Truth or Fiction: The "Illiquidity Premium"
Illiquid investments carry greater degrees of assumed risk, but the payoff can be worth it for the savvy investor.
Investors are constantly in search of assets that promise higher yields. One type of asset that is gaining a great deal of press for doing just that is one that is known as an illiquid asset.
These illiquid assets offer the promise of higher yields than liquid assets as a “premium” for investors who are willing to give up access to their money for the sake of these assets that aren’t as easily traded.
What Types of Investments are Illiquid?
There are many types of investments you can buy into that are illiquid. The term typically refers to your ability to liquidate your funds quickly when you need access to your money.
That is one reason so many investors shy away from this type of investment. They’ve fully bought into the notion that liquid is best. In some cases, it is. However, most investors never need to fully liquidate their entire portfolios.
The real estate bubble and its subsequent burst have many investors shying away from one of the most enduring types of illiquid asset. Over time, though, real estate remains one of the most promising long-term investments to consider as it proves time and again to recover and grow in value.
It is also one of the most illiquid of investments as it may require years to provide the return you seek. However, there are other types of illiquid investments to consider for determined investors:
- Private Equity
- Venture Capital
- Oil and Gas Drilling
- Hedge Funds
- Penny Stocks
While many investors believe there is a premium involved when dealing with illiquid assets, there are some who believe the risks associated with these types of investments negate the risks.
For those seeking a balanced portfolio, though, it might be prudent to consider a healthy balance of both liquid assets that promise more consistent returns and instant access, due to high demand, while weaving in a few illiquid assets as well. These provide longer-term investments with the potential for much higher yields.
Do Private Assets offer the Same Return for New Entrants as for Early Investors?
This is a question that must be asked on an investment by investment basis. Like most investments there are opportunities on all ends of the spectrum. People who invested in WorldCom back when it was LDDS and sold before during its height (and well before its decline) did very well for themselves. Those who purchased later, traded too quickly, or held on too long; did not.
It’s as much about buying in at the right time as it is about getting out at the right time. That’s one reason so many people prefer liquid investments. With those types of investments, it is possible to get out ahead of the purge when things go wrong. With illiquid assets, it is more difficult for investors to weather storms like the ones faced by major market meltdowns like the ones suffered by LDDS WorldCom, which wiped out employee retirement funds and did great harm to countless investment portfolios.
How Far are We from Seeing a Bubble in Illiquid Assets as Investors Desperately Search for Higher Returns?
Bubbles are essentially run-up in prices of assets that are not warranted by the fundamental principles of supply and demand for that particular asset. They can occur in any sector and it has occurred in the housing market and they can happen at any time.
In the housing market, there were signs, long before the bubble burst that it was coming. Plus, there was much more than rising prices that came into play with the absolute crash of the real estate market from late 2007-2009.
The volatility of the market, the existence of bubbles, and sectors that burst or simply crash and burn is the reason diversity is so critical in every investment portfolio. Investors who dealt solely in real estate had to go through some very lean years to weather that particular storm. However, the market has recovered and is growing again.
Granted, real estate is far from the only type of illiquid asset. It is one of the most notable – and the one many investors associate with this type of investment. Because memories of the recent crash are still so raw for many investors, the fear of another illiquid bubble bursting is front and center.
Could another bubble burst in illiquids?
Is one eminent?
No one really knows. Currently, prices appear to be justified for the risks associated with these longer-term investments so there doesn’t seem to be the bubble situation that could lead to a spectacular crash on the other end.
However, not all bubbles are bad. It’s about getting out at the right time when they do take place.
Are “Illiquidity Premiums” the Expectation in Illiquid Investments or is a Thorough Manager the Real Secret to Success?
Again, there are no guarantees when investing. Risk is the nature of the business. This is especially the case when it comes to illiquid investments which do carry greater degrees of assumed risk.
Because these assets aren’t traded as heavily as traditional stocks and bonds, they are not as easy to offload. However, if investors are working with savvy managers who do thorough jobs of vetting potential assets and investments, they mitigate their risks to larger degrees.
This could mean more money in investors futures and lesser degrees of risk for their investments. It also means they won’t be able to easily liquidate their assets should they find themselves in need of fast cash.
It does, though, offer the promise of higher yields when investors do unload your investments and that is attractive when it works in their favors.
The right manager can make all the difference in the world when it comes to helping you secure assets that promise higher yields with minimal risks.
The illiquid premium is alive, well, and very real. However, it isn’t always the direct path to riches that some investors desire. There are risks involved in obtaining those higher returns, which can easily offer three percent greater returns than liquid investments.
For this reason, it is wise to consider sprinkling a few illiquid assets into your investment portfolio to create one that is as well-rounded as it is robust. Investors should bear in mind, that not all illiquid investments are equal and continue to do due diligence and proper vetting of all their investment decisions.