In this commentary the European family office addresses the risks of being overly concerned with having liquid assets.
The following commentary comes from Christian Armbruester, chief investment officer of the European firm Blu Family Office, who regularly airs views on topics in these pages. In this short note, he talks about whether investors can become overly-concerned about liquidity to the detriment of other goals. 10 years on from the financial crash, investors may remember only too well how market liquidity can vanish, leaving even the most cautious asset allocation decisions in trouble. A key issue is understanding the full balance sheet of a client’s life to ensure that liabilities are matched by available cashflow – no more and no less. Famously, the “Yale Model” of investing, developed at the university endowment fund that gave it the name, was built around the idea that investors often over-pay for the ability to have liquid assets and sacrifice returns, while in fact they should and could hold more relatively illiquid, long-term, assets instead. This is, as one can appreciate, a complex field.
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People seem to be obsessed with liquidity. Accordingly, investment strategies that can offer daily liquidity have been in high demand, particularly when wrapped into so-called UCITS funds. It is estimated that nearly $9 trillion is now invested in these investment structures that are also approved for retail investors. Apparently, everyone, including the regulator, think high liquidity is also equal to low risk. But, is this really true and are we potentially missing out on a great part (and returns) of the investment universe?
Surely liquidity is a risk factor - after all, the ability to get out whenever one wants is a great way to take risk off the table, almost immediately. But then again it isn’t the only risk factor and just because something is liquid doesn’t necessarily mean it is low-risk, either. For example, you could hold crypto-currencies, high yield bonds or penny stocks, for that matter, and although very liquid, the risk would be much higher than a long-term, senior-secured lending strategy, for example.
Moreover, by foregoing strategies with longer lock-ups, we are also very plainly missing out on getting rewarded for illiquidity. Depending on how long you choose to tie up your capital, the premium can be as high as 5 per cent a year. Compounded over time, that is a huge opportunity cost in missed performance, making it very clear that only limiting yourself to liquid strategies is too expensive a cost to bear. There are many private equity funds, real estate, or lending strategies that require lock-ups of more than five and even 10 years. The returns have also been outsized and I would argue that to make double digit returns in the current low interest rate environment is nigh impossible, without giving up liquidity.
By only holding liquid investments we are also restricting our investment universe to so-called “plain-vanilla” strategies. The problem with UCITS, is that in an attempt to “reduce risk”, strategies are extremely restricted in using many of the tools to hedge specifics risks. There are limits to leverage, the ability to short certain instruments and how much can be invested into individual vehicles (products). That means most alternative strategies simply can’t be executed effectively in a UCITS structure. As such, we would also be missing out on much needed diversification in a market environment where public bond and stock markets are at historic highs.
But, by far the most important reason why you should never only hold liquid instruments is, no one in their right mind would actually ever choose to sell their entire portfolio in one day. If you go back in history, when has it ever been a good idea to get out of the markets completely? Sure, you can rebalance opportunistically when there is an adverse market event, but that doesn’t mean you sell your entire portfolio to buy something else. In fact, the only reason you would ever do anything so drastic, is if you either panicked or you were trying to time the market. Either way, it is not something we would advise doing, particularly for long-term investors.
Bringing it all together, liquidity is important, and it allows us to manage our portfolio seamlessly as we naturally rebalance our investment allocations or need to take some of our monies out for unforeseen events.
But, given that we have the ability to plan our wealth management strategy, there really shouldn’t be any reason to hold more than 25 per cent of our investments in daily liquidity terms. The rest can be tied up for longer, and why shouldn’t it? After all, we are also investing for the long term and it makes no sense to pay for something we actually don’t need and forgo much needed diversification.