This question between regulators and investment professionals has been ongoing for as long as I’ve been in the financial industry, circa 36 years and counting.
What products are typically considered to be illiquid? Examples often cited are private credit, private equity, venture capital, hedge funds and some might even consider real estate.
With these products, except real estate, investors tend to have restricted access to their capital once funds are invested and the oft-stated reason was that the more liquid assets are inherently safer than illiquid assets. But are they necessarily safer?
Let’s take a look at some of the products that are available to investors, besides the usual liquid stocks, bonds, ETFs, indexes and mutual funds. Today, investors are also able to trade cryptocurrencies, binary options, derivatives, contracts for difference (CFDs) and structured products on public platforms.
These products, though liquid, are complex and often display higher levels of volatility and associated risks. Does the fact that they are liquid and access to capital is not restricted make them “safer” than private market assets? Traditional finance advocated that higher premiums should be expected when investors allocate more to illiquid assets. It also indicated that investors with smaller portfolios and lower income availability, allocation to liquid assets should be greater. But does this assumption still ring true?
Overwhelmingly, most investors invest in the public markets, regardless of their financial literacy or level of wealth. The concept of buying low and selling high, trading the equity market daily with the belief that they can time the market consistently over a long period of time is an illusion. In reality it is difficult to time the market, hence this strategy can lead to losses for a lot of investors.
Private markets with their illiquidity, on the other hand, can offer longer term opportunities from which investors cannot run for the exit on a whim. Liquidity constraints, in behavioural finance, have found that it could actually help to insulate investors from making uninformed, suboptimal and subpar decisions.
In a study done by Barclays Bank in 2022, it indicated that there is an average liquidity premium of about 2%–4% for buyout funds, a 3%–5% for riskier early-stage VC funds. A recently published article on CAIA Association (Chartered Alternative Investment Analyst) blog, author Steve Nesbitt of Cliffwater claims a 4.8% premium for private equity over public markets between 2000 and 2023.
If these studies suggest that investors may be rewarded for their illiquidity risk and that an illiquidity premium does exist, shouldn’t, then, access to these products not be restricted and be more open to investors in general?
It does seem a little strange, then, that non-accredited investors may access products such as crypto, binary options, CFDs on trading platforms because of their liquidity. Should an investor be deemed protected because it is a case of readily available buyers and sellers? This is akin to a casino, where payout from selling a binary option of contracts for difference is ‘all-or-nothing’.
Liquidity is often thought of as a safeguard for investors. However, this can also lead to impulsive, subpar and poor investment decisions driven by behavioural biases and the belief that liquid assets are inherently safer.
Take for example how the year 2022 was the worst year for equities in general since 2008. When inflation fears proved to be much higher and stickier than originally expected, central banks rapidly tightened monetary policy in 2022, hiking interest rates to their highest nominal levels since the 2000s. Many investors, fearful of a recession, began selling off their securities holdings, causing a bear market.
After three years in a row of double-digit gains, the S&P 500 Index at its lowest point was negative nearly 27%, well into bear market territory. Even though it ended the year negative 18.1%.
Another high-profile example was in March 2023. The Silicon Valley Bank (SVB) failed after a bank run, marking the third-largest bank failure in United States history and the largest since the 2007–2008 financial crisis.
Seeking higher investment returns from its burgeoning deposits, SVB had dramatically increased its holdings of long-term Treasuries since 2021, accounting for them on a hold-to-maturity basis. The market value of these bonds decreased significantly through 2022 and into 2023 as the Federal Reserve raised interest rates to curb an inflation surge, causing losses on the portfolio, when they were sold to repay depositors. As of December 31, 2022, SVB had mark-to-market accounting unrealised losses in excess of $15 billion for securities held to maturity.
| Returns on U.S. bonds hit new historic lows in 2022 |
| |
2022 return |
Previous worst-performing 12-mo. period |
Return |
| Intermediate-term U.S. Treasurys |
−10.6% |
Oct 1994 |
−5.6% |
| Total bond |
−13.1% |
Mar 1980 |
−9.2% |
| Long-term U.S. Treasurys |
−29.3% |
Mar 1980 |
−17.1% |
| Long-term investment grade |
−27.0% |
Jan 1842 |
−22.9% |
What’s true is that not all illiquids are created equal. They do carry different risk-reward profiles, strategies and objectives. A one-size-fits-all approach does not work.
Diversification, value alignment and risk-return profile should be taken into consideration when an investor is deciding to include illiquid private market assets to their portfolios. If the objective is to protect investors, the focus should be on investors’ overall risk profile, understanding of financial products instead of only liquidity.
Illiquidity should not be a default restriction, constraint or determinant for access to investors. Illiquid assets can also be looked upon as a valuable discipline for a strategic, long-term investment behaviour for a more balanced approach to investing.
