One of the most common conversations I have with advisors and clients is about liquidity … or more precisely, illiquidity. It might be the number one perceived “terror” in the alternative investment space. It is only a scary proposition if the advisor or client has not planned correctly. For the sake of brevity, for this discussion, illiquid also includes less liquid assets. By this we mean assets where capital is tied up for 3-5 years or more, or there are penalties for early redemption.
The table below shows average allocation to alternatives, comparing institutional investors vs. individuals. I am not saying illiquidity is the only reason more individuals do not allocate more to alts, but it is a big part of the reason. Please note, as this is a few years old, I believe the individuals number has increased but still lagging far behind institutional investors.
Let’s look at the pros of liquid assets: flexibility. It's a pretty short list.
Now let’s examine the argument for a percentage allocation to illiquid assets.
Stupid Decisions
Well-planned allocations to illiquid investments prevent stupid, impulsive decisions. One of the most recent examples is the early Covid dip where many investors panicked, sold, mistimed, and were left wishing they had not acted rashly. A strategic allocation to illiquid assets prevents this emotional reaction investing and avoids anyone trying to time the market, which even the smartest guys in the room do not always get right. It also takes away the day-to-day stress and panic which daily or even hourly position status checking creates.
Valuations
Illiquid assets are usually valued privately rather than publicly. Net asset value (NAV) is often used to value assets within a private fund or vehicle. Nothing is perfect in the valuation world, but a real asset-based calculation, rather than a public market sentiment overreaction/underreaction definitely has the potential to be more objective than subjective.
This is particularly compelling if the appraisal is through a third party, not, sponsor management.
Illiquidity Premium
Let’s take a basic hypothetical example. A public REIT and a private REIT are both offering 3% yield and are identical other than liquidity. Which one do you allocate to? 99% of investors go for the public liquid REIT.