Principal at fixed income asset manager offers a view on liquidity issues that could impact the returns profile that many advisors see in private assets
As more investors demand alternatives and private assets, they may not be considering the liquidity trade-off involved in these products. That’s the view espoused by Liam O’Sullivan, Principal and co-head of client portfolio management at Toronto-based fixed income asset manager RPIA. He uses the example of private debt to demonstrate that historically many alts offered investors a ‘liquidity premium’ between three and four per cent above the yields on public debt products. As interest rates have risen that delta between the more illiquid private debt investments has shrunk and one asset manager thinks it’s time for advisors to take more care with their clients’ private asset allocations.
O’Sullivan explained what he means by a liquidity premium and what that premium can mean for individual investors now. He outlined how advisors can gauge the value of that liquidity, or lack thereof, while they assess their clients’ asset allocation. He offered a view as to why in this market environment, liquidity may be worth considering closely.
“For an individual this is an environment where you want to have flexibility and you want to have more liquidity in your portfolio. We've come from a 10-year period of accommodative monetary policy where the central bank had your back, which was very supportive for risk assets of all types,” O’Sullivan says. “We're now in a, in an environment of more volatility, more uncertainty, and as an individual investor you want more liquidity so you can respond to the environment, so you can rebalance, so you can capture opportunities. Committing a bigger portion of your portfolio to private assets hamstrings you.”
O’Sullivan compares private and public debt yields from 2014 to 2024. Over that time, private debt has generally yielded about four per cent above public. That’s the liquidity premium. Since interest rate hikes began in 2022, that delta has collapsed to “basically zero.”
Even if outperformance is not currently a factor, many advocates for alternatives and private assets will say that the nature of their returns is enough of an appeal. Because they aren’t priced as frequently, the returns profile is smoother and investors don’t have to cope with nearly as much volatility. O’Sullivan argues that the price fluctuations are happening either way, these assets just appear less volatile because of the longer gaps between pricing. The benefit, he says, is illusory.
O’Sullivan is careful to emphasize that he doesn’t think private assets are inherently flawed. He believes they can play a crucial role in portfolios at different times in the cycle. However, this is a moment where rising yields and a changing macroeconomic environment have weakened the case for private assets against public assets. The dramatic rise in the value of private assets, O’Sullivan notes, occurred during a sustained period of low interest rates and a broadly bullish environment for most asset classes. Higher interest rates have changed that outlook.
O’Sullivan notes that we have begun to see private portfolios experience valuation write-downs, arguably made worse by the less transparent nature of private assets. Many private loans have begun to lose performance in a higher interest rate environment, pointing to some signs of stress in the private asset space.
“The other piece of the puzzle is just the sheer volume of assets that have flowed into some of these asset classes. I mean, if the landscape was very different a decade ago,” O’Sullivan says. “Now, so much capital has been committed in these private strategies that lending quality lending standards have probably been deteriorating over time. The quality of portfolios originated over the last few years is of a lesser quality than portfolios originated a decade ago. The environment’s changed and the sheer volume of money that flowed into the asset class doesn't bode well for future returns.”
One area that retail investors can benefit from is the rise of liquid alternatives. Using more liquid vehicles like ETFs, investors can access some alternative strategies without having to give up the liquidity that comes with a public market holding.
Unlike their institutional counterparts, which have the time horizons and capital to weather any potential liquidity-related issues, O’Sullivan believes that retail investors are more likely to be challenged by liquidity. He argues that advisors should be explaining to their clients that while an alts allocation can be helpful, there has been enough of a change in the market environment to preference public market allocations over illiquid alternatives.
“Retail investors, I believe, still need alternatives in their portfolio. I strongly believe, however, that this is the type of public alternatives, not private alternatives. So, you know, a traditional 60/40 or 70/30 portfolio is not going to be optimal long term for risk adjusted returns, you need a slice of something that zigs and zags differently,” O’Sullivan says. “My point would just be that, at this point in the cycle, you should get that alternative exposure through public alternatives with some liquidity rather than locking capital up for a long period of time and sacrificing the transparency.”
