Illiquidity Premium: A Survey

The objective of this report is to survey existing findings on the estimates of illiquidity premia for a range of asset classes, and on the feasibility and conditions required to earn these premia. There is a large amount of evidence of illiquidity premia in a variety of markets. Across equity and bond markets, less liquid securities have higher expected returns. In addition, securities whose returns or liquidity covary with aggregate (systematic) liquidity and liquidity in the financial system (funding liquidity), also have higher expected returns than securities with lower exposures. These results have been found across a range of markets, after controlling for well known market risk factors and firm risk characteristics.

However, it is not straightforward to earn an illiquidity premium for an investor aiming to do so, whether they invest in private/alternative assets or in publicly traded illiquid assets. This is mainly due to two factors. Not only does illiquidity vary over time and is influenced by aggregate conditions such as monetary policy, the illiquidity premium also varies over time and tends to be at its highest when times are hardest. In addition, security level illiquidity is associated with the quality and safety of investments on average (total risk).

Secondly, with increased evidence of liquidity clienteles and the associated market segmentation, strategic features are placed into local illiquidity buckets. Research suggests care should be taken in evaluating whether sufficient compensation is priced into certain types of illiquid securities.