The rise of illiquids: The perils of DC portfolio changes being viewed in isolation

James Fouracre says private markets demonstrate a higher correlation with equities than many think

clock • 4 min read
The rise of illiquids: The perils of DC portfolio changes being viewed in isolation

Over the past decade, pension schemes of all shapes have been cranking up allocations to illiquid assets.

Despite this, UK defined contribution (DC) schemes have been slower to venture into the illiquid space, as evidenced by a survey commissioned by the Department for Work and Pensions which found two-thirds of DC schemes do not currently invest in illiquid assets.

However, that all looks set to change following the chancellor's Mansion House Compact.

With long-term investment horizons, DC schemes are well placed to harness any potential illiquidity premium on offer. The government, Financial Conduct Authority and Bank of England have been working in concert over the past year to pave the way into illiquid assets for DC investors, culminating in the unveiling of the government's Mansion House Reforms package. The Productive Finance Working Group have published a series of guides designed to enhance trustees' knowledge and understanding of illiquid vehicles. It is also now a requirement for scheme trustees to include a formal policy on illiquid investments in their chairperson's statement.

The scene is set for a weighty increase to illiquid assets - but what are the potential pitfalls, or underappreciated investment risks? Crucially, how should DC schemes adjust portfolios to optimise their risk-adjusted returns, and in turn, their resilience?

A lesson learned

The September 2022 Mini Budget caused ructions in the UK gilt market which exposed the soft underbelly of many UK defined benefit (DB) pension schemes. As these schemes scrambled to meet cash liabilities, liquidity fast became the crux of the issue.

These schemes were forced into selling what they could, rather than what they wanted to. Those with large exposure to illiquid investments were especially distressed. Illiquid investments, by their nature, are difficult to exit in a hurry.

While UK DC schemes have no need for liability-driven investment (LDI) strategies, an increase in illiquidity can reduce scheme flexibility. Illiquid assets typically have lumpy cashflows both in and out. It so happens that illiquid strategies' capital requirements tend to coincide with weakness in equity markets - again, potentially forcing investors' hands into selling assets at inopportune moments. And with persistent inflation, a meaningful long-term cash float to fund future commitments will drag on real returns.

Correlation of returns

Achieving positive returns in a DC portfolio, whatever happens in financial markets, means finding and owning assets which respond differently to changes in the investment environment. Crucially, it also means owning assets which respond differently to each other.

Whereas conventional bonds formerly protected clients against falls in equity markets, ankle-high interest rates have suppressed their protective power. When conventional asset classes - namely bonds and equities - are positively correlated, the absence of reliable offsets is a material cause of concern for asset allocators. The illiquidity premium and the enhancement of returns is widely debated - solving the diversification of returns quandary, less so.

A portfolio delivering uncorrelated returns supports the goal of smoothening portfolio returns during volatile periods.

There are some limitations in sourcing publicly available data of private assets, however there are publicly listed proxies that offer some useful insight. We analyse below the correlation between the indices over the past 10 years and the global equity market, using weekly data.

The correlation of private and public assets




(Largest private equity companies listed on global exchanges)



(Leading listed private equity companies - 18% Index Weighting to UK)


S&P Blb Infr Net TR

(leading global infrastructure companies)


Source: Bloomberg

Private market proxies have demonstrated a much higher correlation with global equities than might be assumed. This has been over a period that has comprised both bull and bear markets, highlighting that this lockstep correlation persists through market cycles.

The barbell

Should there be an influx into illiquid investments across DC schemes, portfolios may begin to resemble something akin to a barbell: a heavy weighting to listed equites and bonds at one end; and illiquid (typically private) assets at the other. And while the weightings and allocations will flex across the lifecycle, the inherent risk with this portfolio is that in an environment of volatile bond yields and inflation, both ends of the barbell fall together.

How bonds, equities and illiquid assets fell in tandem 

Source: Bloomberg. (S&P 500, S&P Private Equity Index, Bloomberg Global Bond Aggregate Index. Total return in US dollars.)


The chart above shows how in September 2022, bonds, equities and illiquid assets (in this case private equity) fell in tandem. This is the correlation conundrum.

So where to turn? The key is in balancing the ends of the barbell with an uncorrelated strategy - one that offers material downside and inflation protection, and crucially, liquidity throughout market cycles - serving to improve risk-adjusted returns combined with resilience and flexibility.

James Fouracre is director of UK institutional at Ruffer

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