Don’t Fear Illiquidity (Embrace It!)

Illiquid alternatives are investments that are not easily traded or exchanged and where investors do not have access to their capital for years. In fact, some alternatives hold investors’ capital for as long as a decade. That’s one of the reasons some investors shy away from them. The long lock-up worries investors, especially when the markets turn down. But is that fear justified? In a word: No. Illiquidity should not be feared—for three reasons.

Diversification on Many Fronts

It’s widely believed that alternatives—real assets such as commodities, real estate, farmland and timber, private market investments like private equity or debt, and leveraged public market assets, such as hedge funds—offer several types of diversification from traditional stocks and bonds. Return diversification is one.

When a portfolio with only US equities adds international stocks, for example, a different return stream is accessed. But US and international stocks, though diversifying, have return patterns that are correlated—they are very similar—since they are both public equities. Adding alternatives where the underlying source of return has low correlation to public equities can improve diversification.

Vintage diversification is another. Many types of alternatives invest over multiple years. The year the fund makes its first investment marks the vintage year. Each vintage is subject to certain market conditions like interest rates, market valuations, and inflation rates that are likely different from another vintage. In other words, spreading investment dollars over different vintages provides a built-in level of diversification.

Beyond these diversifying actions, the illiquid nature of these assets—contrary to popular belief—is one of their attractive attributes.

Embrace Illiquidity

Illiquidity offers three benefits that many investors overlook—illiquidity premium, lack of daily market volatility, and attractive buying opportunities. As market volatility increases—like it’s been recently—these three attributes become especially valuable.

The long lock-up of capital is a trade-off investors make when selecting some alternative assets. But it’s not without reward. For example, the private equity asset class can include investments that are illiquid for a decade. These private equity funds may use investment dollars to build businesses; but it may take time for companies to achieve successful results, and investors need to have long time horizons to wait for those returns to be realized. This patience only makes sense if the returns from the private investment outweigh a public market alternative. In other words, investors warrant a premium, or higher return because of their willingness to have their investment dollars tied up for lengthy periods.

Another benefit is that the long-term nature of private equity and other private market strategies shields investors from the daily swings that occur in public markets. They experience less volatility for two main reasons: First, many illiquid alternative investments are valued or marked-to-market only at specific points in time—usually quarterly—but their exact return is only known when the investment is disposed. Second, investors cannot buy or sell illiquid alternatives easily, making them less prone to overall, indiscriminate market sell-offs. In fact, it’s quite possible that the private market investments are experiencing similar stresses as the public ones, but private investors are typically only concerned with their exit price, not the intermittent price that burdens the public investor. So, the daily whipsaw movements of the markets may be less influential on the investor’s mindset while the investment is held in the fund.

Lastly, alternative funds don’t need to rush into making investments. Many funds have multiyear terms in which to use the capital committed by investors for new investments. So when markets get rocky or overly expensive, private funds can cease making investments, and wait for more optimal conditions. This also fosters a “dry powder effect.” While it’s hard for alternative funds to buy the dips—because deals take a long time to analyze and close and it’s hard and risky to react quickly to a correction—a prolonged downturn can provide the opportunity to buy when other investors are fearful, potentially providing an attractive entry point. Thus, alternative investors may have a better starting point from which to build their returns.

Smooth Operator

The diversification benefits of alternatives, including the effects from illiquidity, can smooth the returns of a portfolio that invests in traditional assets. Along with exhibiting lower volatility than public equity securities, they should also provide returns that are higher than those of traditional equities. But since alternatives are less liquid, an allocation needs to consider the unique needs of the investor, including having adequate cash flow to cover spending needs. That’s why an allocation typically complements one to traditional assets.