CAIA Blog:  Illiquidity Risk - 3 Biggest Misconceptions July 2021

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When institutional investors allocate to private equity assets—and the data suggest that many are seeking to do more and more of this in the years ahead—they face a range of complexities that are absent in public markets. High on the list is the liquidity of the asset class, or more precisely, its lack thereof. Liquidity is among those financial concepts—like “risk”—that have multiple correct definitions. So when you have a conversation about it, it’s helpful to define it first so everyone is aligned. In this case we are talking about what is sometimes called funding liquidity: the impact that illiquid assets have on the broader multi-asset portfolio.

For most investors, the starting point in defining their asset allocation is mean-variance analysis. Introduced by Nobel laureate Harry Markowitz in his legendary 1952 article, this framework enables investors to identify a portfolio allocation that maximizes return for a given level of risk. Though it is sometimes criticized, we believe much of this criticism is misplaced. Nearly 70 years after its introduction, the construct is remarkably robust. Having said that, there are occasions where it can benefit from some enhancements. And liquidity is one such occasion.

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