Liquidity may be an appealing characteristic for an investment, but a growing base of research is finding that illiquidity may be even more desirable. Because ironically, demand for illiquid investments is so low, that they appear to carry a persistent excess return premium – a view popularized in recent years by those like David Swensen of Yale Endowment, who racked up a whopping 13.9% annual return for the past 20 years in large part by relying heavily on illiquid investments.
Of course, the first caveat to investing in illiquid assets is that it is only appropriate for the portion of investments that the investor can afford to segment into illiquid holdings. Yet the more significant (albeit more nuanced) danger of investing in illiquidity is that the return premium is only a benefit for an otherwise sound investment. For a bad investment, owning one that is also illiquid just compounds the problem by locking the investor in!
And notably, a bad investment is not just one with poor economic fundamentals, but also one where the interests of the investment manager and the investor themselves are not well aligned – leading to situations where even an appealing investment at first turns out to sour later, as has occurred with illiquid investments from various hedge funds, to certain life insurance and annuity products, and more recently with nontraded REITs.
Yet perhaps the greatest misalignment of interests is simply the one that occurs when illiquid investments are sold by salespeople who benefit in the short-term while an investor is locked into the illiquidity for the long run. In other words, illiquid investments may be one situation that is especially appropriate for the involvement of a fiduciary where long-term economic interests are aligned – which goes a long way to explain why illiquidity has served institutional investors like the Yale Endowment so well, even as for the individual investor it so often goes awry!