Illiquidity premium is the excess return an investor stands to earn in an illiquid asset, compared to a similar investment in a liquid asset. As opposed to publicly traded investments such as Treasury bonds, stocks and bank placements, that are liquid, meaning investors can quickly buy or sell them to access capital, illiquid investments majorly trade in the private markets commonly referred to as alternative markets.
Alternative markets have consistently outpaced their liquid counterparts in the public markets in return. They include private equity, corporate debt and real estate. Whereas, illiquidity can be defined as a state in which an investment cannot readily be converted into cash at a particular period without loss of value, illiquidity premium demystifies the myth of always associating illiquidity with risk and further justifies the importance of having a portion of your portfolio in illiquid assets, and why illiquidity can be a good strategy to introduce in a portfolio.
Assets in the alternative markets often give investors access to diversified, rare and high quality opportunities that have no correlation to the public markets. Real estate in particular is considered as an illiquid asset since it is lengthy to execute, often expensive to transact and sometimes complex to understand. Therefore, it largely relies on the skill, expertise and track record of the fund manager to successfully afford illiquidity premium to the investor.
Firstly, the fund manager must have boots on the ground to do a rigorous research on location, since real estate is about location, location and location. The nearer one develops to a source the higher the property value. Secondly, demonstrate an appealing development concept, and lastly, ensure that he incurs the right development costs during the construction period.
Investment is a function of two parameters- amount of capital committed and the period of investment. Therefore, investors with the appetite of illiquidity premium should consider a long-term investment horizon to exploit this strategy. Asset-class real estate has private valuations that respond slowly to economic downturns compared to investments in the public markets. This underscores the fact that, besides illiquidity premium, real estate is also a stable appreciating asset, if professionally executed it can provide downturn protection against market volatilities. This unique characteristic can help investors balance their portfolios in an efficient and effective way, especially during a crisis period.
Further, both direct investments in real estate, such as property and indirect investments, such as real-estate backed funds can be a form of a ‘forced saving plan’ that can benefit investors with recurring revenue. This revenue comes in form of regular coupons throughout the investment period. Since investing can be emotive, and in saving, more often than not, we are our own worst enemies, real estate keeps the investor away from accessing the cash that one could have otherwise cashed-out with ease were it invested in liquid investments in the public markets.
Therefore, illiquidity as a strategy can be a great concept in personal wealth management. Investors awash with capital should consider. However, it is important to understand individual investment priorities before making an investment decision. Asset allocation, at its most basic level is premised on three pillars that include; investor risk tolerance, investment horizon and the rate of return.