In the search for diversification and higher returns, institutional investors worldwide have steadily increased their exposure to illiquid asset classes such as private equity, infrastructure, and private credit. Although some critics argue that these assets merely obscure volatility due to infrequent pricing, Christoph Junge, Head of Fund Investments at EIFO, points to a more nuanced reality. In a recent study, he argues that illiquid investments introduce three countervailing effects: the illiquidity premium, the loss of rebalancing premium, and the influence of volatility drag.
“The illiquidity premium and the rebalancing premium represent two valuable but potentially conflicting sources of excess return in a portfolio,” says Junge. “The illiquidity premium rewards investors for tying up capital in assets with limited liquidity, while the rebalancing premium is created through ongoing portfolio rebalancing, which requires liquid markets.” He adds that illiquid assets also influence a third component: volatility drag. By muting short-term fluctuations, or by genuinely diversifying underlying risk exposures, illiquid investments can help counter the effect whereby high volatility reduces a portfolio’s geometric return over time.
“The illiquidity premium and the rebalancing premium represent two valuable but potentially conflicting sources of excess return in a portfolio.”
The Illiquidity Premium
Starting with the illiquidity premium, Junge points out that there is broad agreement that illiquid assets have historically delivered higher returns than their listed counterparts. “Often this excess return is described as an ‘illiquidity premium’, a compensation for the absence of ongoing trading and price transparency,” he explains. Yet he stresses that the story is more nuanced. “This additional return is in reality a combination of a complexity premium and an expression of the investors’ skill, as it is unlikely that one can obtain the premium simply by buying arbitrary unlisted assets.”
“This additional return is in reality a combination of a complexity premium and an expression of the investors’ skill, as it is unlikely that one can obtain the premium simply by buying arbitrary unlisted assets.”
Empirical evidence supports that illiquid asset classes have outperformed their liquid counterparts even after adjusting for market risk. “It is worth noting, however, that the premium cannot necessarily be attributed to illiquidity, at least not exclusively,” reiterates Junge. Citing research published in 2021, he explains that “the combination of complex structures, information asymmetry, and active ownership means that the real return depends to a large extent on the investors’ ability to identify and capitalize on attractive investments.” This indicates that a significant portion of the excess return is skill-driven, often referred to as the complexity premium.
The Rebalancing Premium
By contrast, the rebalancing premium receives far less attention in industry discussions and academic research. “Rebalancing as such is not a new phenomenon, but a widely used practice to return portfolios to their strategic asset allocation when market movements or natural portfolio drift shift asset weights,” Junge explains. “However, the idea that rebalancing itself can generate additional returns is often overlooked.”
“The idea that rebalancing itself can generate additional returns is often overlooked.”
According to Junge, empirical evidence shows that even with moderate correlations and moderate volatility, “the rebalancing premium can over time constitute an important source of yield improvement, provided that the portfolio consists of liquid assets that enable rebalancing.” This becomes particularly relevant when considering illiquid investments. “When a larger share of the portfolio is tied up in assets that cannot be rebalanced on an ongoing basis – such as private equity, property, or infrastructure – the potential for capturing the rebalancing premium is reduced,” he notes. “This creates a potential conflict between allocating to illiquid asset classes and maintaining the ability to rebalance effectively.”
“When a larger share of the portfolio is tied up in assets that cannot be rebalanced on an ongoing basis, the potential for capturing the rebalancing premium is reduced.”
The effectiveness of the rebalancing premium depends on the relative performance of the asset classes within a portfolio. “If one asset class consistently outperforms the others, rebalancing will eventually lower the portfolio’s overall return,” Junge explains. “In reality, capturing the rebalancing premium often – but not always – relies on some degree of mean reversion.”
Balancing the Trade-Off
Junge further emphasizes that portfolios often face a trade-off between the illiquidity premium and the rebalancing premium. “The illiquidity premium and the rebalancing premium represent two valuable but potentially conflicting sources of excess return in a portfolio,” he notes. Junge adds that rebalancing requires that an investor can continuously buy and sell assets to restore the desired weighting. Illiquid assets, however, restrict this flexibility, as they cannot typically be traded at market prices or on short notice. “This reduces the investor’s ability to reap the rebalancing premium when the proportion of illiquid assets rises.”
A higher allocation to illiquid assets can boost a portfolio’s expected return through the illiquidity premium, but it may simultaneously reduce the risk-adjusted performance. As Junge explains, “This is because reduced rebalancing freedom and lower liquidity can increase the portfolio’s risk and reduce the contribution from the rebalancing premium, which is an important source of extra returns in volatile, but liquid markets.” He emphasizes that “optimal portfolio composition is therefore about balancing the desire to reap the illiquidity premium with the need to preserve flexibility and utilize the rebalancing premium.”
Volatility Drag
In addition to the illiquidity and rebalancing premiums, which can offset each other, Junge highlights a third factor: volatility drag. “A reduction in the portfolio’s overall volatility (e.g., via diversification) can in itself increase the long-term geometric return, all other things being equal,” he explains. Volatility drag arises when fluctuations in returns cause the realized (geometric) return to fall below the arithmetic average, because losses have a larger negative impact than equivalent gains provide.
Junge adds that “many illiquid asset classes exhibit low reported volatility, which is often due to smoothing from model-based valuation, but at the same time, several of these asset classes offer potentially real diversification gains, which reduce the portfolio’s overall variance.” He cautions, however, that “this effect should be interpreted carefully, as it is often partially driven by artificially low volatility such as through valuation methods, which does not actually reduce risk.” At the same time, Junge emphasizes that “it can also be real, because alternative risk premiums provide genuine diversification benefits.”
Practical Implications
Junge’s analysis highlights a fundamental trade-off in portfolio construction: while the illiquidity premium can enhance expected returns, relying heavily on illiquid assets can limit the ability to capture the rebalancing premium. At the same time, volatility drag and diversification can partially offset this trade-off by reducing portfolio risk and enhancing long-term geometric returns.
He emphasizes that “even if capturing the rebalancing premium seems desirable, a diversified portfolio with exposure to illiquid assets can be more advantageous, both through the higher expected returns of the illiquidity premium and through reduced volatility from diversification, which contributes to higher final wealth.”
“Even if capturing the rebalancing premium seems desirable, a diversified portfolio with exposure to illiquid assets can be more advantageous…”
To assess the optimal trade-off between the reduced freedom to rebalance and, on the other hand, the benefits of the illiquidity premium and diversification, Junge’s calculations indicate that the Sharpe ratio of a portfolio combining liquid equities and bonds with illiquid investments peaks at an allocation of 44 percent to illiquid assets. “Naturally, this result depends on the chosen input parameters in the form of expected returns, volatility, and correlations,” he clarifies.
The key takeaway for investors is that strategic exposure to illiquid assets does not necessarily require sacrificing overall portfolio efficiency. By balancing illiquidity, rebalancing potential, and diversification benefits, investors can achieve a more robust risk-return profile without forgoing long-term wealth accumulation.
Christoph Junge’s full study can be accessed via the following link: Trade-off Between Illiquidity Premium and Rebalancing Premium: A Portfolio Theoretical Analysis
