Most investors are familiar with the liquid market, where stocks and mutual funds are traded publicly and almost everyone has the same information. Few people are familiar with investment opportunities in the illiquid market, where trades happen more slowly and money is tied up for long periods of time. With the right information, however, investors can leverage the illiquid market to increase long-term returns and create more stable, diverse portfolios.
Simply stated, financial liquidity is a measure of how quickly something can be traded and turned into cash. The owner of stock, for example, can easily call up a broker or use an online platform to trade the stock for money; very liquid transactions can take place in seconds. The owner of a house usually takes months to contact a broker, list the property, negotiate with buyers, get a bank's approval and finally receive money for the home; houses are a very illiquid investment.
Almost any investor prefers liquidity and pays a premium for it (or, conversely, requires a discount to assume something illiquid). People prefer something immediate and known – cash in hand – to the uncertain prospect of future cash.
Though they don't share the same kind of prominence in the financial press, there is no shortage of illiquid assets. Of course, defining "illiquid" is tricky, because it's a relative term. Corporate bonds are illiquid compared to stocks, for instance. For these purposes, consider "illiquid" to mean an asset class that trades infrequently and has low turnover.
The classic examples of illiquid investments are real estate (residential or syndicated), precious metals and art. However, there are also derivations of classic funds that are considered illiquid. These include real estate investment trusts (REITs), leveraged buyouts, venture capital funds or hedge funds that have lock-up periods (meaning the investors sign away their rights to withdraw and liquidate for a period of time). Private equity or venture capital funds often don't pay out for five or 10 years.
These assets tend to trade in private market transactions, too, which means investors have to deal with different rules and regulations. They all trade on secondary markets and tend to have far fewer participants in those markets, which means bid and ask spreads tend to widen.
Advantages of Illiquidity
Illiquid investments tend to offer more potential return for your buck. Illiquid assets have to compete with liquid assets for investment dollars, and a higher return is the premium necessary to counterbalance the flexibility of liquid options.
Illiquid investments tend to be – but aren't always – tangible and real. You can physically touch a bar of gold or a rental home, which provides both functional and emotional value. Assets such as these also tend to be more resilient against the forces of inflation.
Investments such as real estate and gold tend to have zero or negative correlation with traditional publicly traded investment assets. If stocks and mutual funds struggle, investors with alternatives in their portfolios might be able to rely on them as a hedge.
Some investors may also benefit from illiquidity if it forces them to be more disciplined with their long-term plays. For example, the owner of a home or a private equity fund investor is less likely to cut bait and exit the market during a downturn.
When to Introduce Illiquidity
Most investors are already participating in a form of illiquidity. All property owners have a foot in the illiquid market, but so does every worker who contributes to an IRA or a 401(k); these plans charge a 10% penalty for early withdrawals, effectively removing any immediate cash convertibility.
All illiquid investments impose costs on investors relating to tactical inflexibility and cash constraints, so they aren't well-suited to be first or largest piece of a balanced long-term portfolio. Nevertheless, the premiums paid on illiquid assets can usually only be maximized over the long term, so there is some pressure to start when you're younger.
In fact, a 2011 study on liquidity and investment style found that less liquid equities outperform higher liquidity equities by nearly 3% per annum over a 40-year period.
It makes sense to introduce illiquidity when you have a relatively long investment horizon and enough money left over to be able to afford to part with cash for a long period of time. The illiquid market is also an excellent source of uncorrelated assets for portfolio diversity. High-net-worth individuals (HNWIs) can more easily access the private equity, leveraged buyout or hedge fund markets, but non-accredited investors can still find opportunities and reap the illiquidity premium in segments such as crowdfunding or real estate.