Illiquid investments: The risks and opportunities

By Jayson Forrest

Should retail investors consider an allocation to illiquid investments? John Julian (Dexus) and Michael Karagianis (JANA Investment Advisers) discuss how investors can gain an exposure to these types of investments

Lukasz de Pourbaix (Fidelity International) explains why investors should consider contrarian strategies in a portfolio.
John Julian is Managing Director at Dexus Infrastructure
John Julian
Dexus Infrastructure
Michael Karagianis is Senior Consultant at JANA Investment Advisers
Michael Karagianis
JANA Investment Advisers
Paul Saliba - Sector Head Equities and Fixed Income at SQM Research
Paul Saliba
SQM Research

‍Industry super funds account for nearly two-thirds of Australian superannuation assets (which stands at $3.7 trillion at the December quarter 2023), with most of these funds having meaningful exposure to illiquid assets — like unlisted infrastructure, private equity, and private credit. However, for retail investors who opt for liquidity, John Julian — Managing Director at Dexus Infrastructure — believes they are missing out on the opportunities and risk diversification benefits that illiquid investments can bring to a portfolio.

As an example, John refers to unlisted infrastructure (like airports, hospitals, water and electrical utilities), which as an asset class, offers some very attractive investment characteristics in a portfolio. These include consistent returns with relatively low levels of volatility through market cycles, due to the essential services nature of these assets. They can also provide consistent long-term income yields with inflation protection, because infrastructure asset revenues are often underpinned by regulation or long-term contracts.

Speaking at an IMAP webinar on ‘Illiquid investments’, John adds that infrastructure can also provide diversification, as this asset class — particularly unlisted infrastructure — has traditionally shown low levels of correlation with many other asset classes.

“This means the inclusion of infrastructure assets within a portfolio is an effective means of reducing overall portfolio risk levels,” says John. “In addition, infrastructure assets are exposed to some of the biggest structural growth themes investors are likely to see in their life time, like global energy transition.”  

According to John, investors can invest in infrastructure via unlisted and listed assets. And while both approaches typically invest in the same underlying assets, they have separate differentiating characteristics that can impact the broader portfolio.

As an example, a major benefit of listed infrastructure is its liquidity. However, listed infrastructure tends to be more impacted by market sentiment, and that means valuations are volatile compared to unlisted infrastructure. This means listed infrastructure is not as effective as unlisted infrastructure as a diversifier in a portfolio.

In comparison, some of the major benefits of unlisted infrastructure include stability of valuation and low volatility, because unlisted assets are not as exposed to the speculation that occurs on listed exchanges. However, on the flip side, unlisted infrastructure is relatively illiquid, and usually requires a large capital outlay to access. 

Some illiquid strategies can be expensive and very complex, with investors not knowing the underlying assets. There is also complexity with multi-strategy hedge funds and in the way certain trust structures are set up. These complexities can be a disincentive for some investors, as well as advisers

Michael Karagianis

The illiquidity premium

JANA Investment Advisers has always taken the view that there is an illiquidity premium that can be achieved by investing a client’s money in less liquid strategies. According to Michael Karagianis — Senior Consultant at JANA Investment Advisers — while liquidity may be an important part of many client portfolios, clients generally give up too much (such as investment return) for liquidity.

He adds that even though retail clients might understand the concept of capital lock-up with residential property investing, when discussing other types of illiquid strategies, there is less familiarity and comfort with these strategies.

“That’s because some illiquid strategies can be expensive and very complex, with investors not knowing the underlying assets. There is also complexity with multi-strategy hedge funds and in the way certain trust structures are set up. These complexities can be a disincentive for some investors, as well as advisers,” says Michael.

We have developed the Dexus Core Infrastructure Fund, which has been designed specifically for retail investors to provide them with access to unlisted infrastructure. While it does provide exposure to unlisted infrastructure assets, it also has an allocation to listed infrastructure to provide investors with some liquidity

John Julian

Private markets

When considering private debt and private credit, Michael believes these investments provide both opportunities and risks. JANA is already seeing many managers coming to market with private credit offerings, which will help to address the underinvestment in this space.

However, the concern Michael has with private credit is that it requires very specific and detailed credit research requirements. “You actually have to go and rate each of the assets you put in your portfolio, and you generally have a lot less diversification of these assets in your portfolio. Some of these private credit strategies have particular skews to certain sectors, like mortgage asset exposure, which means you are also significantly exposed to the banks.”

Michael adds there can be a lot of thematic build-up in these strategies around some very specific risks. This makes it important to be selective about the managers you believe have the right type of portfolio structure in place and the experience to manage a private credit book. 

“It’s a space you really have to understand, including the covenants being applied to many of these loans. The fund manager needs to have a detailed understanding of these assets, as well as hands-on management of the portfolio.”  

How do you rebalance a managed account portfolio when a reasonable slice of it is completely illiquid? That’s the type of issue we need to grapple with, as it does produce complexity with rebalancing, as well as handling individual client cashflows

Michael Karagianis

Exposure to illiquid investments

So, should retail investors have an exposure of illiquid investments in their portfolio? For Michael, it’s a question that comes down to weighing up a number of practical considerations, such as cost and complexity.

John agrees, adding that illiquid investments are attractive assets that can offer compelling benefits to a portfolio. However, the illiquid nature of these assets makes it important for investors to properly understand these investments to ensure they are compatible with their needs and objectives within the portfolio.

Dexus has delivered a vehicle that it believes addresses some of the challenges retail investors have when trying to access illiquid investments, such as the large amount of capital that is typically required to access these assets, as well as capital lock-up.

“We have developed the Dexus Core Infrastructure Fund, which has been designed specifically for retail investors to provide them with access to unlisted infrastructure. While it does provide exposure to unlisted infrastructure assets, it also has an allocation to listed infrastructure to provide investors with some liquidity,” says John.

“This fund is available on all the major platforms and it actually sits within a number of managed accounts. So, I absolutely think there are ways in which it is possible to make unlisted assets available in the retail space.”  

Michael confirms that a number of vehicles have been brought to market, which opens up illiquid investments to retail investors. “We’re seeing fund managers coming to market with feeder funds or wrappers, and we’re also seeing intermediaries coming to market, engaging with fund managers and advisers,” he says.

We need to do a better job with the education piece. It’s incumbent on all of us within the industry to ensure that investors have clarity and a good understanding of what they’re investing in, including the benefits and risks of unlisted assets

John Julian

High and low risk strategies

Ask Michael for examples of risky illiquid investment strategies, and he points to single strategy hedge funds. “I think strategies that apply significant leverage within their portfolios, depending on what the leverage is used for, are probably at the riskier end of the spectrum.”

At the less risky end, he nominates direct assets — like unlisted infrastructure and private equity — which tend to be a little less risky, due to the ‘mark-to-market’ effect. As these assets are not being valued every day, they tend to be less volatile.  

John agrees, emphasising the importance of investors needing to properly understand the characteristics of the investments or strategies they’re getting into, so they can make informed decisions.

“In terms of risk, within the infrastructure asset class there are a range of different types of assets, which have different risk profiles,” he says. “Within infrastructure, lower risk assets tend to be things like government-backed public-private partnerships.

“And moving up the risk spectrum, you’re coming to assets that are more economically exposed, like airports and seaports. These assets are driven by the freight and number of passengers transiting through the airport, and the volume of cargo moving through a seaport. With these assets, investors are taking on a higher level of risk, so you’d expect a higher level of return to compensate for that risk.”

Importantly, John adds that infrastructure is a heterogeneous rather than a homogenous asset class, which means every asset is different. So, assets that look the same on the surface, might actually be subject to very different underlying drivers of risk and return. And conversely, assets that might look different on the surface, might actually be influenced by similar factors.

Changing the narrative

When it comes to illiquidity within an investment portfolio, Michael believes that both advisers and investors need to understand that illiquidity is not a bad thing. He says the industry needs to do a better job at managing the liquidity expectations of investors by properly explaining to them that some degree of illiquidity in a portfolio is beneficial.

“This really becomes an education piece for clients,” says Michael. “Advisers know their clients best. They are tasked with providing recommendations that are in the best interests of their clients. There will be some types of clients where illiquid strategies are unsuitable, while being suitable for other types of clients. It’s also important that advisers are properly educated about illiquid investments in order to recommend them.”

When it comes to adviser and investor understanding of illiquid assets, John says it’s a “mixed bag”. While some people embrace the inclusion of unlisted assets in retail portfolios and in some managed accounts, for others, it’s still a ‘bridge too far’.

“So, we need to do a better job with the education piece. It’s incumbent on all of us within the industry to ensure that investors have clarity and a good understanding of what they’re investing in, including the benefits and risks of unlisted assets,” says John.

A multi-faceted issue

Whilst illiquid assets and strategies seem to be underrepresented in the portfolios of many retail investors, Michael believes that despite the opportunities these assets offer, the sticking point for investors remains the illiquidity aspect of these assets in portfolios.

“How do you rebalance a managed account portfolio when a reasonable slice of it is completely illiquid? That’s the type of issue we need to grapple with, as it does produce complexity with rebalancing, as well as handling individual client cashflows,” says Michael.

He says the issues surrounding illiquid assets are multi-faceted, which makes it essential for responsible entities, advisers, and their clients, to be comfortable with these assets when investing in them.

“If part of the portfolio is illiquid and clients need to drawdown money, they need to be at ease knowing that some of their capital is locked up. They need to understand both the opportunities and risks of investing in illiquid assets,” says Michael.

About

John Julian is Managing Director at Dexus Infrastructure; and

Michael Karagianis is Senior Consultant at JANA Investment Advisers.

They spoke on ‘Illiquid investments’ as part of an IMAP Specialist Webinar Series on ‘Investing outside the mainstream’.

The session was moderated by Paul Saliba — Sector Head Equities and Fixed Income at SQM Research

Contact us

Email
This email address is being protected from spambots. You need JavaScript enabled to view it.

 

Phone
0414 443 236