A Counterintuitive Approach to Liquidity
January 11,2016 Michael Kitces
Liquidity may be an appealing characteristic for an investment, but a growing base of research is finding that illiquidity may be even more desirable. Ironically, demand for illiquid investments is so low, that they appear to carry persistent excess return premiums. This view has been popularized in recent years by people including David Swensen of Yale Endowment, who racked up a whopping 13.9% annual return for the past 20 years in large part by relying heavily on illiquid investments.
Of course, the first caveat to investing in illiquid assets is that it is only appropriate for the portion of a portfolio that the investor can afford to place into illiquid holdings. Yet the more significant (albeit more nuanced) danger is that the return premium is only beneficial for an otherwise sound investment. Owing a bad investment that is also illiquid just compounds the problem by locking the investor in.
And notably, a bad investment is not just one with poor economic fundamentals, but also one where the interests of the investment manager and the investor are not well aligned. That leads to situations where even an appealing investment turns sour later, as has occurred with illiquid investments from various hedge funds, to certain life insurance and annuity products, and non-traded REITs.