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November 4, 2019

Debunking the Liquidity Argument

Debunking the Liquidity Argument: There’s a place in most portfolios for illiquid investments

Some investors scoff at the idea of owning an investment that ties up their money for a set period of time. Such investors point to lock-up agreements in alternative investments – private equity, venture capital, and real estate – as being reason enough to avoid them entirely. Investors with this mindset may very well be making a significant financial planning mistake. Let alone missing out on potentially lucrative investment opportunities.

Right off the bat, we need to debunk the notion that illiquidity defines a bad investment. It doesn’t. Lock-up periods are merely intended to give an investment manager adequate time to acquire assets and manage them so that they achieve their full potential. This is a standard operating procedure for alternative investment funds. For long-term investors, a lock-up period shouldn’t be the deciding factor on whether to own an alternative investment. The more pertinent issue is where such an investment fits into an otherwise well-diversified portfolio of long and short-term assets.

Matching Investments and Goals Can Optimize Returns

Investors considering alternative investments need to consider them not as standalone opportunities, but as part of their overall investment program. That program needs to be informed by a comprehensive financial plan. In the absence of planning any investment is ill-advised.

The central principle of financial planning is that an investor’s assets are the currency he or she will use to attain all of his or her current and future consumption goals. Therefore, matching one’s investments to one’s consumption goals works to optimize his or her investment portfolio. Optimization comes when one considers investments and consumption goals as balanced somewhere on two sets of dual continua. 

For consumption goals, there is a time continuum and a priority continuum. Some goals will be achieved sooner than others. Some goals are more important than others. The time continuum has short-term goals on one end and long-term goals on the other. The priority continuum has “must-have, can’t-do-without ” goals at one end and “nice-to-have, can-do-without” goals at the other.

For investments, there are also two ranges. They are time and liquidity. On the time scale “today” is at one end and “far off into the future” is at the other. On the liquidity spectrum, cash is at one end and something that is “tied up for a long time” is at the other. 

When an investor places all of his or her consumption goals into this matrix of priority, time, and liquidity the result is a portfolio design map like the one shown below. Selecting investments whose liquidity matches the timing and priority of the investor’s consumption goals gets every one of them adequately financed. Matching investments to goals also avoids disrupting the structure of the portfolio (i.e., selling something too soon). In this way, the investor helps to optimize his or her total long-term return.

This happens because high priority short-term goals get financed with short-term highly liquid investments like cash, Treasury Bills, or Certificates of Deposit. The investor avoids having to sell long-term assets to achieve a short-term goal. This allows long-term assets to grow until needed, allowing them to achieve their full potential.

Where Do Alternative Investments Fit into One’s Portfolio?

Matching investments and objectives mean that long-term, high priority goals can be financed with long-term investments that are highly liquid. Examples of the types of investments that meet this definition are common stocks, mutual funds, and ETFs. More importantly, long-term, low priority goals can be financed with more illiquid investments. This is where alternative investments play a crucial role in the portfolio design map. And here is where investments like real estate investment trusts (REIT) are perfectly suitable. 

Financing a goal that is intended to be realized in five, ten, or more years with an illiquid investment like a REIT is sound financial planning. The fact that these types of investments have lock-up periods is inconsequential. The lock-up will expire long before the asset is needed to attain the future consumption goal.

Illiquidity Isn’t an Issue for Long-Term Investors

An investment portfolio that includes any risk asset – stocks, high yield bonds, real estate – typically should have a long investment horizon. It is sub-optimal to finance short-term consumption goals with long-term assets. The same is true of financing long-term goals with short-term assets. The notion that one would forego a potentially lucrative long-term investment opportunity because of a fear that it isn’t immediately available to convert to cash is simply bad financial planning.

Alternative investments that have a lock-up period are perfectly reasonable additions to an otherwise well-diversified long-term investment program. It is an asset class that fits into almost any portfolio intended to be held for many years. Matching the timing of an investor’s consumption goals with an investment’s holding period helps improve long-term returns because it avoids the necessity to sell something before it can achieve its full potential. 

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