## **Learning Outcomes**

This article explains how alternative real assets fit into institutional portfolios and how illiquidity premia affect return expectations, including:

- differentiating alternative real assets from traditional listed equities and bonds in terms of cash-flow characteristics, trading frequency, and valuation practices;
- assessing the trade-offs between illiquidity risk, required returns, and diversification benefits across real estate, infrastructure, timberland, and farmland strategies;
- interpreting the concept, sources, and economic drivers of illiquidity premia and relating them to market conditions and investor risk tolerance;
- decomposing expected returns for real asset alternatives into risk-free rates, systematic risk premia, illiquidity premia, leverage effects, and active management alpha;
- evaluating how illiquidity constraints influence strategic asset allocation, liquidity budgeting, and rebalancing policies for long-horizon investors;
- analyzing common exam-style scenarios that contrast private real assets with public market proxies, and determining when an observed return adequately compensates for illiquidity risk;
- applying a structured framework to judge whether proposed allocations to illiquid strategies are consistent with an institution’s spending needs, liability profile, and tolerance for valuation uncertainty.

## **CFA Level 3 Syllabus**

For the CFA Level 3 exam, you are expected to understand the characteristics, risks, and expected returns for real asset alternatives, with a focus on the following syllabus points:

- The role and types of alternative real assets (real estate, infrastructure, commodities, timber, farmland, etc.)
- How illiquidity premia influence expected asset returns
- Risk–return trade-offs unique to illiquid assets (compared with public equities and bonds)
- Measurement and practical interpretation of illiquidity premia
- Portfolio construction and liquidity planning with alternative real asset exposures

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. What does the illiquidity premium represent for real assets, and how is it generally expected to affect required returns?
2. List two specific risks faced by institutional investors when allocating to private real asset alternatives.
3. True or false? In a low-interest-rate environment, the observed illiquidity premia for core real estate and infrastructure is likely to decrease.
4. Which types of real assets commonly exhibit the highest degree of illiquidity?

## **Introduction**

The inclusion of alternative real assets in institutional portfolios—such as real estate, infrastructure, timber, and farmland—has increased significantly. These assets are typically less liquid and less frequently traded than listed equities or bonds. As a result, investors expect compensation for holding these assets in the form of an **illiquidity premium**, which has become an increasingly important component of return expectations in portfolio construction.

> **Key Term: illiquidity premium**
> The incremental expected return demanded by investors for holding assets that are difficult or costly to trade, due to infrequent transactions or limited resale markets.

## THE ROLE OF REAL ASSET ALTERNATIVES IN PORTFOLIOS

Alternative real assets include both publicly traded and private market investments. While public real estate investment trusts (REITs) can be bought or sold easily, most "real asset alternatives" refer to private market assets such as:

- Core, value-add, and opportunistic real estate (commercial properties, housing, logistics centers)
- Infrastructure (transport, utilities, energy pipelines)
- Timberland (working forests managed for harvest)
- Farmland (agricultural investments)

Compared to listed stocks, these assets often have long holding periods, valuation delays, and limited markets for resale. In return, investors may benefit from higher expected yields and lower correlation with equity markets.

> **Key Term: real asset alternatives**
> Investments in physical or tangible assets—such as real estate, infrastructure, timberland, and farmland—that may provide income, inflation protection, and diversification, but often involve higher illiquidity.
>
> **Key Term: core real estate**
> A real estate investment strategy focused on high-quality, stabilized properties with moderate use of debt, prioritizing steady income and low portfolio risk.

## ILLIQUIDITY RISK AND PREMIA

Illiquidity is the risk that an investor cannot convert an asset to cash quickly, or must accept a significant price reduction to do so. For real assets, illiquidity arises from lengthy sale processes, appraisal-based values, infrequent auctions, and limited numbers of interested buyers.

> **Key Term: illiquidity risk**
> The potential for a substantial loss, delay, or additional cost when seeking to exit or adjust a position in an asset with limited or slow secondary markets.

Illiquidity affects portfolio planning in two main ways:

1. Investors must hold higher cash balances to meet unforeseen needs.
2. They demand higher long-term returns from illiquid assets to compensate for loss of flexibility and potential price discounts in distress sales.

The **illiquidity premium** is therefore the expected incremental return for accepting illiquidity risk above a diversified, liquid asset portfolio (e.g., public equities or bonds).

> **Key Term: illiquidity premium**
> The additional average return required for investing in an asset with restricted trading opportunities relative to similar, fully liquid assets.

## SOURCES AND DRIVERS OF ILLIQUIDITY PREMIA

The size of the illiquidity premium depends on:

- The ability to exit the asset (ease, time, transaction costs)
- Market depth (number of buyers/sellers)
- Availability and terms of debt financing
- Macroeconomic conditions (tight credit narrows illiquidity premia)
- Investor risk tolerance—periods of crisis or uncertainty raise required premia

For institutional investors, the largest premia are associated with:

- Large, unique, or highly specialized properties or infrastructure projects
- Early-stage or opportunistic real asset strategies
- Geographies or sectors with less transparent, less active markets

Less healthy economic conditions, high financial system stress, or unfavorable regulation can increase the illiquidity premium demanded.

## EXPECTED RETURNS FOR REAL ASSET ALTERNATIVES

The expected return for a real asset alternative typically includes:

- Base risk-free or reference rate (e.g., government bond yields)
- Risk premia for asset class (equity, credit, sector/market premia)
- Illiquidity premium (asset-specific)
- Use of debt or financing effects (for levered assets)
- Active management alpha (where relevant)

In practice, real asset managers and consultants estimate return targets using public market proxies, observed deal data, and models that impute illiquidity premia from transaction discounts and risk-adjusted discount rates.

> **Key Term: expected return**
> The anticipated average annual return for an asset over the long term, incorporating all relevant risks, including illiquidity, in portfolio modeling.

## PRACTICAL IMPLICATIONS FOR PORTFOLIO CONSTRUCTION

Allocations to real asset alternatives offer diversification and may improve long-term portfolio risk–return characteristics. However, they require careful:

- Liquidity forecasting and scenario analysis
- Stress-testing for capital calls and redemptions during market shocks
- Recognition of the illiquidity "lock-up"—inability to rebalance or exit quickly
- Setting higher hurdle rates for investments in illiquid strategies versus liquid assets

### **Worked Example 1.1**

An Australian superannuation fund is considering a 10% allocation to unlisted infrastructure with an estimated illiquidity premium of 2% above public equity returns. If expected public equity returns are 7%, what is the infrastructure return target? Why is the illiquidity premium included?

> **Answer:**
>
> - The infrastructure return target = 7% (public equity) + 2% (illiquidity) = 9%.
> - The 2% premium compensates the investor for tying up funds in assets that cannot be sold or rebalanced easily. If liquidity tightens or if the investor must sell quickly, the asset may need to be priced below fair value, reflecting this risk.
> - Illiquidity premium is included to ensure the portfolio, as a whole, remains aligned with overall fund liquidity needs and obligations.

### **Worked Example 1.2**

A Canadian pension plan holds \$100 million in core real estate with an expected illiquidity premium of 1.5% and \$100 million in public REITs. If public REITs return 7%, what long-term return should the total real estate allocation produce to justify holding the private assets?

> **Answer:**
>
> - The core real estate allocation should target 1.5% higher return than the public REITs, so 8.5% annualized.
> - The illiquidity premium should match or exceed the plan’s opportunity cost for giving up flexibility, especially when the plan must meet regular pension payments and requires some assets to be liquid.

### **Exam Warning**

> On exam questions, be careful to distinguish between "illiquidity risk" (cost and constraints of selling) and "valuation uncertainty" (difficulty in ascertaining true market price). Do not confuse the cash-flow certainty of some real assets (like leased infrastructure) with liquidity—they can still be difficult to transact.

## SUMMARY

Illiquid real asset alternatives such as infrastructure, real estate, timberland, and farmland can provide portfolio diversification and inflation protection, but require higher expected returns (illiquidity premia) to compensate for trading constraints. The illiquidity premium depends on selling difficulty, transaction costs, market stress, and investor liquidity needs. Asset owners must balance higher expected returns against the reality that assets cannot be sold or rebalanced quickly, especially during periods of market turmoil or high cash flow needs.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Identify and explain the main real asset alternatives found in institutional portfolios
- Recognize illiquidity risk and the illiquidity premium, and how these affect return expectations
- Distinguish the sources and drivers of illiquidity premia in different asset classes
- Apply expected return components in projected portfolio returns for real asset alternatives
- Appreciate the practical importance of illiquidity constraints in institutional portfolio construction

## **Key Terms and Concepts**

- illiquidity premium
- real asset alternatives
- core real estate
- illiquidity risk
- expected return

Asset class expectations - Real assets alternatives and illiquidity premia