Liquid vs. Illiquid Assets

Liquid vs. illiquid assets: should we prefer one or the other, or is a mix better? As with all investments, it depends on a variety of factors. Liquidity is perhaps one of the most important elements an investor must consider when analyzing an asset. In this blog, we seek to outline some of the pros and cons of liquid and illiquid investments.

Investments come in a variety of shapes and sizes, and they all have different degrees of liquidity. For proper portfolio management, it is essential to have a solid grasp of the liquidity profile of each investment.

In the world of finance, liquidity refers to the ease with which an asset can be converted to another asset, typically cash, without affecting its market price – in other words, how easily the asset can be “liquidated” in the market. Assets can be both tangible and intangible. Intangible assets include stocks, bonds, and other securities. Tangible assets include art, collectibles, and real estate.

From a liquidity standpoint, tangibles can be harder to convert to other assets like cash, thus they are generally considered illiquid assets. On the other side of the spectrum, we have cash, which is universally accepted to be the most liquid asset because of the ease with which it can be converted to other assets. However, tangibility is not necessarily a definitive indicator of an asset’s liquidity. For example, a thinly traded, low volume, over-the-counter penny stock may be much harder to sell out of than, say, a tangible asset like a popular luxury purse.

Source: Seeking Alpha

Cash is considered to be the most liquid asset, followed by cash equivalents like certificates of deposit. In the liquidity scale, instruments such as marketable securities like equities or stocks come next, and then debt securities like bonds. Within these asset categories, nuances arise that offer varying degrees of liquidity.

Often the most important factor in determining liquidity is the available supply of bids and offers (e.g., market makers indicating the prices at which they would purchase or sell a security, respectively). Take the equities universe for example. The stocks with higher levels of liquidity will be the mega caps, in other words, companies that have achieved market capitalizations of more than $200 billion. These companies are targeted by retail and institutional investors alike, and owing to the large available quantity of securities, are traded with high frequency. The most illiquid stocks will be those that are consistently overlooked by the crowd, with small floats, limited public interest from investors, and are often some of the least valuable securities within the equity markets.

When it comes to debt securities an investor could reference credit ratings issued by third parties to assess risk and in turn, liquidity. As shown in the image below, credit ratings will rank debt securities from lowest risk, the AAA’s, to highest risk, bonds currently in default (the D’s). As bonds drop in credit rating, generally speaking, a smaller pool of institutional investors have a mandate to invest in these riskier assets, and therefore the overall demand (and available “offers”) for these bonds is typically lower than those of higher credit quality assets. As a result, just like in equities, riskier bonds, also called junk bonds, will offer the lowest amount of liquidity, but could offer the highest reward.

“Illiquidity” in essence occurs when an asset cannot be traded or sold with ease and without incurring a loss in value relative to its “fair market” value. Typically, with illiquid investments, an investor will require compensation for the added risk of parking their capital in an asset that may not be able to be sold for a long duration. This added compensation that is built into the return of an investment is referred to as the liquidity premium. As a rule of thumb, the more illiquid an investment is, the greater the risk and associated liquidity premium will be.

Looking at an example of an illiquid investment, unlike stocks and bonds, real estate can’t be traded in an exchange daily. The ability to convert real estate into cash or into another asset type is on the tougher side of things. Therefore, real estate, like collectibles and art, is an illiquid asset. To put it into perspective, buyers of $10,000,000 houses are not as common as buyers of $100 stocks.

Note that degrees of liquidity within the illiquid side will vary just as on the liquid side. There is real estate that is more desirable, and there is real estate that is not so desirable. Other asset classes that sit on the illiquid side include Hedge Funds and Private Market Funds. Liquidity terms amongst these funds will vary.

So, liquid vs. illiquid assets, what is better? There is no definitive answer and depends on many factors including the investor’s sophistication level, risk appetite, and investment objectives. To help understand the distinctions, let’s first examine some pros and cons for each type.

Liquid assets can be easily converted to other asset types. Certainly, it is nice to have an asset with that option embedded, especially when you are facing some sort of emergency and need cash, for example immediately. Investors with very short-term horizons would most likely benefit more from liquid investments.

High levels of liquidity have downsides though There is a correlation between liquidity and risk. The safest bets will often be very liquid, and thus will offer the lowest reward. Liquid assets like cash are more susceptible to suffering more from inflation, owing to their often lower returns (as a result of the lower risk profiles). Sometimes, it could be best to only have the option to buy and hold rather than also having the option to sell.

Illiquid investments tend to be less accessible to investors. Owing in part to their lower liquidity, they are deemed to be riskier assets than liquid investments, and as a result, are not available for all types of investors. Oddly, one of the potential benefits of buying into the illiquid is that you cannot sell as easily, and therefore may not be subject to the same type of volatility that highly liquid assets may experience. Another potential benefit illiquid private market investments offer is diversification away from the public markets, which could allow investors to avoid additional volatility to some degree.

Liquidity refers to the ease with which an asset can be converted into another asset like cash without affecting its market price. “Illiquidity” in essence occurs when an asset cannot be traded or sold with ease and without incurring a loss in value relative to its “fair market” value. Typically, with illiquid investments, an investor will require compensation for the added risk of parking their capital in an asset that may not be able to be sold for a long duration. In the debate between liquid vs. illiquid assets, there is no definitive answer, and depends on many factors including the investor’s sophistication level, risk appetite, and investment objectives.

Sources:
Investopedia, March 2022. “Understanding Liquidity and How to Measure It”
Investopedia, December 2021. “Illiquid”
Forbes, August 2021. “Understanding Liquidity and Liquid Assets”
Kiplinger, November 2021. “5 Mega-Cap Stocks Analysts Love the Most”
U.S. News, March 2020. “3 Rules for Buy and Hold Real Estate Investing”
Seeking Alpha, June 2019. “Different Asset Classes – Part I”
SEC, October 2017. “The ABCs of Credit Ratings”