Understanding the Liquidity of Alternative Investments: What You Need to Know

Liquidity is a crucial factor to consider when building an investment portfolio, as it determines how easily an asset can be converted into cash without a significant loss in value. When it comes to alternative investments, liquidity varies significantly depending on the asset type, making it essential for investors to understand the trade-offs between liquidity, risk, and return.

What is Liquidity?

Liquidity refers to how quickly and easily an asset can be converted into cash without affecting its price. Highly liquid assets, like stocks or bonds, can be sold quickly at their current market price. On the other hand, less liquid assets, such as real estate or private equity, may take longer to sell and might not achieve the expected price due to the time it takes to find a buyer or navigate legal processes.

Generally, the easier and faster an asset can be sold, the more liquid it is. However, liquidity can come at the cost of potentially lower returns compared to less liquid investments, which often provide higher potential yields as compensation for their illiquidity.

Alternative Investments with High Liquidity

Alternative investments cover a broad range of asset types, and some offer high liquidity, similar to more traditional investments like stocks and bonds. Liquid alternatives typically invest in public markets, which makes them easier to trade. These include:

Equities and Fixed Income: Alternative strategies that focus on publicly traded stocks or bonds are relatively liquid, allowing investors to enter and exit positions with ease.

Commodities and Currencies: Investing in commodities (such as gold or oil) and currencies offers investors a high degree of liquidity since these assets are traded on global markets.

Derivatives: Contracts tied to the performance of other financial instruments, such as options and futures, can also be highly liquid, provided they are linked to publicly traded assets.

The advantage of these alternative investments is that they allow for quick access to cash if needed, making them suitable for investors who may need flexibility or prefer more frequent portfolio rebalancing. However, high liquidity often correlates with lower returns compared to less liquid alternatives.

Less Liquid Alternative Investments

In contrast to liquid alternatives, some investment vehicles are considered illiquid, meaning they take more time and effort to convert into cash. These often belong to the private market space and give investors access to unique opportunities with higher return potential. Less liquid alternative investments include:

Private Equity: Involves investing in private companies or ventures that are not publicly traded. Investors typically need to commit their capital for extended periods, often several years, until the company reaches a liquidity event, such as a public offering or acquisition.

Private Credit: This refers to lending to private companies, which typically comes with longer lock-up periods for investors.

Infrastructure: Investments in public infrastructure projects, such as transportation systems or utilities, can provide stable long-term returns but are generally illiquid due to the complexity of these projects.

Real Estate: While real estate is a tangible asset, selling properties or stakes in private real estate funds takes time and effort, making this an illiquid alternative investment.

The trade-off for this illiquidity is the potential for higher returns, as investors are often rewarded for the patience required to hold these assets long-term.

The Benefits and Drawbacks of High Liquidity

High liquidity is generally viewed as a positive attribute because it allows investors to quickly access their money when needed. In volatile market environments, liquidity provides flexibility, enabling investors to reposition or sell assets to take advantage of new opportunities or mitigate losses. For those with short-term needs or uncertain cash flow requirements, liquid assets are highly desirable.

However, the main drawback is that highly liquid investments can offer lower returns than illiquid investments. This is largely because when you need the money, the investment may not be performing well due to greater fluctuations. Investors may need to forgo potential gains in exchange for liquidity, making it less appealing for those with a long-term investment horizon who are willing to wait for the possibility of higher returns. In short, while liquidity provides flexibility, it may also limit the opportunity for substantial growth.

MICs and Mortgage Pooled Funds: A Balanced Approach

Mortgage Investment Corporations (MICs) present an interesting option when considering liquidity in alternative investments. MICs pool investor capital to fund private mortgages, providing exposure to real estate without the direct responsibility of managing properties. While real estate itself is generally considered an illiquid asset, MICs offer investors a degree of liquidity through pooled mortgage funds unavailable to those who own physical properties.

In a MIC, the mortgage loans are structured to provide consistent interest payments, which can either be distributed to investors as income or reinvested to compound over time. Moreover, MICs are uniquely positioned to benefit from interest rate changes. Unlike real estate ownership, where rising interest rates may result in increased costs for property owners, MICs can offer investors a more stable return as mortgage interest rates rise.

Although MICs do not offer the same liquidity as stocks or bonds, they do provide a middle ground. Investors can often sell their shares in a MIC, though this may require a notice period or come with some restrictions. This level of liquidity, combined with the income potential from real estate-backed mortgages, makes MICs a compelling option for those seeking real estate exposure with more flexibility than traditional property ownership.

To learn more about how mortgage pooled investments can fit into your portfolio, contact Jordan on our team for expert guidance and insights.