Macro Minute: Week of October 28, 2024
Last week I wrote about micro vs macro. This week I want to cover another important topic, liquid vs illiquid. This is a topic that is very important to me. I always look at the liquidity of an investment at the onset. I define liquidity as the ability to get the value of an investment returned to you in a short, timely manner. When looking at the market, we have a wide range of instruments with varying degrees of liquidity. We also have phantom liquidity, meaning you may have the belief that you can sell the instrument and get the stated value but in reality, the price offered will be much less. Let’s dig in to some of the different types of investments and look at how liquidity will differ.
Let’s first look at some of the most liquid. Public markets provide great liquidity. Equities in general, and treasuries, are some of the most liquid securities. In general, these securities have a large pool of buyers and sellers exchanging shares of these securities for a stated price. These prices change second-by-second while the exchanges that they trade on are open. If you were to invest in these public securities, you could see exactly what the value of that investment is whenever you like. You do have some securities that transact on public exchanges that have phantom liquidity. They are usually small companies and niche bonds. While you can still usually sell these securities in a reasonable time frame, you just need to be aware that sometimes these securities do not transact often or in great quantity. For example, if you hold 10,000 shares XYZ stock and the stated price on the exchange for that security is $20, you could expect to get close to $20 a share if more than 10,000 shares trade in that security daily and you set a limit sell order of $20. The same thing is true for bonds. Sometimes bonds do not trade often on exchanges, and the stated price can differ from what is actually received.
The next investment that offers limited liquidity are interval funds. These investments have windows of liquidity with limits on the total amount of redemptions. These typically will be set up like this, once a month or quarter you can buy or sell into the investment as long as the amount being sold is not more than 5% of the total value of the fund. This investment bridges the gap between liquid and illiquid and can provide a daily price, or may only be priced monthly.
The last piece of the liquidity landscape are truly illiquid investments. These can range from private equity to real estate to opportunity zones. Typically, you pledge a certain amount of capital for a minimum amount of time. Sometimes you will pay the initial investment upfront and sometimes you pay over time. Typically, you agree to receive your investment back plus whatever return is generated 7 to 10 years later. The time can vary, but it is almost always years later. You also only get values irregularly. This may be monthly, quarterly, or yearly depending on the structure. In the form of opportunity zones, you qualify for special tax parameters if held for 10 years.
The biggest takeaway is to know going into an investment what the liquidity will be. Make sure that if you are allocating money to an illiquid investment, you are okay getting back less than you put in, even if what you get back is years later. I have seen illiquid investments return much better than liquid investments over the same time period, and I have seen some that were complete losses. Either way, just know there is a cost associated with having money locked up in an illiquid investment.
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