The Challenge of Liquidity in Alternative Investing

Garnering increased attention and popularity in recent years, alternative investments have become a staple portfolio addition for those seeking stable returns and less volatility.

Interest in this “patient” approach has especially intensified after the financial crisis of 2008, as investors realized the importance of risk mitigation by investing in assets that are not correlated to markets and now in 2022 in the current market crisis. 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 sometimes can take upwards of a few years for an investment to be realized responsibly. 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. As a result, investors with shorter time horizons and greater liquidity needs may find it difficult, even undesirable, to incorporate alternatives.

The extended time it takes to realize investment returns also makes it more difficult to manage a consistent allocation to alternatives. 

Liquid Alternative Investments 

Liquid alternative investments are mutual funds for example REITS (Real Estate Investment Trusts) or exchange-traded funds (ETFs) that aim to provide investors with diversification and downside protection through exposure to alternative investment strategies. These products’ selling point is that they are liquid, meaning that they can be bought and sold daily, unlike traditional alternatives which offer monthly or quarterly liquidity. They come with lower minimum investments than the typical hedge fund, and investors don’t have to pass net-worth or income requirements to invest. 

Critics argue that the liquidity of so-called liquid alternatives will not hold up in more trying market conditions; most of the capital invested in liquid alts has entered the market during the post-financial crisis bull market and again recently. Critics also contend that the fees for liquid alternatives are too high. For proponents, though, liquid alts are a valuable innovation because they make the strategies employed by hedge funds accessible to retail investors there is still a level of volatility (less than standard equities and bonds) for example 

• The Global REIT sector has fallen in 4 of the first 5 months of 2022, including a -3.51% total return in May.
• Only 31.18% of REIT securities had a positive total return in May.
• Timber (+7.73%) and Health Care (+5.95%) led all property types in 2022. 

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 a degree of illiquidity, of more than 3% annually. 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.

Behavioral Finance 

Behavioral finance attempts to understand and explain actual investor behavior, in contrast to theorizing about investor behavior. It differs from traditional (or standard) finance, which is based on assumptions of how investors and markets should behave. 

This phenomenon is what creates severe market volatility that is not correlated to economic cycles and is very difficult to almost impossible to forecast. 

The Advantage of illiquidity 

Illiquidity has the additional benefit of promoting rational investment behavior by insulating an investment portfolio from irrational investor behavior. The longer lockup periods that characterize alternative assets can benefit investors by reducing behavioral risk. As seen in the public markets, continuous investment pricing can have the adverse effect of framing irrational results.

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 impulsive reactions.

Is liquidity the king?

The importance of liquidity 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 is acceptable. However, investors should also consider their risk profiles, need to access capital over a given time, and spending requirements in evaluating the trade-off between liquidity and potentially enhanced returns.