The Difference Between Liquid and Illiquid Alternative Investments
Alternative investing presents a whole new universe for investors to pump up their portfolios by adding resources that have the inherent capability to generate non-correlated returns. Alternative investments differ from stocks and bonds, and their liquidity is one of the reasons why. Most investors battle with the comparison and contrast between liquid and illiquid investment opportunities, since both have unique properties that give different benefits as well as risk factors.
What are alternative investments?
An alternative investment is an investment in assets apart from cash, stocks or bonds. Alternative investments can be investments in tangible assets such as collectibles or famous artwork. They can also be financial assets such as cryptocurrency, hedge funds, or private equity.
As a whole, alternative investments have a tendency to present a low correlation with conventional investments. It’s also hard to determine the exact intrinsic value of alternative investments, say, for example, expensive wine. The valuation of an alternative investment needs you to have specific knowledge, like the age of the wine, for instance. Some show unpredictable value patterns and may be dictated by the demand from potential buyers.
Alternative assets have comparatively low liquidity, as compared to traditional investment ventures, and high purchasing costs. Some, like hedge funds, have a minimum investment amount and an investment fee.
What is investment liquidity?
In simple terms, liquidity is how easy it is to turn your assets to cash. It’s how quickly your investments can be sold on the secondary market. Liquid assets can quickly be turned to money without losing value or incurring any hefty fees. Cash is termed as the most liquid asset because of easy access through your bank account or an ATM.
Liquidity allows you to cover basic living expenses and handle emergencies as soon as they arise. The drawbacks of liquid assets are that their value is affected by fluctuating market atmospheres, especially during crises. These may be global pandemics or any other negative global headlines which plummet liquid asset value.
Another overlooked issue with liquid assets is the pricing, which is affected by liquidity premiums due to the flexibility and diversity of options provided. This means that the investor cannot be compensated in case of added risk or lost investment flexibility.
Low alternative investment liquidity can be attributed to lack of a centralized market and low demand for some of the assets (like antiques and stamps) as compared to conventional investments.
Liquidity is more of a spectrum than a black or white situation. At one extreme are illiquid assets which are very hard to value or sell for money, and at the other end, we have cash, which is the most liquid asset.
Why does illiquidity matter?
While liquid assets are important for day to day living, the more liquid an asset is, the lower its chances of increasing in value over time. An asset like cash is subject to inflation and reduction in purchasing power over time. To protect against this, illiquidity comes into play.
Illiquid assets are not easy to value or sell for cash. Some examples are collectibles (antiques, jewelry, stamps, and fine art), real estate, intangible assets (intellectual property, corporate goodwill), stock options, and estates. These are hard to assign a price to, since they’re traded in low volumes and have less frequent transactions.
Illiquid investments are useful because of their high tendency to increase in value over time and to often be immune to inflation. Their value is also not affected by day-to-day stock market volatility and they fetch higher returns in the long run compared to traditional investments.
It’s important to have illiquid assets to diversify your portfolio and isolate it from the broader market by tapping into non-correlated gains attached to illiquid alternative investments.
How to use investment liquidity to your advantage
A high level of liquidity typically provides you with several tangible advantages that you can use to your advantage. It’s important to seek out liquidity when investing in volatile assets. Highly liquid assets have little problem getting you a fair price. A liquid market is generally associated with less risk due to the high transaction traffic. This can attract more investors, which improves market conditions.
One way to use investment liquidity to your advantage is by investing in a money market fund (MMF). This exploits the volatility of liquid assets by trading your cash in securities with low maturity periods. You can easily access your assets and your investment will most likely grow over time. Money market funds are a safe way to park your money, since the Securities and Exchange Commission (SEC) allows only securities with the highest credit ratings to trade in money market funds, creating a form of safety-net for investors. This kind of security is hardly found in other fixed-income investment plans.
Investment liquidity and illiquidity have distinct benefits and drawbacks. Alternative investments mostly fall on the illiquid side of the liquidity spectrum and can be a worthy investment option if you invest wisely.