Portfolio values can fall slowly at first, and then very quickly, with some of the pain potentially delayed as the valuations of illiquid and less liquid assets are updated less frequently than assets such as equities.
Many alternative assets, in areas such as private equity and physical property, update only quarterly, so the scale of any downturn may not be immediately apparent.
The challenge for many investors may be that the assets that are least correlated with equities and bonds tend to be less liquid than those asset classes.
Mark Lane, head of active funds at Progeny, says the problem with owning fewer liquid assets is not simply that they may fall in value without a client noticing, but also the lack of ability to sell those assets to fund better opportunities that may come along creates an opportunity cost to owning them.
But if one wants to be diversified, what are the options?
Simon King, chief investment officer at Vermeer Partners, says liquidity is to some extent a subjective consideration, as the needs of each client are different, and from King’s perspective as long as the liquidity of the asset matches the time horizon of the client, then liquidity should not be a major consideration.
Ross Crake of Osprey Wealth says another key consideration is around whether an investor is getting rewarded for the lack of liquidity via the “liquidity premium”.
This is the idea that an asset which is less liquid should trade at a lower valuation than the equivalent asset that is liquid, and so, potentially, offer the client a greater potential return.
But Crake says caution is still warranted: “However, it can also be a negative. For example, direct property is highly illiquid with a high individual unit cost. Investors are therefore unable to benefit from holding such assets in tax-efficient wrappers such as Isas.
"Given that rental income is subject to income tax and there are capital gains considerations, this can be a big drag on returns over time. It also makes planning more difficult as a capital gain on a property will have to be realised in one transaction whereas with investments in traditional investments, it is possible to just sell enough units to utilise tax-free allowances each year (while they are still available)."
Simon Molica, senior investment manager at Parmenion, says that as liquidity is “probably what you have to compromise on”, when allocating to alternative assets, it is important to understand the liquidity profile of the investments.
He says: “You need to be aware what alternative you are selecting and ensure it matches your preferences. Investors only recently became aware of the liquidity mismatch in open-ended property funds when they started suspending.
"Liquidity is possibly the compromise when it comes to alternatives and so it is very important to do your homework when it comes to investing in alternative assets.”
Dan Boardman-Weston, chief executive at BRI Wealth, is keen to own assets such as physical property and infrastructure, but says he will only own those through listed investment trusts, as he feels that owning such assets through an open-ended fund is “stupid”.
The challenge is that owning such assets through a listed fund has the potential side-effect of reducing the diversification benefits, as those vehicles are listed, so exposed to equity market volatility.
Boardman-Weston adds that he anticipates some of the assets in this area of the market have the capacity to deliver double digit returns this year, when the yield and the capital appreciation are considered, and he regards this as superior to the potential yields on offer from bonds, so he tends to have such assets in the portfolio at the expense of part of the bond allocation.
Rory Maguire, chief investment officer at Fundhouse, is sceptical that many alternative assets reward clients sufficiently for the lack of liquidity.
Philip Waller, an investment specialist in the alternative solutions business at JPMorgan Asset Management, says: “Liquidity is a crucial consideration when building allocations to alternative assets.
"Alternative assets, such as private equity, real estate, hedge funds, and infrastructure, often have lower liquidity compared to traditional assets like stocks and bonds. This means they can be harder to buy or sell quickly.
"When investing in alternative assets, investors need to carefully assess their liquidity needs and ensure they have sufficient liquid assets to meet short and medium-term obligations/liabilities. This involves balancing the portfolio with a mix of liquid and illiquid assets to maintain flexibility and avoid potential liquidity mismatches.
"As part of this, the investment horizon is a critical factor. Alternative assets are typically suited for long-term investors who can afford to lock up their capital for extended periods."
He adds: "In liquidity terms, not all alternative assets and structures are created equally. For example, certain hedge fund investments will typically provide greater liquidity than traditional private equity investments. Similarly, some alternatives, such as infrastructure and real estate, will provide a steady income which provides some form of ongoing liquidity.
“Diversifying across different types of alternative assets with varying liquidity profiles can help manage overall portfolio liquidity.”
David Thorpe is contributing editor at Asset Allocator
