Why Are More People Adding Illiquid Alternatives to their Investment Lineup?

For almost a century, most individuals have limited their investing realm to stocks, bonds, and cash. Why? Largely because these were available at a retail level with easy thresholds and minimal capital investment. Additionally, stocks, bonds, and cash are commonly thought to be easily understood, and they can be cashed in, exchanged, or traded at a moment’s notice. At the very minimum, daily changes can be made to the investment structure. These features are known as liquidity. But there’s a hidden cost with this liquidity.

Liquidity is important. There’s nothing more freeing than being able to carve out small pieces of a portfolio and “reallocate” them to an industry, class, or type of investment deemed to be a good value. For example, even before investing for the long term, a liquid emergency/opportunity fund provides a nice buffer in a situation where a “reallocation to debt” would be the only other option. Cash liquidity gives you options.

Too Much of a Good Thing

On the flip side, if 100% of our investments are available to write a check against in the form of cash, we aren't getting much of a return. This makes liquidity expensive when taken to extremes. So, once we have a sufficient emergency fund, we typically take calculated risks by allocating some of our savings into investments that could go down in value while hoping and expecting them to appreciate over time.

Or, we give up even further access to our assets by participating in our 401K or a type of IRA. In fact, we give up a form of liquidity by contributing to a qualified plan recognizing we would pay a 10% penalty on top of any other tax consequences by withdrawing any of these funds prior to age 59 and a half. For most people, the additional illiquidity risk is worth it because of the tax advantages and long-term investment horizon.

Can you see how most investors are already participating in several layers of illiquidity? Why are we so willing to give up access to these funds for years or even decades? The answer would be unanimous: because it’s worth it! When we have the rest of our financial house in order, and that’s important to note, the potential appreciation in investments and tax advantages available in retirement accounts far outweigh the potential penalties.

Less Liquidity, More Potential Return For Just a Slice of Your Portfolio
The mismatch between the demand for and supply of liquid securities creates an opportunity for those willing to employ a long-term alternative investment strategy. The persistent market volatility has intensified the bias toward liquidity. In broad strokes, more liquid assets have seen declining yields due to a lack of supply while yields have been increasing in less liquid investments because of lower demand. This creates an illiquidity premium and potential for superior returns with less correlation to traditional stocks and bonds.

The Effect of Alternatives
Several compelling strategies employ the use of reallocating some portion of a portfolio to non-traded alternative investments. By taking advantage of the yield premium on illiquid assets, these reallocated portfolios can generate higher yields without the bumpy ride of broader markets.

In addition, pricing inefficiencies in illiquid investments can also be harvested by skilled managers. This skill provides a greater impact on returns than those operating in the publicly traded markets where access to information is priced in almost immediately.

Today individuals have access to many types of alternatives through mutual funds, closed-end funds, and business development companies, etc. There are variations on benefits, risks, costs, and liquidity for each.

Given the right investment horizon and goal for an investment sum, a non-traded alternative investment may provide a boost to your overall return while reducing volatility.

With a good understanding and comfort in adding alternative investments to your portfolio, how is your outlook on this type of investment?