on domestic marketable securities by reallocating
150
With USD 22.9 billion of assets at the end of June this year, the Yale assets to non-traditional asset classes. In 1987, about 80% of the fund
Approach Assets Risks Risk control
Objectives
Endowment contains thousands of funds with varying strategies. The was invested in US stocks, bonds, and cash. Today, these account for
100
Partnered Diversification
California Publicterm total
Enhance long Employees’ Retirement System (CalPERS), meanwhile, only 15%, while style,
management: diversifying assets such as overseas equities, private eq-
Buy outs and restructuring
Investments Financial
risk adjusted returns Expansion capital 50
geography, sector
Operating
manages nearly long-term
Hedge against USD 250 billion of assets for approximately 1.5 million uity, absolute return strategies and real assets dominate the Endowment,
Liquidity
Energy, resources
liabilities
Californians. Countrymaking up 85% of the target portfolio.
Ongoing due
Distressed
Provide diversification 0
Direct Investments
Structural diligence 1990 1995& 1996 1997
tracking
Benchmark: CalPERS Turnarounds 1985 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
monitoring
Asset
Wilshire 2500 + 300Bps
International
of returns valuation
With aComparison to 28%, 2007 was the third consecutive yearmezzanine, in
return of Venture Yale Endowment’s asset allocation as at June 30 2007
Specials, e.g. Investment
Strategic Investment
Economics young fund Processes for
excess of 20% for the Yale Endowment. Over the last 20 years it has
Vehicles valuation initiating corrective
hedge funds
universe
actions
grown by an average of 15.6% per year. 100% 1.9% 2.30%
4.0%
12.70%
11.0%
Evolution of Yale AUM 75% 14.1%
26.30%
18.7%
300
50%
Aum (mn) 22.10%
23.3%
250
$25 000.00 7%
25%
200 19.50%
$20 000.00 27.1%
10.10%
150
0%
Yale University Educational Institution Mean
$15 000.00
100
Real Assets Absolute Return Private Equity Foreign Equity
Domestic Equity Fixed Income Cash
$10 000.00 50
0
Source:1990 1995 1996 1997 1998 1999 2000 2001 2002 2003
1985 Yale University, Fortis Investments
$5 000.00 2004 2005 2006 2007
$0.00
This surge in non-traditional asset classes stems from their return po-
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
tential and diversifying power. Today’s portfolio has significantly higher
100% Objectives Approach Assets Risks Risk
1.9% 2.30%
4.0%
12.70%
11.0%
expectedEnhance longandtotal
returns term lower volatility than the portfolio 20 restructuring
Buy outs and years ago.Financial
The
Source: Yale University, Fortis Investments Partnered D
Investments man
75% 14.1%
risk adjusted returns
Endowment’s against long-term
long time horizon is well suited to exploiting illiquid, less ef-
26.30%
Expansion capital ge
Operating
Hedge
Liquidity
Energy, resources
18.7%
With an average return of 13.2% per year over the past five years, CalP- ficient marketsdiversification venture capital, leveraged buy-outs, oil and Country
such as gas,
liabilities
50% Distressed
Provide Direct Investments
22.10%
Structural dilig
ERS has also performed well. Even up to April 30 this year, the scheme timber and real estate.
Benchmark: CalPERS Turnarounds
23.3%
Asset
Wilshire 2500 + 300Bps 7%
International
had managed to gain in value year-to-date in a market in which most valuation
25% Comparison to Venture
19.50% Specials, e.g. mezzanine, Investment
Strategic Investment
Economics young fund P
27.1%
investors had made losses. Private equity returns were an important rea- CalPERS has made a similar shift towards alternative asset classes,
Vehicles valuation init
hedge funds
universe 10.10%
0%
son behind these gains. with impressive investment results: its private equity and venture capital-
Yale University Educational Institution Mean
centric Equity Absolute Return Private Equity
alternative investments programme generated a 30% return from
Real Assets Foreign Equity
Domestic Fixed Income Cash
October 2006 to September 2007.
CalPERS’ growth in assets under management (USD billion)
Aum (mn)
CalPERS’ alternative investments programme
300
$25 000.00
Approach Assets Risks Risk control
Objectives
250
$20 000.00 Partnered Diversification
Enhance long term total Buy outs and restructuring
Investments Financial management: style,
risk adjusted returns Expansion capital geography, sector
Operating
200 Hedge against long-term
liabilities 000.00
$15 Liquidity
Energy, resources
Country Ongoing due
Distressed
Provide diversification Direct Investments
Structural diligence tracking &
Benchmark: CalPERS Turnarounds
150 monitoring
Asset
$10 000.00
Wilshire 2500 + 300Bps
International valuation
Comparison to Venture
Specials, e.g. mezzanine, Investment
Strategic Investment
Economics young fund Processes for
Vehicles valuation
100 initiating corrective
hedge funds
universe
$5 000.00 actions
50 $0.00
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
0
1985 1990 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Aum (mn)
$25 000.00
Source: CalPERS, Fortis Investments $20 000.00
100% 1.9% $15 000.00
2.30%
4.0%
12.70%

8. 1
Fortis Investments 2
Paradigm Shift I November 2008 I 8 I
3
4
5
6
7
Paradigm Shift 8
Investing in illiquid assets
1
2
Why illiquidity can be advantageous
3
4
5
6
7
8
misunderstanding among European pension funds and sometimes their The best way to reduce this type of risk is to constrain the use of lever-
9
consultants as to what constitutes “risk”. Their view of risk is not appro- age and ensure appropriate diversification. Investing in a fund of hedge
priate for the investment needs of many long-term institutional investors. funds is one way of achieving this, but at the cost of an extra layer of
For some asset classes, most notably private equity, periodic returns are management fees.
not a valid performance measure, which means that traditional risk mod-
els are inherently flawed. In other words, they do not like private equity Alpha is often seen as a useful measurement for hedge funds. Hedge
because they cannot calculate a risk-adjusted rate of return. fund alpha, however, is debated by critics, some of whom claim it is not
true alpha. The beta content of a hedge fund’s return is an important
Pension funds should assess risk with regard to their target rate of return issue as it can be a serious source of distortions for the asset allocator.
and their long investment horizon. The returns of all asset classes can be Despite this, alpha is the main justification for the fees that hedge funds
restated on a vintage year basis: that is, showing the compound returns charge.
earned to date from investing in that year. Then, mean variance can be
used to calculate the probability of any asset class failing to meet a given Performance attribution is extremely complex for hedge funds given the
target rate of return over a long period. absence of a benchmark. Their exceptional flexibility, which means they
can sell short, use leverage and use derivatives with non-linear pay-offs
How to allocate illiquid assets within a broad portfolio in unrestricted investment universes makes this type of analysis ques-
tionable.
The only valid reason for concern about liquidity is when solvency is an
issue. If there is no concern over a fund’s solvency, then the liquidity of Determining the optimal allocation to hedge funds based on alpha and
its investments becomes less relevant. Assessing each investor’s liquidity beta considerations is not a solution.
requirements is vital for risk management and determining an appropriate
In a recent article entitled “Alternative Metrics”7, Sassan Zaker, a Senior
asset allocation. Long-term investors such as pension funds should as-
Portfolio Manager at Julius Baer, proposed another method of maximis-
sess illiquid investments’ risks and returns with regard to their target rate
ing the chance of achieving a portfolio’s risk-return target. Hedge funds,
of return and their long investment horizon.
he stated, fall into two main groups, each with a different objective: “re-
turn enhancers”, which increase the overall expected return for the same
Portfolio managers, meanwhile, should not think in terms of allocating
amount of risk, and “risk stabilisers”, which reduce expected risk for the
assets, but rather in terms of allocating between different risks bearing in
same expected return.
mind the differing levels of liquidity of each asset class.
He suggests partitioning the asset allocation process into two distinct
Whereas determining the allocation to illiquid traditional asset classes is
steps. In the first a portfolio of passive assets is defined using traditional
relatively straightforward, deciding on the allocation between traditional
mean-variance optimisation methodology, and in the second the output
asset classes and illiquid alternative investments is more problematic.
of this optimisation is used to determine two new optimisations leading
to an allocation to the two groups of hedge funds.
Hedge funds
Hedge funds provide strong return potential combined with low corre-
This process is similar to the pragmatic approach used by many man-
lations with traditional asset classes. Modern Portfolio Theory recom-
agers who start from a traditional benchmark and take the percentage
mends an allocation to any potential investment demonstrating these
allocated to “return enhancers” out of the equity allocation and the per-
favourable characteristics, and so simple mean-variance optimisations
centage in “risk stabilisers” out of the allocation to fixed income.
would suggest a sizable allocation to hedge funds.
The problem with this approach is that volatility and correlations are in- Private equity
Due to the absence of a secondary market and the long immobilisation
sufficient when it comes to assessing the specific risks of hedge funds.
period (10+ years), allocations to private equity are above all limited by
LTCM had an excellent track record, relatively low volatility and a low
liquidity constraints, which in turn are a function of each investor’s liability
correlation with equities and bonds, but it still went bust in 1998 when
schedule and risk considerations.
Russia defaulted on its external debt. In other words, volatility and cor-
relations are not the appropriate risk measure to detect hidden vulner-
abilities linked to excessive leverage or to a liquidity crisis.
Zaker, Sassan, “Alternative Metrics” , The Journal of Alternative Investments: Spring 2007 p. 79
7

9. Fortis Investments
Paradigm Shift I November 2008 I 9 I
Usually, the allocation to private equity is defined as a maximum percent-
age of the strategic equity exposure. Venture Capital private equity, mean-
while, is often considered as part of the small cap bucket.
The allocation to non-listed real estate private equity is similarly defined as
a maximum percentage of the strategic weight in real estate.
Infrastructure is trickier, as its intrinsic risk decreases over time. In the
case of social infrastructure projects, such as schools or prisons, the risk
linked to the construction and set-up phase decreases after the first few
years, making way for the long-term credit risk of the public authorities
who pay for the use of the facilities. Due to its similarities with non-listed
real estate, in our view the allocation to infrastructure should be consid-
ered alongside that to property (somewhere between equity risk and fixed
income risk).
Conclusion
Investing in illiquid assets can provide clear benefits – namely high returns
and diversification. However, this kind of investment is not for the faint-
hearted and any potential investor must make a detailed assessment of
their liquidity needs beforehand – if they get this wrong then they run the
risk of not locking in the illiquidity premium (which is currently extremely
attractive) or of not being able to meet their liabilities.
They must also be certain that they will not need to access the money
they have invested in the near future. Illiquid assets are just that – they can
often only be cashed in several years after the initial investment, and so
are only suitable for investors with an appropriate time horizon.
Finally, they must have the knowledge and time to be able to manage
what are extremely complex asset classes. In general, this involves se-
lecting an investment manager to carry out this role for them, but even
then they should conduct extensive due diligence as managers vary
widely in their ability.
In short, the longer that investors are prepared to lock up their money, the
higher the return on their investment is likely to be. Given that the illiquidity
premium is currently high as a result of the ongoing financial turmoil, in our
view it is the ideal time to consider investing in illiquid assets.

10. Fortis Investments
What is a Paradigm Shift?
In The Structure of Scientific Revolution (1962), Thomas Kuhn defined and popularised the concept of Paradigm Shift. According to Kuhn, scientific
advancement is not evolutionary but rather a “series of peaceful interludes punctuated by intellectually violent revolutions”. In those revolutions “one
conceptual world view is replaced by another”.
Fortis Investments believes that the investment world is dynamic and driven by multiple agents of change. Periodically our clients face new problems
to resolve. Developments within the investment world mean that new solutions are possible. We aim to be ahead of the pack in identifying where
agents of change are forcing a reconfiguration of the paradigm. We strive to be an innovation leader in developing the appropriate product solutions
to enable our clients to meet this challenge.
As the research publication of Fortis Investments, Paradigm Shift seeks to identify recent or imminent changes in dominant investment paradigms
that have direct consequences for our clients. In doing so we aim to demonstrate the intellectual basis of our investment processes and to argue the
case for our innovation.
www.fortisinvestments.com
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