Acropolis diversifies in more ways than you may realize. In addition to the well known methods like single company exposure, sector, industry, geography, creditworthiness and asset classes, we also diversify by risk factors.
I’ve written about the equity factors that we use (see a list of our primers on size, value, momentum and quality here), but I think it’s also important to note that there are some factors that we avoid.
For example, we don’t explicitly try to exploit what is known as the illiquidity premium, which is the idea that illiquid assets tend to outperform liquid ones.
It’s a perfectly sensible approach, and one that has worked well for some large institutional investors like Yale, but we struggle with how it could work for our clients.
Illiquid investments tend to earn higher returns because investors demand a discount on the price to compensate for the inability to sell the investment on demand. Of course, simply being illiquid doesn’t guarantee excellent or even positive results.
One of the worst problems with illiquid investments is they become most illiquid during bad times, which is just when you want your money back the most.
Even if you’re responsible and are prepared to weather a storm, you have to worry about whether your co-investors will demand their money back and force a liquid investment at fire sale prices (creating an opportunity for other illiquid investors).
A recent paper in the Journal of Portfolio Management (JPoM), ‘Forced Liquidations, Fire Sales and the Cost of Illiquidity’ details the problem and offers methods to factor in the hidden costs associated with illiquid investments.
Although we don’t have explicit exposure to illiquid investments, there is a good argument that part of the size premium in stocks and credit premium in bonds are associated with illiquidity.
A lot of micro-cap stocks and corporate bonds don’t even trade daily, let alone every pico-second, like large cap stocks (a pico-second is one-trillionth of a second and some high frequency traders measure time in pico-seconds).
The JoPM article is very interesting, but for the time being, we’re going to stick with liquid assets and forgo attempting to profit directly from the illiquidity premium.