Illiquidity – A Feature or a Bug?

To be, or not to be … liquid. That is the question many investors are now facing.

Should one’s portfolio include investments with less than daily liquidity? Is illiquidity a feature or a bug?

While liquidity exists on a spectrum and can be viewed through a variety of lenses, in short it simply represents the ability to turn an asset into cash or cash into an asset.

Until recently, investors in alternatives had a binary choice when it came to liquidity—dip a toe in the shallow end of the pool with daily liquid mutual funds and ETFs or do a cannonball into the deep end of the pool with long-lockup private partnerships. Fortunately, there are a growing number of semi-liquid fund structures that find a healthy middle ground between the two, allowing for the ability to own illiquid assets while also offering periodic liquidity windows, subject to certain limitations. Examples include interval funds, tender offer funds, and private REITs. These semi-liquid fund wrappers also retain some of the operational, tax reporting, and regulatory benefits that many investors find comfort in.

The reality is that most people do not need fully liquid portfolios. We have just grown accustomed to investing that way due to common portfolio construction practices and the historic lack of quality illiquid investment choices for the average investor. High minimums and other factors have kept less liquid asset classes out of reach for much of modern investment history, reserved only for the pensions, endowments, and uber-wealthy of the world.

For investors with long-term goals, sacrificing some liquidity may bring multiple benefits. First and foremost, there are additional diversification opportunities to be had. In addition, there is the opportunity to earn the illiquidity premium that is associated with certain private investments. The perhaps understated benefit of illiquidity is that it enforces discipline and a long-term mindset in a way that public markets can’t. The temptation to change course and succumb to market volatility are all too present in daily liquid investments.

Just as illiquidity isn’t inherently a negative, neither is liquidity. Liquidity provides optionality, and like any option there can be value to it. It allows you to fine-tune risk in a way that illiquidity does not. Liquidity also allows you to rebalance a portfolio to a degree that illiquidity does not. Conversely, while there may be a behavioral benefit to locking up capital in illiquid investments, it forgoes the flexibility that liquidity provides.

Liquidity gives us a feeling of control over our investments by allowing us to determine when and how we move into and out of them. But the sense of control can come at a cost. By demanding 100% liquidity in a portfolio, we may be forgoing potentially valuable opportunities for return enhancement, income generation, and risk management. We should view illiquidity as the price of admission to gain access to alternative investments with favorable properties.

While the increased access to semi-liquid and illiquid alternatives is a net positive for investors, it is not without controversy. This became evident late last year when the Blackstone Real Estate Income Trust (a.k.a. BREIT), a popular product geared towards individual investors, began to limit withdrawals amid a spike in redemption requests. As The Wall Street Journal reported:

“Despite strong returns, a wave of BREIT investors headed for the exits at the end of last year, spooked by a stock market downturn, rising interest rates and the slumping property market. Small investors differed sharply from the methodical, big-picture investors on which Blackstone had built its fortunes. They had smaller stakes and shorter timelines—and often made decisions based on gut and emotion.”

To be clear, Blackstone did nothing wrong here – they merely followed the liquidity terms clearly spelled out in the fund’s offering documents. Limiting redemptions in a semi-liquid fund like BREIT is designed to protect remaining shareholders from a fire sale of illiquid assets. In other words, they did exactly what they said they were going to do.

What is less clear is how many of the individual investors in BREIT had the liquidity terms clearly laid out to them when the fund was presented by the advisor pitching it to them. For some investors, it is highly likely that important details were glossed over or left out altogether. It is exactly these gaps in communication and mismatches in expectations that can transform a feature into a bug in the blink of an eye.

The feature vs. bug debate of illiquidity and the lack of mark-to-market of private assets has picked up steam in professional investor circles. Two people who I admire and respect deeply (and who probably agree on most other investing topics) are on opposing sides of this debate.

In one corner, longtime institutional allocator Chris Schelling shared his views in a recent Institutional Investor article:

“The frictionless ease of transaction in public markets means it’s extremely easy to over- or underreact. You can panic sell a stock, and if you change your mind, it’s easy to buy it back. I highly doubt this efficiency equals more price accuracy in intra-year intervals, though. This is quite literally System 1 processing — quick, efficient, but often inaccurate.”

On the other hand, in private markets, it is precisely the friction of transaction that prevents frivolous pricing. No one panic sells a house, for example. It costs far too much. The time, effort, and legal work that go into a transaction mean market participants don’t buy or sell unless they are truly convinced it’s worth it. Private markets force market participants to engage rational, System 2 thinking.

Put another way, private markets have no voting mechanism; they are only a weighing machine. There is no reason for multiples to oscillate wildly based upon emotional and inaccurate predictions about the future. In fact, most private-equity funds hold multiples fairly constant over the life of the investment.”

In the other corner is AQR’s Cliff Asness. Never one to ever back down from a debate, Cliff opined with his counterargument:

“My criticism has been narrowly focused on PE’s lack of mark-to-market valuations and some of the implications this brings. The illiquidity and nonmarking were once implicitly acknowledged, appropriately, as a bug, but are now clearly sold as a feature. The problem is logically you get paid extra expected return for accepting a bug (possibly explaining some of PE’s historical success), but you pay by giving up expected return for being granted a feature. This is a potential problem going forward.”

If you find yourself nodding in agreement with both gentlemen, you’re not alone. And therein lies the nuance, which tells us that the truth is likely somewhere in the middle.

So, is illiquidity a feature or a bug? The short answer is it can be both. Features are intentional, while bugs are accidental. Those who align their allocation with a well-constructed illiquidity budget tailored to their unique goals and circumstances will appreciate its features. Those that overextend themselves in illiquid assets and are unable to access their capital just when they need it most will certainly be looking for some bug spray.