What is liquidity in finance? Liquid vs. illiquid assets

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Liquid vs. illiquid asset allocation is a subject that even educated accredited investors wrestle with. While your allocation strategy ultimately hinges on the concrete understanding of your own personal investment goals and time horizon, there’s no one-size-fits-all answer.

The best way to make sense of something so complex is by first going back to basics and understanding the fundamental concept of liquidity. Let’s examine the difference between liquid and illiquid assets and why your investment portfolio could potentially use both. 

What exactly is liquidity?

Simply put, liquidity is a measure of the ability to quickly sell an asset at market price. Liquid assets are those that can be converted into cash at fair prices with relative ease. Think of an asset as liquid if you can easily sell it in a short span of time without sacrificing meaningful value.

Markets themselves are liquid if they are well established, with plenty of buyers and sellers that drive trading volume. Such markets are characterized by what’s known as immediate price discovery. This means that investors are able to harness the power of free-flowing information and historical data when they transact.

Cash itself is at the very top of the liquidity stack because it’s a unit of value that can be used immediately. In just a few seconds, you could go online and trade your cash for goods and services. That’s because the demand for cash is universal and there should always be another party willing to meet you on the other side of the transaction.

Stocks, bonds, and money market instruments are also very liquid. Every day, these securities change hands with transaction volume in the order of millions. They also benefit from technological advancements that have flourished in recent years—such as electronic and algorithmic trading and real-time price quotes—all facilitating efficiency and ease of use.

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What exactly is an illiquid asset?

On the flip side, an illiquid asset is one that cannot be quickly converted into cash without an immediate loss in value. Illiquid assets comprise a broad stable of alternative investment products, including real estate, private equity and venture capital, infrastructure finance, and private placement loan issuances—even art and collectable cars. 

Illiquid assets tend to not have a convenient secondary market that allows investors to exit quickly. For example, if you own a home, you can’t simply sell it one minute and have cash in your hand the next. Illiquid assets don’t benefit from high-volume, global exchanges with real-time pricing. Even finding a buyer or seller can be a time-intensive process. 

The benefits of liquidity

More often than not, liquidity is referred to in a very positive light, and for good reason. This is because more than anything, liquidity enables flexibility and optionality. Investors can move in and out of their liquid assets easily. 

Think of it this way: With liquid assets, you have the comfort of knowing that you have the potential to generate a return in the market while still having relatively quick access to cash in case of an emergency. That’s often a reassuring thought for investors. Also, the established marketplaces we’ve mentioned naturally create higher levels of pricing transparency. More eyes should mean more scrutiny, and that should be useful when investing.

Finally, a key differentiator between liquid assets and illiquid assets is that liquid assets are typically accessible to most investors to purchase, regardless of their individual net worth. That’s a bigger deal than you might realize. The fact that investing continues to become more democratic is a huge plus for free and public markets. Many opportunities that used to be open to only institutional investors and the ultra-wealthy are now accessible to the general public.

The drawbacks of liquidity

Despite the benefit of optionality, liquidity isn’t always a positive. In fact, transaction volume can be a double-edged sword during times of uncertainty. It’s no secret that the bottom can fall out of previously “invincible” public markets in an instant, as seen during the COVID-19 pandemic, while negative sentiment tends to compound on deteriorating fundamentals.

Before you know it, even century-old aircraft manufacturers are lining up for government handouts just to keep the lights on. Portions of your portfolio that have exposure to these liquid assets can be highly vulnerable during periods of a market downturn.

Price fluctuations aren’t even always tied to logic and reason. Irrational market actors can easily get spooked and one negative headline can send shares plummeting–even if the underlying fundamentals remain solid.

Back at the end of 2018, U.S. indices were in a panic at the thought of a potential trade war with China. The Dow shed nearly 6% during that December alone. Then the headlines died down and the Dow reversed upwards, on the way to extending its tremendous bull run by finishing up more than 22% for 2019. 

Sometimes, even routine institutional investor actions like monthly/quarterly portfolio rebalancing can artificially impact share prices in the near-term. That means your portfolio could take a hit simply when the smart money rotates in and out of their positions.

Even though many assets can yield returns and offer liquidity, they won’t always necessarily align with your long-term investment objectives. Cash will always be great to have, but an all-cash portfolio will likely lose its value to inflation. An index fund is considered both reliable and liquid, but it can lose out to managed funds over the long haul.

Let’s look at an example. Private equity funds are decidedly illiquid, and they’ve outperformed public markets by an average of >6% over the last nearly 20 years, between 1999 and 2018. Ultimately, liquidity is important but it’s not the only proverbial tool on the portfolio belt.

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The benefits of illiquidity

Compared to their more liquid counterparts, the concept of illiquid assets can be hard to wrap your head around. By definition, illiquid assets receive less attention than liquid markets of stocks and bonds. This makes them considerably less understood. Yet they 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, you as an investor can sometimes see higher returns, or what are known as “liquidity premiums,” a great upside to having to deal with 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 drawbacks 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 although 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.  

Knowing when illiquid assets are right for you

Despite their unique challenges, 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 twenty 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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Even within the umbrella of illiquid products, there’s an array of options with unique characteristics. And the features of each product may or may not contribute to your personal investment objectives.

Regardless, unique return profiles and diversification can help lead to improved risk-adjusted returns for an overall portfolio. This, in turn, can help drive better long-term performance by reducing the impact of short-term volatility.

For now, know that a portfolio can consist of both liquid and illiquid products. The balance of the two will reflect the unique needs that each investor brings to the table.

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