The 3 Virtues of Illiquidity

February 24, 2020

For many investors, the word “illiquid” evokes a restrictive vision of locked-up capital, out of reach and unresponsive to dynamic conditions. 

What goes unconsidered is the fact that liquidity in and of itself is meaningless unless it serves a distinct purpose, and illiquid investments such as commercial real estate and private equity have intrinsic properties which can bolster the overall structure and returns of an investor’s portfolio. 

Below we dive into the three main virtues of illiquidity—patience, thrift, and temperance—and how these fundamental attributes can positively impact an investor’s bottom line.

 

Patience: Insulating Capital for Growth

The most common point in favor of increasing portfolio liquidity argues that liquid assets allow investors to more dexterously redeem their invested capital and re-allocate funds towards higher-performing investments. Conventional wisdom states that liquid assets allow for these timely shifts, while illiquid assets are more unwieldy.

While liquidity does make an investor’s capital more agile, the consequences of this characteristic are more complicated than expected. For instance, a 2017 survey from financial services firm Barclays compared the average returns among hedge funds with differing lockup periods—the span in which investors in the fund are prohibited from redeeming their  investment.

The research results showed that funds with longer lockup periods consistently posted higher average returns than those with shorter periods, with funds exercising 2-3-year lockups posting average returns more than 3% higher than the next highest sample group.

Less Liquid Hedge Funds Offer a Potential Return Advantage

Less Liquid Hedge Funds Offer a Potential Return Advantage

Source: Barclays Strategic Consulting

Because of their longer time commitment and the risks investors are undertaking for their equity shares, the risk/reward dynamic in illiquid assets is generally structured to reward this kind of measured patience. Illiquidity compels investors to carefully consider their long-term outlook and goals and helps prevent them from making hasty moves or overreacting to short-term market phenomenon.

Nor do liquid investments necessarily guarantee a lower risk profile in practice, especially in turbulent times when investors most desperately want liquidity. A recent study from Penn Financial underscores the hazards of liquidity by showing that supposedly liquid assets like ETFs can incur a premium when a high volume of investors simultaneously attempts to exit their positions. The study took ETF market price data from the 2008 Financial Crisis and compared it to the net asset value of those funds, which revealed a price disparity as high as 11% on high-yield ETFs during the height of the crash.

Cost of Liquidity is Harsh During Crisis

ETF market price data from the 2008 Financial Crisis

Source: Bloomberg

In summarizing its findings, the report concludes that if investors in these funds had simply rode out the liquidity crunch, these disparities would have lessened. There are a variety of instances in which accessing an asset’s liquidity comes with a cost, and these historical examples support the argument that investors can receive higher investment returns in return for their patience.

 

Thrift: Unlocking Value in Private Markets 

Many assets are illiquid due to the difference between the number of asset buyers and sellers. While this may prevent investors from quickly exiting an illiquid position, it can also foster favorable market inefficiencies than benefit buyers who can find investments that carry market prices below the actual asset value or at a higher expected return. Although this “illiquidity premium” is hard to measure concretely, several illuminating attempts have been made to quantify how much of a benefit private, illiquid assets can deliver to investors relative to their public market counterparts.

A 2016 time-weight return comparison conducted by JPMorgan between the Burgiss Corporate Finance & Venture Capital Fund and both the MSCI World and S&P 500 indices revealed a one-year illiquidity return premium of 10.4% and 7.2%, respectively. While the averages over extended periods moderated that difference, returns from private markets were routinely 4%-5% higher than the sampled broad market indexes over the previous two decades.

Private Equity Time-weighted Performance vs. MSCI World and S&P 500

Private Equity Time-weighted Performance vs. MSCI World and S&P 500

Source: JPMorgan Asset Management

Different private markets will have different levels of liquidity and different inefficiencies to capitalize on, and many private investments are more complex and difficult to analyze and assess than assets traded on public exchanges. With the relatively high search costs involved with locating qualified and willing buyers for private market assets, most opportunities in this space center on the fact that savvy investors with a sufficient level of access and expertise in private market dynamics can potentially secure investment advantages via private market asymmetries.

 

Temperance: Reducing Risk Through Diversified Alternatives 

Illiquid assets on the private market can also serve as effective portfolio diversifiers due to the fact that they often appreciate in value independent of common factors that influence public equity markets. 

Private equity markets, for example, are ostensibly valued at prices that hew more closely to a business’s book value, whereas shares of publicly traded stocks can trade for as much as 10-20x their book value. Furthermore, private markets don’t have to compete with the day to day noise of the stock market, which influences price discovery.

This diversification hasn’t been lost on the overall investment world. Retail investors are increasingly migrating away from public markets and into the world of private equity. The result has seen private equity’s stockpile of cash has surge to new highs in recent years while fewer companies are making the leap into public exchanges. A recent 2024 projection from the publication Institutional Investor predicts that more than a third of the global asset management industry’s estimated $424 billion in revenue will come from these sources.

Private real estate funds carry a similar detachment from public markets. The value and risk/return profile of an individual commercial property is largely dictated by local socioeconomic trends, and these investments are less tied to the public market than publicly-listed REITs, which share a positive correlation with the stock market that can range from anywhere from 30% to nearly 80%.

With institutional investors upping their exposure to private market options such as private equity and real estate and individual investors increasingly mirroring this shift as access to private markets is further democratized, more investors are beginning to understand and take advantage of the potential stabilizing effect of illiquid assets.

 

Illiquidity Should Be Leveraged, Not Feared

Ever since the liquidity crisis that precipitated the 2008 financial collapse, the financial world has largely focused on the benefits of enhanced liquidity. However, this top-down mentality has led some individual investors to take their liquid asset exposure at face value without questioning the function this liquidity serves within their portfolios. 

The current emphasis on liquidity has overshadowed the potential virtues of illiquid assets and their ability to add an extra dimension to an investor’s overall investment profile returns over the long run when thoughtfully integrated. Therefore, while these investments are more time and capital intensive than many other investment options, illiquidity is something investors can leverage, rather than fear.

At iintoo, we strive to provide a healthy balance of exit-oriented, premium commercial real estate offerings which capitalize on the earning potential of the private market while avoiding excessively long holding periods. We understand investors’ desire to balance flexibility, stability and growth, and our transparent investment process offers convenience and clarity into the complex world of commercial real estate investing.

 

For a closer look at what iintoo can offer you, feel free to explore our platform.

 


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