Illiquid Investments for a More Diversified Portfolio

November 4, 20227 min read
Illiquid Investments for a More Diversified Portfolio
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Key Takeaways

•  Sealing capital away for a long period might be unappealing at first glance, however illiquid investments can be a key aspect of a diversified portfolio.

• Among the assets considered illiquid are penny stocks, rare art and classic cars, capital placed with a hedge fund, and private equity real estate — many of which are considered alternative assets because they aren’t traded on traditional stock markets.

• Illiquid assets can be a great way to balance a portfolio. They can help diversify away from systemic risk, while also building a moat against market uncertainty.

Illiquid investments can be an integral aspect of a well-crafted and diversified portfolio of assets. Granted, at first glance, the idea of sealing capital away for an extended period might be somewhat less than appealing to fledgling investors. This is particularly true in the cases of those who have short-term needs for cash, or those who are simply uncomfortable with the idea of holding on to a passive investment long term. 

However, there are some very sound justifications for taking a position in illiquid assets and holding on to them.

What Are Illiquid Assets?

Any asset capable of being bought or sold or otherwise changed hands readily is considered a liquid asset. Cash, cryptocurrency, publicly traded equities, municipal and other types of government bonds fall into this category. In each instance there is minimal friction as well as little or no price discovery concerns.  

Simply put, liquid assets are generally readily convertible into cash or a cash equivalent.

Thus it follows that illiquid assets are exactly the opposite. Their fair market value can take some effort to ascertain. Exchanging, selling, or trading them can entail a high degree of difficulty. 

Among the assets considered illiquid are penny stocks, rare art and classic cars, capital placed with a hedge fund, and private equity real estate — many of which are considered alternative assets because they aren’t traded on traditional stock markets.

How Illiquid Investments Work

While an inexperienced investor might consider illiquidity a negative, seasoned investors know the opposite is true. As an example, consider real estate. Even though there are definitive barriers to acquiring and selling it, real estate is one of the most profitable asset classes available. In fact, many significant fortunes rely upon real estate investments as their foundations.

Here, it is useful to take a moment to understand the three different types of risks investors face. When it comes to the fixed-income marketplace, interest rate changes and credit risks are concerns. This is especially true for bonds and dividend-paying stocks. Equity ownership can also be problematic when the price of the asset held experiences a significant downturn. The third involves liquidity, in that the inability to trade an asset at will can be problematic for investors.

In exchange for taking on these risks, investors expect a more lucrative return on their investments. This liquidity premium is the “fragrance that attracts the bees,” so to speak.  In other words, investors taking positions in assets that must be held for five years or more expect a higher potential return to reward their patience. 

Why Some Investments Are Illiquid

Reasons for the illiquidity of an asset vary. Among them are:

• The trading of shares in an equity fund may be limited by securities laws. 

• Shares that are not traded publicly have a limited pool of investors.

• Equity firms offering illiquid assets mandate when they can be sold and capital distributions can occur. 

The common factor here is the lack of a pool of ready buyers upon which to draw in order to conduct an immediate transaction. Market influences can sometimes change the liquidity of an asset as well. This is particularly true in the case of collectibles, as their desirability can fluctuate — leading to extreme volatility in their pricing. 

The Benefits of Illiquidity

Illiquid assets can be great vehicles for achieving financial goals with longer time horizons, while also providing plenty of opportunities for diversification. Because of the lack of liquidity, investors can sometimes realize liquidity premiums in exchange for accepting longer capital lock-up periods.

There are also many more deep-value plays within illiquid markets. For example, even though art investing is increasingly in vogue, there’s never going to be a venue in which to buy and sell art that’s even remotely comparable in size or scope to a stock exchange. With that lack of visibility, there are more opportunities to realize outsized returns vs. what you’d typically find in the public markets. 

Often, what you sacrifice in price discovery, you can potentially gain back in price negotiation. This is especially true when you’re trying to get the most bang for your buck in markets with real assets, a huge advantage over liquid markets that are characterized by efficiency. There’s simply no room for you to negotiate when you’re purchasing shares of Apple. But a new work from an under-the-radar artist you’ve been following? Now that’s a different story.

Finally, a key feature shared by many illiquid products is a concept known as low beta. This is when an asset has a low correlation to public markets, which can be a great shield against day-to-day market uncertainties.

The Disadvantages of Illiquidity

From the perspective of your average retail investor, the main disadvantage of illiquid assets has been access. Whether we’re talking about private equity, venture capital, or real estate, the general public can’t just open up a Schwab account to begin trading these products. These vehicles have historically been accessible only to institutions or high-net-worth investors, due to their unique nature and often high minimum investment size requirements.

Thankfully, accessibility has evolved in recent years. Thanks to key provisions added to the JOBS Act of 2012, crowdfunding platforms can now publicly solicit investments. Platforms like Yieldstreet allow for access to alternative asset classes, previously unavailable to retail investors. SEC regulations still require that investors investing on these platforms be accredited, but the landscape has begun to shift in favor of retail investors vs. their institutional counterparts.

As we’ve touched on, illiquid investments may have longer lock-up periods that can span several years, with little opportunity to exit investments prior to the maturity date. Private equity funds are known to lock-up investor capital for more than five years. Sales of assets may even be one-offs, with no relevant public comparables or precedent transactions to refer to for a vanilla valuation.

It’s important to acknowledge that while alternative assets typically have low stock market correlation, they do carry their own risk factors, such as loss of principal and delayed timing of payments, among others.  

Portfolio Diversification and Alternative Investments

Alternative investments can be potentially useful tools for portfolio diversification, which is generally agreed upon by experts to be a smart investment strategy to pursue. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets such as crypto, and collectibles are among asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember alternatives also entail a degree of risk. In some cases, this risk can be greater than that of traditional investments.

Owing to that fact, these asset classes have long been accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  However, Yieldstreet opens a number of the alternative investment strategies that were formerly available only to institutional investors and the top one percent of earners to all investors. 

The company offers help in the potential to capitalize on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. Moreover, investors can get started with a relatively small amount of capital. 

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

Illiquid assets can be a great way to balance a portfolio. They can help diversify away from systemic risk, while also building you a moat against market uncertainty. But before you begin to invest in alternative products, it’s important to first have the rest of your house in order.

First and foremost, you need to ensure that you have enough liquidity to cover any short-to mid-term expenses and contingencies. That’s because the nature of illiquid products often mandates a longer timeline for exiting an investment. 

As mentioned above, it’s much easier to sell a few shares of Apple stock than to sell a house. Provided that you’re comfortable with what could be an extended timeline, the next step would be to determine exactly which illiquid assets align with your investment objectives. 

Some questions to ask are as follows:

  • Are you preserving capital for retirement in the next 20 years?
  • Are you just looking to place a few speculative bets in opaque markets?
  • Do you need your assets to generate consistent income?

Not all illiquid assets offer the lowest level of correlation to public markets. Some are valuable simply because of their potential for capital appreciation; others because of their ability to generate a consistent income for you.

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