One of the cornerstone investment principles for long term investors is that they should be able to accept more risk than an investor with a shorter investment horizon, all else being equal. The construction of a robust long term investment portfolio requires diversification across different asset classes and risk premia such as the illiquidity premium.
Institutional investors often position their investment portfolios relatively conservatively from a liquidity management perspective, even those with very long investment horizons. This is driven by a range of factors such as governance constraints, regulatory requirements, concerns about historical market events and the behavior of peers. However, this tends to result in inefficiencies from a long term investment perspective and we therefore recommend that institutional investors review their liquidity requirements periodically. Indeed, we suggest that the liquidity budget is considered explicitly as part of any long term Strategic Asset Allocation (SAA) review.
We have developed a Liquidity Budgeting Framework to assist institutional investors with a fundamental assessment of their own liquidity requirements. Once such a first-principles review has been carried out, an appropriate liquidity budget can be quantified and documented. This framework allows investors to integrate their liquidity requirements into the SAA setting process and facilitates the management and monitoring of their investment portfolio’s liquidity characteristics over time.
In this paper we summarise Mercer’s views on the illiquidity premium, revisit the case for investing in illiquid asset classes and provide a high level overview of Mercer’s Liquidity Budgeting Framework.