There is an interesting article in  the FT which has sparked quite different reactions from people I know. Here is it’s presentation from Jo Cumbo, who has strong views on investing other people’s money for social purpose. It’s Jo’s article.

Thanks for sharing Jo. V interesting debate. V timely too.

— Richard Butcher (@RButcherptl) February 16, 2021

For those without an FT subscripion, what Richard Tomlinson – the LPP CIO – is saying is that if you’re investing in illiquid investments to get extra return because you don’t need the money back, then you may have missed the boat. The “illiquidity premium’s” boat sailed when QE flooded the market with so much cash, demand for liquidity dried up.

My friend Con Keating explained this to me

It is the price of liquidity which matters. The effect of QE has been to drive down the price of liquidity – among other things that is the explanation for the decline of dealer bond inventories – with liquidity this cheap, it does not make sense for banks to create it.

In other words, you will earn very little, if anything, extra from buying illiquids today.

Incentives are not always a good reason to buy

Short term incentives such as “buy one get one free” or a simple discount to the RRP often seem tempting and lead to piles of unwanted goods at the back of the cupboard which (in our household) get recycled through charity shops. Buying cheap and selling cheaper is not a good economic model and it’s one that Jo has warned me against (among many things Jo is a thrifty housekeeper)

Jo is  uncomfortable with the headlong push by the Government into encouraging DC pensions to invest more to help the economy rebuild. She thinks this is complicated for DC and she worries that  the recent Pension Schemes Act now puts a fiduciary duty on trustees to act in the best interests of the environment.  For Jo, there are tensions and conflicts of interest here which need to be challenged and fleshed out.

Of course in pensions, the incentive to tie up our cash in a scheme where we may not see it back for over 40 years is already incentivized by the tax system. Although it doesn’t always quite work, the EET taxation system where we get taxed on the benefits and relief on tax we would have paid on contributions and investment returns, provides an interest free loan from the Treasury from tax deferral, 25% of the loan is written off at the end of the investment period – long term saving is already incentivized wherever the money goes.

But that does not diminish Jo’s point , just because the capacity to invest has been boosted by tax relief , shouldn’t make you any less diligent in investing, especially when you are investing other people’s money. Incentives should not be the reason to buy, and too often they devalue the money used to make the purchase.

The case for purchasing and holding illiquids  has to be fundamental

If we can no longer buy in the sale, it doesn’t mean we cannot buy. Richard Butcher makes a number of good points in a sharp tweet.

But the case for illiquids must be fundamental. We don’t invest in our pension just because of tax-breaks and we shouldn’t invest in illiquids just to capture an illiquidity premium.

— Henry Tapper (@henryhtapper) February 16, 2021

Con Keating points out that for those who bought illiquids when they were discounted, holding those investments is as good an idea today as it was when the investment was made. The fundamental case for illiquids is that they generate long-term value and investors shouldn’t look to bail out because they fear a “Woodford” or because they can crystallize a quick profit from the discount they got when they purchased the asset (s).

The second point is that the illiquidity premium is fixed by the acquisition cost. (I am ignoring the possibility of sale prior to maturity, but these are illiquid or “not traded” instruments) That means that there is nothing incongruous about holding a portfolio of illiquids which were acquired in more normal times when there was a premium for illiquidity.

Trading is not investing, “cashing out” rarely works

I am reminded of a betting analogy. It is now possible to bet on a horse either before the start of a race or “in running” and “cash out” your investment, prior to the horse winning or losing. Quite often you can make a quick buck doing this, but over time you will end up losing, because you cannot see what the naked eye can see, the progress of your horse in real time. People on course, who make the market are typically two seconds ahead of those on their laptops or phones and so the punter is always trading with imperfect information.

There is not full transparency in the market as you are betting against someone who has better sight than you. So you will lose more than you win. The analogy with illiquids is obvious, you are the best over time to let your horse finish the race, or your investments run their full duration.

This is why the trading strategies of hedge funds, quant funds and even the multi-strategy DGFs like GARS have not really caught the pension world’s imagination (or money). Trading on complex algorithms they are at the other end of the spectrum from the patient capital of illiquids. No matter how good the idea behind the strategy, there will always be someone 2 seconds ahead of you, who will seek to exploit better trading information.

The value of paying for proper investment management

Another friend, Paul Stanworth, who for a time was CIO of Legal & General’s internal funds spoke with me about how little expertise there is in this area of investment.

It worries Richard Tomlinson (and Jo Cumbo)  that the UK government consultation document in 2019 said that by investing almost wholly in highly liquid investments, such as listed equity and debt, pension funds could be missing out on the illiquidity premium.

Paul’s comments were directed at those in Government who simply see the investment in an asset class as a socially responsible thing to do and therefore blindly trust the market will incentivise that investment through a mechanism that is no longer needed (the illiquidity premium).

Paul’s point is Richard Butcher’s point, there needs to be expertise behind infrastructure investment and not speculation. A point well made in one of the comments to the FT article which broadens the debate to the transparency (or lack of it) in private equity.

Fees are negotiable but only where the buyer has skill and expertise. They form part of the fund manager’s value add which is very much about managing the initial transaction which often appears to be badly executed,

The poor execution that Paul mentioned to me is not of course the same thing as flagrantly exploiting the lack of transparency of many illiquid investments, for private equity read Woodford and in extremis the long tail of retail investment scams.

Perhaps the final word should go to another commentator on Richard Tomlinson and his comments.

Once we have accepted that DC pension funds can invest in illiquids , we move on to the next questions – “should they?” and if so, “how?”.

A DC/CDC footnote.

Although I am a fan of patient capital, I am minded of its impact on many DC funds right now. That many people are in drawdown strategies that include “gated” property funds either purchased directly or forming part of defaults, tells me that not all the risks have been through through, or even considered.

Jo Cumbo is right when she tells me

There are tensions and conflicts of interest

which need to be challenged and fleshed out.

We need to remember that DC funds are for individuals who will eventually want their money back. Unless the aim of the fund is to create a family office wealth management service (for future generations), all DC investments will need to be redeemed.

Unless of course the scheme is collective and truly open-ended.