The Independent Market Observer

9/11/13 – Illiquid Strategies and Your Portfolio

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Sep 11, 2013 10:45:06 AM

and tagged Economics Lessons

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Following on yesterday’s post, we’ll continue looking at various types of alternative strategies that you might consider using in your portfolio. Since “alternative” covers a multitude of sins, I thought it would be useful to offer a brief overview of some of the strategies that fall under that umbrella.

Yesterday, we talked about long-only strategies, which we define here at Commonwealth as “core financial strategies,” and compared them with what we consider “alternative financial strategies.” Both use liquid underlying investments—that is, investments that can be freely bought and sold. The liquidity of the underlying investments is one of the principal determinants of whether a strategy is suitable for use in a mutual fund, which is where many of the strategies I discussed are being deployed.

Another category of alternative financial strategies uses illiquid underlying investments, which cannot be freely and quickly bought and sold. Private equity, which invests in entire companies, is a good example of this. Yet another class of alternatives, which we call real assets and which includes real estate, also is illiquid. Because the underlying assets are illiquid—for example, a company or an office building—it can be difficult for the manager to allow investors to pull their money out at short notice. Because of this, the legal structure often limits investors’ rights to redeem.

Liquidity is valuable. It allows you to access your money when you need it and to pull it out when things aren’t going your way. Why would you want to surrender those rights? More to the point, what benefits can you expect in return for those costs?

There are potentially good reasons to put part of your portfolio in illiquid investments. In theory, illiquid investments should generate a higher return—the illiquidity premium—to compensate for the greater risk involved. To illustrate where this premium might come from, consider the market for a stock, as compared with the market for a company. With stocks, there are millions of investors, thousands of analysts, hundreds of websites, and so forth. Because shares are traded publicly, based on widely available information, with bids and asks disclosed down to the hundredth of a second, it is tough to get a bargain. This is an efficient market.

Now consider buying a company. If it is a private company, there are usually few bidders, maybe only one. Information isn’t available to the same degree as for a public company, making bidders’ offers less certain—and therefore lower. Bids and asks are not widely disclosed. Each company is different from every other company, making comparisons difficult. This is an inefficient market.

Illiquid markets are, by their nature, less efficient than liquid markets, which opens the possibility for higher returns, as there is more opportunity to buy something cheaply. The flip side, of course, is that it’s equally possible to get lower returns. This is why the quality of the manager is so important for illiquid investments, because you’re stuck with them.

Most of our research and due diligence process here at Commonwealth is based on understanding the management company and the actual people who manage the investments—where they’ve come from, how they think, and how their strategies fit into the economic and market environment as we understand it. We do this for all products, but especially for the illiquid ones. With these products, even more than for the liquid products, management matters.

Tomorrow, I’ll focus on some of the illiquid asset classes and how they can fit into investors’ portfolios.

This material is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Investing in alternative investments may not be suitable for all investors and involves special risks, such as risk associated with leveraging the investment, adverse market forces, regulatory changes, and illiquidity. There is no assurance that the investment objective will be attained.

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