The Case for Illiquidity

A lack of liquidity is a very good match when investing for the long term.

You really want long term thinking? Really want it?

Put your money where your mouth is, and lock it into a private equity fund for 10+ years - no risk of getting cold feet later.

Illiquid assets are also a nice way of delaying bad news. There's no better way to convey losses than reporting them next month or next quarter!

A while back I wrote about a hypothetical way to convert returns which exhibit a vanilla beta of 1 into -1 using a sleight of hand; in a similar vein you can see how illiquidity might help institutional portfolio managers.

Just delaying reporting of accumulated returns has a big impact on portfolio betas.

If we have a fund that accumulates S&P 500 returns on a weekly basis and then publishes its current value; that fund will report a beta of 0.18 compared to liquid daily returns.

Many hedge funds report on a monthly basis. A hedge fund which invests in the S&P 500 but reports monthly, will have a beta of 0.037.

Finally private equity funds report every quarter; such a fund which just invests in the S&P 500 instead would report a beta of 0.006.

Obviously, you need to calculate like with like! No doubt the calculations are wrong, but it underlines the qualitative advantage such 'alternative investments' have over their more vanilla liquid counterparts.

That's not to mention owning assets which cannot be easily marked to market. Sensible pricing of such assets often only happens at purchase and sale.

For example, if your PE fund has bought a Japanese golf course in 2005, that would mean that the price you report has virtually been left untouched by reality until you sell it on this year.

All those awkward chasmic drops over the past decade can be papered over quite nicely.

The thing is, this is exactly why institutional investors love alternative investments, while everything else is going down the pan their alternates seem to be telling a good story.

In reality of course, Japanese golf courses are no more immune to earthquakes, stock market crashes and nuclear meltdowns than any other company.

All those alternative investment fees serve as tickets to a little escapism.