If a person has no liquidity, it often means they don't have any money. But if an investment is not liquid, it means that it’s difficult to cash it in quickly. The term used for this is "illiquid". It doesn't take a second to sell Nestlé shares. But in terms of the patience required, private equity funds, where investors don't see their money again for five, six, or even more years, are at the other end of the spectrum. If investors urgently need access to their money in the meantime, they have a problem. As a result, if there’s a choice between two otherwise identical investments, everyone will prefer the more liquid one.
Patience pays off
In view of this situation, less liquid investments have to offer advantages in terms of returns. According to Daniel Egger, head of investment at private bank Maerki Baumann & Co., this "illiquidity premium" really does exist. He explains that institutional investors with a long time horizon can access this premium, as can wealthy individuals who do not require access to all their money.
So-called alternative investments include investment products (hedge funds and private equity) alongside tangible assets such as commodities, real estate and works of art. In other words, any investment other than stocks or bonds belongs to this category. It comes as little surprise that there is a high level of interest in alternative investments at present. However, simply making investments based on promised returns is never worthy of the term investment strategy.
Individuals who do not have particular specialist knowledge and who also lack the time and inclination to acquire this expertise face a problem due to the complexity of some alternative investments. Eric Steinhauser, head of investment at private bank Rahn & Bodmer, advises investors to ask themselves whether such investments really do meet their own objectives, and whether the large amount of time required to select and monitor such investments is actually worth it. Buying your own home is an alternative investment that everyone understands. The same is true of gold bars kept in a safe. According to Steinhauser, people should only invest in other alternative investments if they have specialist knowledge, or have received professional advice. He explains that this can also ensure that the investment suits the client and his or her financial planning. He goes on to say that otherwise the risk is high that the disillusioned client will at some stage ask whether it might have been better to hold cash.
Not as complex as you might think
The maxim: don't buy anything you don't understand, is justified. However, there are no real secrets involved in classifying hedge funds according to the way they work. The book "Alternative Investments" by authors Mostowfi and Meier offers a good introduction. For example, the most widely used strategy is known as long short equity. These funds take positions on both rising as well as falling stock prices. This approach makes it possible to lower the risk in comparison with traditional equity funds.
Managers of such funds try to buy undervalued and sell overvalued stocks. Of course, this strategy is only successful if the stock prices reflect how things really stand at a company. This is not always the case, as in the recent past, expansionary monetary policy has boosted stock prices across the board. Equity prices have moved in the way described by the old saying: a rising tide lifts all boats. In fact, the high correlation between stocks has made it difficult to earn money from short selling, comments Nicolas Campiche, who heads the alternative investments business at private bank Pictet. However, he goes on to say that this has now changed. For investors who took positions on falling stock prices, 2015 was a very successful year. CTAs (commodity trading advisors) are another hedge fund category. In simple terms, they follow price trends across a range of different markets. The software that guides the investment fund may be clever. But this type of fund is generally founded on the basic principle that what went up yesterday will continue rising today. Global macro, another strategy, is not based on the analysis of individual firms, but on macroeconomic developments. Campiche believes that thanks to the expected interest rate hikes in the US and other measures implemented by the central banks, there should be a wide range of areas where these two strategies can be used in future.
For large and small budgets
Direct investments in hedge funds require putting in millions of dollars. For investors whose total assets are below CHF 100 million, funds of hedge funds are the only practical way to access this form of investment. These funds even allow investments in the low five figures. The vehicles take care of choosing the individual hedge funds themselves. Their liquidity is restricted, although not to an extreme extent. At Pictet, for example, redemptions are possible either weekly or quarterly, depending on the fund.
Private equity funds, in which the money invested is tied up for years, are even more illiquid. These investments are also only available to a restricted group of people as the minimum investments are even higher – generally six-figure sums and above. The funds invest in companies that are not listed on the stock market. However, Campiche explains that the prices of listed companies do have an effect on the prices of private companies. He adds that is therefore difficult at present for private equity funds to buy companies at favorable prices.
In contrast, commodities are considered cheap at the moment. Yet because they do not generate any yields, you need to pick the right time to benefit from rising prices. The chances of a private investor without specific expertise making a long-term success of this are relatively small. Nevertheless, the prices of commodities do not move in tandem with stock prices, which means that they really can contribute to diversifying a portfolio. Daniel Egger believes that opportunities currently outweigh the risks, given that agricultural commodities are so cheap by historical standards.
Illiquidity as an advantage?
Private equity and hedge funds in particular are often criticized because their products are seen as too complex, too expensive, and – in the worst case scenario – impossible to sell. If this were actually the case, why would the largest investors in the US, foundations with billions in assets and family offices, invest half their wealth or even more in alternative investments? One reason is undoubtedly the expertise that such investors have. However, the long investment horizon is likely to be just as important.
How many private investors describe themselves as long-term investors, only to panic when a crisis arises and they sell? Illiquidity can be seen as a disadvantage, but also as a benefit. Looking back, more than a few investors have wished they’d been forced to simply sit out a poor year. The freedom to take action also means you’re free to sell at the worst possible time. As a result, when it comes to making investment decisions, alternative investments should not be a secondary consideration because of their illiquidity. If you really are prepared to invest for the long term, you should assign the necessary weight to these investments.
Financial Personality Test
If you want to find the right investment strategy, it’s important to assess your risk tolerance correctly. That’s where the UBS Financial Personality Test comes in.