Institutional investors have been rushing into the arms of alternative, less liquid, investments over the past two decades.

But there is considerable variation in how major players approach these investments, according to a paper by Kristy Jansen a PhD-student at Tilburg University and Patrick Tuijp, a research affiliate at the University of Amsterdam.

In examining a survey of nine Dutch and five Canadian pension funds and fiduciary managers, the paper found that survey participants from both countries indicated the risk-return trade-off as the main reason for investing in illiquid, followed by diversification benefits. Canadian respondents differed from their Dutch counterparts by more commonly reporting that steady cash flow and liability-hedging were the main reasons for these investments.

Dutch survey participants most commonly mentioned asset-liability modelling studies as determining how much to allocate to illiquid asset classes, the paper said. On the other hand, Canadian respondents most often said they deviate from target allocations depending on a specified target return for illiquid assets.

Many of the funds surveyed indicated they have explicit or implicit liquidity management policies, which include maintaining a cash buffer, using the repo market or securities lending. Respondents mentioned the option they least prefer is selling existing positions to generate cash, the paper said.

Notably, the maximum limits on illiquid assets are on average significantly lower for Dutch funds than Canadian funds, the survey found.

The paper outlined four best practices for investors around illiquid assets, based on how the funds surveyed interact with them.

First, an investor needs to establish a clear motivation to invest in illiquid assets since those decisions may depend on what role those assets play in the overall portfolio.

Further, investors need to understand what valuation methods are used for illiquid assets so they can gauge their real value in the portfolio, risk measures and solvency position. “Depending on the intended method, inadvertently using a different method could lead to volatility measures which understate the actual risk,” the paper said. “Investors should therefore understand how valuation methods affect their overall portfolio value, their risk measures, and in particular their solvency position.”

As well, liquidity needs, current and future, should be top of mind for investors. They should regularly evaluate whether they have sufficient liquid resources available. “Stress tests are needed to analyze the impact of an adverse shock to market conditions on the ability to satisfy immediate cash requirements since the latter may be substantial . . . Such stress tests should take into account that the size of the cash requirements themselves may also depend on these market conditions.”

Finally, in scenarios when investors need to free up cash for immediate liquidity needs, investors need a clear policy as to what methods to use and in what sequence.