alternative investment liquidity

How Important is Liquidity When it Comes to Investments?

alternative investment liquidity

 

Garnering increased attention and popularity in recent years, alternative investments have become a staple portfolio addition for those seeking to adopt a longer-term investment horizon. Interest in this “patient” approach has especially intensified after the financial crisis of 2008, as investors realized the importance of risk mitigation by incorporating assets uncorrelated to the public markets. Despite this, there are still some who shy away from alternatives altogether because these investments are less liquid when compared to their public stock and bond counterparts. In addition to being a major deterrent to portfolio inclusion, illiquidity has presented many challenges to investors new to increasing allocations to alternative investments.

 

Challenges of Illiquid Alternative Investments

Traditional investments such as public stocks and bonds are frequently traded at high levels of volume. By contrast, alternatives have varying degrees of tradability and can take upwards of ten years for an investment to be realized. The longer lockup periods of alternative investments and a lack of secondary markets result in a reduced ability to address cash flow requirements, quickly react to new information, enter and exit investments, and consequentially, rebalance portfolios on a frequent basis. Periods of portfolio deviations from optimal allocations will be inevitable since continous rebalancing is near impossible with illiquid alternatives. As a result, investors with shorter time horizons and greater liquidity needs may find it difficult, even undesirable, to incorporate alternatives.

The extended time period it takes to realize investment returns also makes it more difficult to manage a consistent allocation to alternatives. In a private market vehicle such as a venture capital or private equity fund, an upfront capital commitment to invest is incrementally called down over time by a fund manager to invest in portfolio companies. Since the investment capital is only allocated to actual investments or “put to work” once called down, an upfront commitment of $250,000 is not necessarily the same as achieving a constant $250,000 allocation during that time period. However, to maintain a target percentage allocation to alternatives, an investor can either overcommit to the allocation or invest across multiple funds to make sure that a target amount of capital is always at work[1]. The latter requires aligning distributions (positive investment returns periodically distributed to the investor) from one fund with the capital calls of another.

 

Benefits of Illiquid Alternative Investments

Despite the perceived challenges of investing in alternatives, these assets have the potential to enhance returns. In fact, returns are known to generally increase with degree of illiquitity, of more than 3% annually[2]. For many investors, this “illiquidity premium” is more than sufficient compensation for less liquidity. A portfolio that incorporates an asset allocation to alternatives has the additional benefits of potentially diversifying risk exposures and cushioning market volatility. As alternatives are incorporated, a wider investment opportunity net is cast and a balancing effect on a portfolio is achieved.

This illiquidity has the additional benefit of promoting rational investment behavior by insulating an investment portfolio from financial crisis. The aforementioned, longer lockup periods that characterize alternative assets can benefit investors by reducing behavioral risk. As seen in the public markets, continuous pricing on investments can have the adverse effect of framing myopic perspectives. As market volatility is tempered through allocations to alternative investments, so too is the likelihood that an investor will succumb to fear-based selling. All too often during market corrections, investors consistently stray from the course and sell at the wrong time, increasing the potential for losses and damaging returns. The illiquid nature of certain alternatives can temper these knee-jerk reactions.

The importance of liquidity, then, appears to be debatable. An investor with a long enough time horizon can benefit greatly from incorporating alternative investments and ensuring that the range of allocations over a certain time period is acceptable. However, investors should also consider their risk profiles, need to access capital over a given time period, and spending requirements in evaluating the tradeoff between liquidity and potentially enhanced returns.

 

[1] Patient Capital, Private Opportunity: The Benefits and Challenges of Illiquid Alternatives, Blackstone.

[2] Expected Returns, Antti Illmanen, 2001.

 

 

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