The rise of private markets has been supported by the perceived existence of an ‘illiquidity premium’ – or the extra return provided to investors as compensation for holding assets that are difficult to trade. Although the concept has seemingly become commonly accepted, there is no clear definition of precisely what it is or how it comes about. At times it can feel as if it is simply some magic dust sprinkled on private assets to boost performance. Given the growing importance of this area, it feels worthwhile being a little more specific – so just what is the illiquidity premium?

Let’s return to the basic definition – investors demand a higher return for an asset that is hard to buy and sell. This makes sense – if I am going to lock my money away, I want some reward for the inflexibility. *

While this idea may seem reasonable, investors demanding an additional return does not make it so, and the above framing is still a little vague.  A better one might be:

The illiquidity premium is the additional return for holding an illiquid asset relative to a more liquid asset, other things being equal.

The ‘other things being equal’ part is important here. To isolate the illiquidity premium we need to say that if we had two identical assets but one was illiquid (private) and the other liquid (public), we should anticipate a higher return from the private asset.

The next question is – how do we get a higher return from the illiquid asset? It must be because it is cheaper than its liquid counterpart. If there is no difference in fundamentals, then there has to be a valuation discount to enhance my prospective return. How else could it come about?

There are, of course, other ways that additional performance may be garnered from illiquid, private market exposure – the opportunity set might be wider, there may be a benefit to private equity firms having control of a business and a private market manager may have a greater ability to add ‘alpha’. While all these elements may be valid, they are simply potential features of private market investing not an illiquidity premium.

If we define the illiquidity premium as being derived from a valuation gap between private and public assets, it tells us two things:

1) The premium should be in some way observable: Although we will never be able to observe the valuation of a private asset in a parallel universe where it is publicly listed , it should be possible to compare the valuations of similar assets in the public and private sphere, and ascertain whether there is a discount. (This is probably easier to analyse in private credit than private equity). If private assets of similar quality are priced more expensively – where is the illiquidity premium coming from?

2) The premium will be time varying: If the illiquidity premium is about the valuation gap between public and private assets then it will not be static, but will wax and wane based upon the prevailing environment. If private assets are in high demand, the illiquidity premium will be (at best) lower. We should not treat it as a permanent, structural advantage.

One of the primary drivers for the burgeoning demand for private assets has been the long-run return advantage relative to public markets (let’s leave the validity of this argument for another day). Part of this apparent edge is widely believed to have come from the illiquidity premium. We need to be careful, however, that what is being identified as an inevitable premium is not simply a significant valuation re-rating in private assets from a period where demand was far lower and access much more difficult.

There is a not insignificant risk that the clamour to capture an illiquidity premium acts to extinguish it.

The broader use of private assets will inevitably be a critical investment theme over the coming years. Given how consequential this area may be for investors, if we are to use coverall terms like ‘the illiquidity premium’ we need to be clear about precisely what we mean.

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* From a behavioural perspective, there is a strong case that illiquidity improves ‘behaviour-adjusted’ returns by forcing us to be long-term investors and preventing us from following our worse impulses. Perhaps this is the real illiquidity premium.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point.

When you disagree with someone about an investing issue, is it because you have distinct interpretations of a specific topic or because your starting beliefs and aims are entirely incompatible? It is almost certainly the latter. Most financial market debate and discussion amounts to people shouting at each other in different languages.

We can think about our investing language as being founded upon two things – our investment principles and our objectives. What we believe about how investing works and what we are trying to achieve. These two aspects shape how we think about a given subject and the position we will take on it.

Let’s take two investors – a short-term trader looking to realise day to day profits, and a fundamentally driven, long-term stock picker – they have significant disagreement on the impact of US tariff policy. Are they likely to have a productive conversation where they exchange views and potentially learn from each other’s perspective? Absolutely not, because they are not speaking the same language. It is doubtful that they will even understand what the other person is saying. 

What might sound like a disagreement between investors is often just a proxy war that is really about conflicting investment beliefs. A conflict that is unlikely to be resolved.  

One of the (many) unusual features of the investment world is that it brings people together who are engaged in entirely distinct endeavours and assumes that they are (pretty much) doing the same thing. Much of the heat and noise that comes from financial markets is caused by these fractious interactions.  

This dynamic is a critical one for individual investors to understand, otherwise we are at risk of having our head turned by every opinion that we hear. When someone voices an investment perspective, we should always ask ourselves what it is that this person believes and what are they trying to achieve? If the answer is wildly misaligned with our own principles and goals then we should treat it with caution.

That doesn’t mean that we should never challenge our own investment beliefs, but there is a big difference between taking the time to deliberately reflect on the merits of our own approach, and listening to the day to day cacophony of individuals whose activities – under the surface – bear very little relation to our own.

These language problems are also a major issue for investment teams. Although diversity within teams across expertise, experience, temperament and background can be highly beneficial, this does not stretch to investment beliefs and objectives. Teams with conflicting incentives and principles are inevitably beset by constant friction, frustration and disharmony.

If we are trying to build a successful football team, we want individuals with unique (complementary) skills, but shared goals and consistent, overarching principles about how to be effective. If, instead, we have a group of talented people all striving to achieve different things in different ways, the team is almost inevitably destined for failure, no matter how strong the component parts.

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Having shared principles and goals does not mean just listening only to people who agree with us – individuals can share foundational beliefs and disagree a lot. This is an essential feature of a healthy decision-making dynamic. We must, however, be on guard against being overly distracted by the views and actions of people who exist in the same universe as us but are speaking an entirely different language.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

There are three types of investors: momentum, valuation and noise. Momentum investors care about price movements, valuation investors care about fundamentals and noise investors care about a random assortment of stuff. Many of us are noise investors, even though we won’t realise it.

Of course, investment approaches do not all neatly fit into such discrete categories. Most are a combination of momentum and valuation, and every investor lets some noise into their world. The critical question is – how much is market noise impacting our behaviour?

The more influential noise is, the more inconsistent and unpredictable our decisions will be. When observing the choices made by a noisy investor it will be difficult to discern any recognisable pattern.

This is not a path to good investment outcomes.

Why is noise such an overwhelming issue for most investors? There are two factors at play. First is the sheer amount of ‘information’ available to us, which means that we face a constant struggle to understand what is important and what is immaterial. Second is our reaction to this torrent of stimulus. If we don’t define what is consequential, we will act like everything is. Is that GDP print important? What about that conflict in the Middle East? What about that technological change?

Noisy information leads to noisy behaviour.

The key differentiator between a noise-influenced investor and a momentum or valuation-led investor is that the latter group will have a far more clearly defined idea of what information matters and how they are likely to react to it.

That doesn’t mean that valuation and momentum approaches are inherently good, it is just that they are less noisy. An investor with a process that involves buying the best performing mutual funds of the past three years is momentum-focused but not noisy. It is still a very bad idea, just not one beholden to market noise.

Noise-driven investment behaviour is incredibly destructive, but it is almost certainly how most of us act. Why is it so hard for investors to avoid being captured by noise?

1) We are surrounded by it: It is close to impossible to switch off from the slew of financial market news and information. It is all-encompassing and overwhelming.

2) It is heavily incentivised: While noise may be bad for us it is fantastically lucrative for many in the industry – noise means clicks, trading, turnover, spreads and commissions.

3) Everything feels important in the moment: We tend to judge the importance of something by how available or prominent it is. Even if an issue has no real relevance for our objectives or over our time horizon, it will feel very much like it does.

4) Other people think it is important: It is incredibly hard to ignore subjects that everyone else is treating with the utmost significance. We will either look naïve or negligent, perhaps both.

5) Noise is exciting: Financial market noise is fascinating and, at times, exciting – engaging with it is stimulating and enjoyable. The trick is to be interested in it, without letting impact our investment decision making.

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It is vital to acknowledge that our default state is to succumb to the allure of financial market noise. Once we have done this, is there anything we can do about it?

The starting point is to define the things that we care about. What matters most given our investment approach and objectives? Anything that is not in this list we can categorise as unhelpful noise.

(There is no objective list of what constitutes ‘noise’. One investor’s noise will be another’s essential information – it depends on what we believe and what we are trying to achieve).

We also need to take an active approach to blocking out market noise. All investors should be thinking carefully about how we can disregard things that are not likely to be influential, even when we know that at times they will feel crucial.

Being complacent about the amount of superfluous noise in financial markets is not a viable option, if we don’t find a way to guard against it, it will quickly come to define our investment approach.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).